e10vq

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended June 30, 2005


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

FOR THE TRANSITION PERIOD FROM___________TO____________.

Commission file number: 000-50463

Callidus Software Inc.

(Exact name of registrant as specified in its charter)


Delaware		77-0438629
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

Callidus Software Inc.
160 West Santa Clara Street, Suite 1500
San Jose, CA 95113
(Address of principal executive offices, including zip code)

(408) 808-6400
(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 requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act. Yes o No þ

The aggregate market value of the voting and non-voting stock held by non-affiliates of the Registrant, based on the closing sale price of the Registrant’s common stock on June 30, 2005, as reported on the Nasdaq National Market, was approximately $43.7 million. Shares of common stock held by each executive officer and director and by each person who may be deemed to be an affiliate of the Registrant have been excluded from this computation. The determination of affiliate status for this purpose is not necessarily a conclusive determination for other purposes. There were 26,296,101 shares of the registrant’s common stock, par value $0.001, outstanding on August 5, 2005, the latest practicable date prior to the filing of this report.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

CALLIDUS SOFTWARE INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amount; unaudited)


	June 30,			December 31,
	2005			2004
ASSETS
Current assets:
Cash and cash equivalents	$	11,644		$	7,651
Short-term investments		47,760			52,166
Accounts receivable, net		8,767			12,126
Prepaids and other current assets		1,882			1,868

Total current assets		70,053			73,811
Property and equipment, net		3,163			3,361
Deposits and other assets		1,587			1,317

Total assets	$	74,803		$	78,489

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	1,489		$	1,904
Current portion of long-term debt		221			471
Accrued payroll and related expenses		3,700			3,827
Accrued expenses		1,497			1,881
Deferred revenue		7,958			6,856

Total current liabilities		14,865			14,939

Long-term debt, less current portion		—			48
Deferred rent		323			292
Long-term deferred revenue		31			178

Total liabilities		15,219			15,457


Stockholders’ equity:
Common stock; $0.001 par value; 100,000 shares authorized; 26,210 and 25,255 shares issued and outstanding at June 30, 2005 and December 31, 2004, respectively		26			26
Additional paid-in capital		186,213			184,443
Deferred stock-based compensation		(1,288	)		(2,316	)
Accumulated other comprehensive income		74			108
Accumulated deficit		(125,441	)		(119,229	)

Total stockholders’ equity		59,584			63,032

Total liabilities and stockholders’ equity	$	74,803		$	78,489

See accompanying notes to condensed consolidated financial statements (unaudited).

CALLIDUS SOFTWARE INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
	(In thousands, except per share data)
Revenues:
License revenues	$	1,295		$	1,889		$	4,795		$	6,428
Maintenance and service revenues		11,320			11,345			22,321			23,268

Total revenues		12,615			13,234			27,116			29,696
Cost of revenues:
License revenues		86			286			183			549
Maintenance and service revenues		7,684			8,384			14,864			16,994
Impairment of purchased technology		—			1,800			—			1,800

Total cost of revenues		7,770			10,470			15,047			19,343

Gross profit		4,845			2,764			12,069			10,353
Operating expenses:
Sales and marketing		3,549			5,345			7,961			11,745
Research and development		2,838			3,876			5,789			7,586
General and administrative		2,140			2,774			4,342			4,746
Impairment of intangible assets		—			1,994			—			1,994
Stock-based compensation (1)		423			2,721			863			4,465

Total operating expenses		8,950			16,710			18,955			30,536

Operating loss		(4,105	)		(13,946	)		(6,886	)		(20,183	)
Other income (expense), net:
Interest expense		(5	)		(16	)		(16	)		(95	)
Interest and other income, net		358			272			681			544

Loss before provision (benefit) for income taxes		(3,752	)		(13,690	)		(6,221	)		(19,734	)
Provision (benefit) for income taxes		(34	)		25			(9	)		50

Net loss	$	(3,718	)	$	(13,715	)	$	(6,212	)	$	(19,784	)

Basic net loss per share	$	(0.14	)	$	(0.57	)	$	(0.24	)	$	(0.82	)

Diluted net loss per share	$	(0.14	)	$	(0.57	)	$	(0.24	)	$	(0.82	)

Shares used in basic per share computation		26,144			24,204			25,948			24,095

Shares used in diluted per share computation		26,144			24,204			25,948			24,095


(1)		Stock-based compensation consists of:


Cost of maintenance and service revenues	$	41	$	193	$	91	$	441
Sales and marketing		63		457		189		952
Research and development		102		311		226		669
General and administrative		217		1,760		357		2,403

Total stock-based compensation	$	423	$	2,721	$	863	$	4,465

See accompanying notes to condensed consolidated financial statements (unaudited).

CALLIDUS SOFTWARE INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)


	Six Months Ended June 30,
	2005			2004
	(In thousands)
Cash flows from operating activities:
Net loss	$	(6,212	)	$	(19,784	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation & amortization		813			737
Amortization of intangible assets		—			359
Provision for doubtful accounts and sales returns		290			1,807
Stock-based compensation		863			4,465
Non-cash expenses associated with non-employee options and warrants		4			68
Impairment of intangible assets		—			3,794
Net amortization on investments		297			354
Changes in operating assets and liabilities:
Accounts receivable		3,043			2,956
Prepaids and other current assets		(20	)		(201	)
Other assets		(276	)		(1,000	)
Accounts payable		(411	)		(1,249	)
Accrued payroll and related expenses		(117	)		1,233
Accrued expenses		(345	)		1,407
Deferred revenue		999			(1,523	)

Net cash used in operating activities		(1,072	)		(6,577	)

Cash flows from investing activities:
Purchase of investments		(15,012	)		(39,858	)
Proceeds from maturities and sales of investments		19,200			40,350
Purchases of property and equipment		(616	)		(1,628	)
Purchase of intangible assets		—			(1,621	)
Decrease in deposits		—			332

Net cash provided by (used in) investing activities		3,572			(2,425	)

Cash flows from financing activities:
Repayments of long-term debt		(298	)		(381	)
Net proceeds from issuance of common stock and warrants		1,935			276

Net cash provided by (used in) financing activities		1,637			(105	)

Effect of exchange rates on cash and cash equivalents		(144	)		34

Net increase (decrease) in cash and cash equivalents		3,993			(9,073	)
Cash and cash equivalents at beginning of period		7,651			17,005

Cash and cash equivalents at end of period	$	11,644		$	7,932

Supplemental disclosures of cash flow information:
Cash paid for income taxes	$	—		$	163

Cash paid for interest	$	5		$	35

Noncash investing and financing activities:
Reversal of stock compensation expense for cancellation of unvested stock options	$	248		$	1,473

See accompanying notes to condensed consolidated financial statements (unaudited).

CALLIDUS SOFTWARE INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying interim unaudited condensed consolidated financial statements have been prepared on substantially the same basis as the audited consolidated financial statements included in the Callidus Software Inc. Annual Report on Form 10-K for the year ended December 31, 2004. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to Securities and Exchange Commission (“SEC”) rules and regulations regarding interim financial statements. All amounts included herein related to the condensed consolidated financial statements as of June 30, 2005 and the three and six months ended June 30, 2005 and 2004 are unaudited and should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all necessary adjustments for the fair presentation of the Company’s financial position, results of operations and cash flows. The results of operations for the interim periods presented are not necessarily indicative of the operating results to be expected for any subsequent interim period or for the full fiscal year ending December 31, 2005.

Reclassifications

As a result of reclassifying auction rate securities from cash equivalents to short-term investments for all periods presented, the Company reclassified the purchases and sales of its auction rate securities and short-term municipal bonds in its Consolidated Statements of Cash Flows, which increased purchases of investments by $9.9 million and increased maturities of investments by $29.4 million for the six months ended June 30, 2004, with the offset to cash and cash equivalents.

Principles of Consolidation

Unless otherwise indicated, the consolidated financial statements include the accounts of Callidus Software Inc. and its wholly owned subsidiaries in the United Kingdom, Germany, Australia and Italy (collectively, the Company). All intercompany transactions and balances have been eliminated in consolidation.

Use of Estimates

Preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America and the rules and regulations of the SEC requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Management periodically evaluates such estimates and assumptions for continued reasonableness. Appropriate adjustments, if any, to the estimates used are made prospectively based upon such periodic evaluation. Actual results could differ from those estimates.

Valuation Accounts

Trade accounts receivable are recorded at the invoiced amount where revenue has been recognized and do not bear interest. The Company offsets gross trade accounts receivable with its allowance for doubtful accounts and sales return reserve. The allowance for doubtful accounts is the Company’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company reviews its allowance for doubtful accounts monthly. Past due balances over 90 days are reviewed individually for collectibility. Account balances are charged-off against the allowance after reasonable means of collection have been exhausted and the potential for recovery is considered remote. The sales return reserve is the Company’s best estimate of the probable amount of remediation services it will have to provide for ongoing professional service arrangements. To determine the adequacy of the sales return reserve, the Company analyzes historical experience of actual remediation service claims as well as current information on remediation service requests. Provisions for allowance for doubtful accounts are recorded in general and administrative expenses, while provisions for sales returns are offset against maintenance and service revenues.

Below is a summary of the changes in the Company’s valuation accounts for the six months ended June 30, 2005 and June 30, 2004 (in thousands):


	Balance at		Provision,
	beginning		net of						Balance at
	of period		recoveries			Write-offs			end of period
Allowance for doubtful accounts
Three months ended June 30, 2005	$	327	$	(33	)	$	(254	)	$	40
Three months ended June 30, 2004		338		32			—			370
Six months ended June 30, 2005	$	320	$	39		$	(319	)	$	40
Six months ended June 30, 2004		187		210			(27	)		370


	Balance at		Provision,		Remediation
	beginning		net of		Service			Balance at
	of period		recoveries		Claims			end of period
Sales return reserve
Three months ended June 30, 2005	$	394	$	89	$	(178	)	$	305
Three months ended June 30, 2004		915		789		(1,219	)		485
Six months ended June 30, 2005	$	537	$	251	$	(483	)	$	305
Six months ended June 30, 2004		647		1,597		(1,759	)		485

Restricted Cash

Included in deposits and other assets in the condensed consolidated balance sheets at June 30, 2005 and December 31, 2004 is restricted cash of $675,000 and $282,000, respectively, pledged as collateral for letters of credit used as security deposits on leased facilities for our New York, New York and San Jose, California offices. Restricted cash is included in deposits and other assets based on the expected term for the release of the restriction.

Stock-Based Compensation

The Company accounts for its stock-based employee compensation plans under the recognition and measurement principles of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under APB No. 25, deferred stock-based compensation expense is based on the difference, if any, on the date of the grant between the fair value of the Company’s stock and the exercise price of related equity awards. Deferred stock-based compensation is amortized and expensed on an accelerated basis over the corresponding vesting period, using the method outlined in Financial Accounting Standards Board (FASB) Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.

The following table illustrates the pro forma effect on net loss and loss per share as if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation for the three and six months ended June 30, 2005 and 2004 (in thousands, except per share amounts):


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2005			2004			2005			2004
Net loss as reported	$	(3,718	)	$	(13,715	)	$	(6,212	)	$	(19,784	)
Add: Stock-based employee compensation expense included in reported net loss, net of tax		423			2,721			863			4,465
Less: Stock-based employee compensation expense determined under the fair value method for all awards, net of tax		(934	)		(4,178	)		(1,852	)		(7,192	)

Pro forma net loss	$	(4,229	)	$	(15,172	)	$	(7,201	)	$	(22,511	)

Basic and diluted net loss per share, as reported	$	(0.14	)	$	(0.57	)	$	(0.24	)	$	(0.82	)

Pro forma basic and diluted net loss per share	$	(0.16	)	$	(0.63	)	$	(0.28	)	$	(0.93	)

For purposes of the foregoing fair value calculations, the Company used the Black-Scholes method. The assumptions used in computing the fair value of stock options or stock purchase rights are discussed in the remainder of this paragraph. The Company estimated the expected useful lives, giving consideration to the vesting and purchase periods, contractual lives, and the relationship between the exercise price and the fair market value of the Company’s common stock, among other factors. The expected volatility

was estimated giving consideration to the expected useful lives of the stock options and recent volatility of the Company’s common stock, among other factors. The risk-free interest rate is the U.S. Treasury bill rate for the relevant expected life. The fair value of stock options was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2005			2004			2005			2004
Stock Option Plans
Expected life (in years)		3.73			2.96			3.70			2.75
Risk-free interest rate		3.03	%		2.98	%		3.04	%		2.28	%
Volatility		72	%		77	%		69	%		80	%
Employee Stock Purchase Plan
Expected life (in years)		1.0			0.9			1.05			0.9
Risk-free interest rate		2.06	%		1.28	%		1.88	%		1.28	%
Volatility		49	%		70	%		56	%		70	%

The estimated fair value of stock-based awards to employees is based on a multiple-option valuation approach, and amortized over the options’ vesting period of generally four years with forfeitures being recognized as they occur. Purchase rights granted under the Employee Stock Purchase Plan are amortized over the respective purchase periods of six or twelve months.

The weighted-average estimated fair value of stock options granted during the three and six months ended June 30, 2005 were $1.68 and $1.74 per share, respectively. For the three and six months ended June 30, 2004 the weighted-average estimated fair value of stock options granted were $3.61 and $6.93, respectively. No stock option grants were made during the three and six months ended June 30, 2005 or 2004 with exercise prices below market price on the date of grant. The weighted-average estimated fair value of stock purchase rights granted under the Employee Stock Purchase Plan during the three and six months ended June 30, 2005 was $1.88 per share, including the 15% discount from the quoted market price. The weighted-average estimated fair value of stock purchase rights granted under the Employee Stock Purchase Plan during the three and six months ended June 30, 2004 was $5.72 per share, including the 15% discount from the quoted market price.

Net Loss Per Share

Basic net loss per share is calculated by dividing net loss attributable to common stockholders for the period by the weighted average common shares outstanding during the period, less shares subject to repurchase. Diluted net loss per share is calculated by dividing the net loss for the period by the weighted average common shares outstanding, adjusted for all dilutive potential common shares, which includes shares issuable upon the exercise of outstanding common stock options and warrants to the extent these shares are dilutive.

Diluted net loss per share does not include the effect of the following potential common shares because to do so would be antidilutive for the periods presented (in thousands):


	Three Months Ended June 30,				Six Months Ended June 30,
	2005		2004		2005		2004
Stock options		4,851		5,454		4,736		5,455
Warrants		47		14		30		14

Totals		4,898		5,468		4,766		5,469

The weighted average exercise price of stock options excluded during the three and six months ended June 30, 2005 was $3.99 and $3.83, respectively, as compared to the weighted average exercise price of stock options excluded during the three and six months ended June 30, 2004 of $3.36 and $3.33, respectively. The weighted average exercise price of warrants excluded was $8.30 and 10.96, respectively for the three and six months ended June 30, 2005 and $20.15 for the three and six months ended June 30, 2004.

Recent Accounting Pronouncements

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123R (revised 2004), Share-Based Payment (“SFAS 123R”), which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Generally, the approach in SFAS 123R is similar to the approach described in SFAS 123. However, SFAS 123R 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 will no longer be an alternative. SFAS 123R will be effective for annual periods beginning after June 15, 2005 and, accordingly, the Company must adopt the new accounting provisions effective January 1, 2006.

Upon the adoption of SFAS No. 123R, the Company can elect to recognize stock-based compensation related to employee equity awards in its consolidated statements of operations using the fair value method on a modified prospective basis and disclose the pro forma effect on net income or loss assuming the use of the fair value method in the notes to the consolidated financial statements for periods prior to adoption or the Company can elect to adopt the new principle on a retrospective basis. Further, the Company will be required to adopt one of the fair value methods described in SFAS 123R for measuring compensation expense. The Company believes it will use the Black-Scholes fair value method, however, it is still in the process of evaluating both the transition methods and fair value methods. Since the Company currently accounts for equity awards granted to its employees using the intrinsic value method under APB No. 25, the adoption of SFAS No. 123R is expected to have a significant impact on the Company’s results of operations.

In response to the enactment of the American Job Creation Act of 2004 (the “Jobs Act”) on October 22, 2004, the FASB issued FASB Staff Position (FSP) No. 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, for the Tax Deduction Provided to U.S. Based Manufacturers” (FSP 109-1), and FSP No.109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provisions within the American Jobs Creation Act of 2004” (FSP 109-2).

FSP No. 109-1 clarifies how to apply SFAS No. 109 to the new law’s tax deduction for income attributable to “domestic production activities.” The fully phased-in tax deduction is up to nine percent of the lesser of taxable income or “qualified production activities income,” as defined by the Jobs Act. The staff position requires that the deduction be accounted for as a special deduction in the period earned, not as a tax-rate reduction. FSP FAS 109-2 provides guidance on when an enterprise should recognize in its financial statements the effects of the one-time tax benefit of repatriation of foreign earnings under the Act, and specifies interim disclosure requirements. The Company does not expect the adoption of these new tax provisions to have a material impact on our consolidated financial position, results of operations or cash flows.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”), which replaces APB No. 20 “Accounting Changes”, and SFAS No. 3 “Reporting Accounting Changes in Interim Financial Statements”. SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle, and applies to all voluntary changes in accounting principles, as well as changes required by an accounting pronouncement in the unusual instance it does not include specific transition provisions. Specifically, SFAS 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine the period-specific effects or the cumulative effect of the change. SFAS 154 is effective for the Company beginning January 1, 2006.

2. Investments

The Company classifies debt and marketable equity securities based on the liquidity of the investment and management’s intention on the date of purchase and re-evaluates such designation as of each balance sheet date. Debt and marketable equity securities are classified as available-for-sale and carried at fair value, which is determined based on quoted market prices, with net unrealized gains and losses, net of tax effects, included in accumulated other comprehensive income in the accompanying condensed consolidated financial statements. Interest and amortization of premiums and discounts for debt securities are included in interest and other income, net, in the accompanying condensed consolidated financial statements. Realized gains and losses are calculated using the specific identification method. The components of the Company’s debt and marketable equity securities as of June 30, 2005 were as follows (in thousands):


			Unrealized		Unrealized
June 30, 2005	Cost		Gains		Losses			Fair Value
Auction rate securities and preferred stock	$	17,775	$	—	$	—		$	17,775
Corporate notes and obligations		14,716		—		(64	)		14,652
US government and agency obligations		19,500		—		(172	)		19,328

Investments in debt and equity securities	$	51,991	$	—	$	(236	)	$	51,755


			Unrealized		Unrealized
December 31, 2004	Cost		Gains		Losses			Fair Value
Auction rate securities and preferred stock	$	10,925	$	—	$	—		$	10,925
Corporate notes and obligations		16,500		—		(99	)		16,401
Municipal obligations		5,050		—		—			5,050
US government and agency obligations		21,000		—		(211	)		20,789

Investments in debt and equity securities	$	53,475	$	—	$	(310	)	$	53,165


	June 30,		December 31,
	2005		2004
Recorded as:
Cash equivalents	$	3,995	$	999
Short-term investments		47,760		52,166

	$	51,755	$	53,165

There were no realized gains or losses on the sales of these securities for the six months ended June 30, 2005 and 2004, respectively.

3. Debt

The Company has a Master Agreement that includes two term loans. The interest rates on the two loans were renegotiated in March 2004. The first term loan was for $1.5 million. The interest rate was lowered to the prime rate plus 0.50% and is payable in 36 monthly installments ending in September 2005. The amount outstanding under the first term loan was approximately $125,000 and $375,000 as of June 30, 2005 and December 31, 2004, respectively. The second term loan allows for borrowings of up to $1.0 million. The interest rate was lowered to the prime rate plus 0.50% and is payable in 36 monthly installments ending in June 2006. The amount outstanding under the second term loan was approximately $96,000 and $144,000 at June 30, 2005 and December 31, 2004, respectively. The loans are collateralized by substantially all of the Company’s assets. The Master Agreement requires the Company to maintain certain financial covenants. The Company was in compliance with all of the covenants as of June 30, 2005 and December 31, 2004, respectively.

4. Commitments and Contingencies

In July 2004, a purported securities class action complaint was filed in the United States District Court for the Northern District of California against the Company and certain of its present and former executives and directors. Additional actions were consolidated and a single consolidated amended complaint was filed. The suit alleged that the Company and the other defendants made false or misleading statements or omissions in violation of federal securities laws. In addition, in July and October 2004, derivative complaints were filed against the Company and certain of its present and former directors and officers in the California State Superior Court in Santa Clara, California and in the United States District Court for the Northern District of California. The derivative complaints allege state law claims relating to the matters alleged in the purported class action complaint referenced above. The federal derivative case was deemed related to the federal securities case and assigned to the same judge. In February 2005, the parties stipulated to a stay of the state derivative case in favor of the federal derivative case.

In February 2005, the Company filed a motion to dismiss the amended complaint in the federal securities case. The court granted the motion to dismiss in May 2005 and granted Plaintiffs leave to amend. Plaintiffs declined to amend the complaint and the court thereafter entered a dismissal with prejudice on July 5, 2005. As of June 30, 2005, the Company had accrued approximately $79,000 for legal costs.

In addition, the Company is from time to time a party to various other litigation matters incidental to the conduct of its business, none of which, at the present time the Company believes is likely to have a material adverse effect on the Company’s future financial results.

Other Contingencies

The Company generally warrants that its products will perform to its standard documentation. Under the terms of the warranty, should a product not perform as specified in the documentation, the Company will repair or replace the product and if the Company is unable to repair or replace the product, the Company shall return the product fees paid by the customer. Such warranties are accounted for in accordance with SFAS 5, Accounting for Contingencies. To date the Company has not incurred material costs related to warranty obligations.

The Company’s product license agreements include a limited indemnification provision for claims from third parties relating to the Company’s intellectual property. Such indemnification provisions are accounted for in accordance with FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. To date the Company has not incurred any costs related to such indemnification provisions.

5. Segment, Geographic and Customer Information

SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for the reporting by business enterprises of information about operating segments, products and services, geographic areas and major customers. The method of determining what information is reported is based on the way that management organizes the operating segments within the Company for making operational decisions and assessments of financial performance. The Company’s chief operating decision maker is considered to be the Company’s chief executive officer (CEO). The CEO reviews financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. By this definition, the Company operates in one business segment, which is the development, marketing and sale of enterprise software.

Geographic Information:

Total revenues consist of (in thousands):


	Three Months Ended June 30,				Six Months Ended June 30,
	2005		2004		2005		2004
United States	$	12,014	$	11,882	$	24,602	$	27,025
Europe		394		853		1,012		1,663
Asia Pacific		207		499		1,502		1,008

	$	12,615	$	13,234	$	27,116	$	29,696

Substantially all of the Company’s long-lived assets are located in the United States. Long-lived assets located outside the United States are not significant.

Significant customers (including resellers when product is sold through them to an end user) as a percentage of total revenues:


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Customer 1		18	%		—			14	%		—
Customer 2		14	%		—			10	%		—
Customer 3		6	%		23	%		6	%		20	%
Customer 4		1	%		11	%		1	%		7	%

6. Comprehensive Loss

Comprehensive loss includes net loss, changes in unrealized loss on investments, net and foreign currency translation adjustments. Comprehensive loss is comprised of the following (in thousands):


	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
Net loss	$	(3,718	)	$	(13,715	)	$	(6,212	)	$	(19,784	)
Other comprehensive income (loss)
Change in unrealized loss on investments, net		(93	)		(450	)		(110	)		(371	)
Change in cumulative translation adjustments		114			7			76			68

Comprehensive loss	$	(3,697	)	$	(14,158	)	$	(6,246	)	$	(20,087	)

7. Warrant and Restricted Stock Grant

On May 31, 2005 the Company issued a warrant for the purchase of 100,000 shares of its common stock in connection with executive recruiting services performed related to the hiring of the Company’s new chief executive officer. The common shares underlying the warrant were fully vested on May 31, 2005 and are exercisable at a price of $3.45 per share through May 31, 2012. The Company recorded a stock compensation charge for the fair value of the warrants of $222,000 during the three months ended June 30, 2005.

On May 31, 2005, the Company granted its new chief executive officer a non-plan option to purchase 1,000,000 shares of its common stock with an exercise price of $3.50 per share. The shares vest over four years, with 25% vesting on the first anniversary of the grant date and the remainder vest monthly for three years.

In addition, on June 7, 2004 the Company granted 28,000 shares of restricted stock at $3.50 per share to its new chief executive officer. The shares become fully vested on May 31, 2006. The Company recorded deferred compensation of $98,000 and will continue to expense this amount over the vesting period.

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

The following discussion of financial condition and results of operations should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and the Notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2004 and with the condensed consolidated financial statements and the related notes hereto contained elsewhere in this Quarterly Report on Form 10-Q . This section of the Quarterly Report on Form 10-Q, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements include, but are not limited to, statements concerning the following: our newly appointed President and Chief Executive Officer, our plans for hiring a vice president of sales, changes in and expectations with respect to maintenance and service and license revenues and gross margins, future operating expense levels, the impact of quarterly fluctuations of revenue and operating results, levels of capital expenditure, staffing and expense levels, expected future cash outlays, the adequacy of our capital resources to fund operations and growth, the likely outcome of pending litigation, the extent of stock-based compensation charges and expectations with respect to research and development spending. These statements involve known and unknown risks, uncertainties and other factors that may cause industry trends or our actual results, level of activity, performance or achievements to be materially different from any future results, level of activity, performance or achievements expressed or implied by these statements. Many of these trends and uncertainties are described in “Factors That Could Affect Future Results” set forth elsewhere in this Quarterly Report on Form 10-Q. We undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Quarterly Report on Form 10-Q.

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

We are a leading provider of Enterprise Incentive Management (EIM) software systems to global companies across multiple industries. Large enterprises use EIM systems to model, administer, analyze and report on incentive compensation, or pay-for-performance plans, which compensate employees and business partners for the achievement of targeted quantitative and qualitative objectives, such as sales quotas, product development milestones and customer satisfaction. We sell our EIM products both directly through our sales force and indirectly through our strategic partners typically pursuant to perpetual software licenses, and offer professional services, including configuration, integration and training, generally on a time and materials basis. We also generate maintenance and support revenues associated with our product licenses, which are recognized ratably over the term of the maintenance agreement.

In April 2005, we announced the hiring of our new President and CEO, Robert H. Youngjohns. Mr. Youngjohns, also a member of our Board of Directors, started his tenure on May 31, 2005, replacing interim President and CEO, David Pratt, who remains a member of our Board of Directors. Prior to joining Callidus, Mr. Youngjohns was Executive Vice President of Strategic Development and Sun Financing at Sun Microsystems and prior to that, Executive Vice President of Sun’s global sales organization. Prior to joining Sun, Mr. Youngjohns spent 15 years at IBM in a variety of roles ranging from systems engineering to general management. Mr. Youngjohns has extensive experience in international sales, marketing and business development in the Americas, Asia and Europe.

Second quarter license revenues were $1.3 million, a decrease of 63% from the prior quarter and 31% year-over-year. We continued to experience extended and unpredictable sales cycles in a competitive environment making it difficult to complete license transactions. License gross margin was 93%, a 4% decline from the prior quarter but an 8% increase year-over-year. Maintenance and service revenues remained steady and predictable in the second quarter at $11.3 million, a 3% increase from the prior quarter and equal to the same period in the prior year. Maintenance and service gross margin was 32% in the second quarter, reflecting a 3% decline from the prior quarter and a 6% increase year-over-year.

Operating expenses were $9.0 million in the second quarter compared to $10.0 million in the prior quarter and $16.7 million the prior year. The decrease from 2004 is due in large part to lower stock-based compensation expense, non-recurring impairment charges recorded in 2004 and a reduction in our workforce compared to 2004. The decrease from the prior quarter resulted primarily from lower personnel costs, including commissions and bonuses, and non-recurring costs recorded in the prior quarter including, CEO search fees, severance costs and our annual sales conference. Net loss was $3.7 million in the second quarter compared to $2.5 million in the prior quarter and $13.7 million in the prior year. Cash and investments totaled $59.4 million at June 30, 2005.

From a financial perspective, we have a number of late stage sales opportunities in process and other business coming through our sales pipeline which makes us optimistic about near-term revenue opportunities; however, at the same time our recent license revenue performance gives us reason to be cautious about the level of business that will actually close in a quarter. We expect our license revenues to fluctuate from quarter to quarter and remain difficult to predict. We continue to focus on our sales processes to develop new leads and complete existing opportunities. Our operating expenses are expected to increase in the third quarter resulting from an increase in personnel costs, including commissions, bonuses, and hiring, and from costs associated with our annual users’ conference which will be held in September. We expect to maintain what we believe is a proper level of investment in headcount and operations based on our perception of the market opportunity ahead of us, while at the same time closely monitoring spending decisions and the use of cash.

On the business side, we plan to accelerate the delivery of new modules for our TrueComp suite improving the analytic, strategic planning and sales force optimization features to broaden and increase the strategic value of our products. To better meet customer needs we also plan to be more flexible in our licensing terms which we expect will build more predictability into our license revenues. We will be seeking new strategic partnerships, and evaluating ways to reduce our customers’ implementation and operational costs. We believe these initiatives will, over time, increase the strategic value of our products and help us better capture the market opportunity ahead of us.

Application of Critical Accounting Policies and Use of Estimates

The discussion and analysis of our financial condition and results of operations which follows is based upon our consolidated financial statements, which are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The application of GAAP requires our management to make estimates that affect our reported amounts of assets, liabilities, revenues and expenses, and the related disclosure regarding these items. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation of our financial condition or results of operations will be affected.

In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, management’s judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Our management reviews these critical accounting policies, our use of estimates and the related disclosures with our audit committee.

Revenue Recognition

We generate revenues primarily by licensing software and providing related software maintenance and professional services to our customers. Our software arrangements typically include: (i) an end-user license fee paid in exchange for the use of our products in perpetuity, generally based on a specified number of payees; and (ii) a maintenance arrangement that provides for technical support and product updates, generally over renewable twelve month periods. If we are selected to provide integration and configuration services, then the software arrangement will also include professional services, generally priced on a time-and-materials basis. Depending upon the elements in the arrangement and the terms of the related agreement, we recognize license revenues under either the residual or the contract accounting method.

Residual Method. License fees are recognized upon delivery when licenses are either sold separately from integration and configuration services, or together with integration and configuration services, provided that (i) the criteria described below have been met, (ii) payment of the license fees is not dependent upon performance of the integration and configuration services and (iii) the services are not otherwise essential to the functionality of the software. We recognize these license revenues using the residual method pursuant to the requirements of Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9, Software Revenue Recognition with Respect to Certain Transactions. Under the residual method, revenues are recognized when vendor-specific objective evidence of fair value exists for all of the undelivered elements in the arrangement (i.e., professional services and maintenance), but does not exist for one or more of the delivered elements in the arrangement (i.e., the software product). Each license arrangement requires careful analysis to ensure that all of the individual elements in the license transaction have been identified, along with the fair value of each undelivered element.

We allocate revenue to each undelivered element based on its respective fair value, with the fair value determined by the price charged when that element is sold separately. For a certain class of transactions, the fair value of the maintenance portion of our arrangements is based on stated renewal rates rather than stand-alone sales. The fair value of the professional services portion of the arrangement is based on the hourly rates that we charge for these services when sold independently from a software license. If evidence of fair value cannot be established for the undelivered elements of a license agreement, the entire amount of revenue from the arrangement is deferred until evidence of fair value can be established, or until the items for which evidence of fair value cannot be established are delivered. If the only undelivered element is maintenance, then the entire amount of revenue is recognized over the maintenance delivery period.

Contract Accounting Method. For arrangements where services are considered essential to the functionality of the software, such as where the payment of the license fees is dependent upon performance of the services, both the license and services revenues are recognized in accordance with the provisions of SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. We generally use the percentage-of-completion method because we are able to make reasonably dependable estimates relative to contract costs and the extent of progress toward completion. However, if we cannot make reasonably dependable estimates, we use the completed-contract method. If total cost estimates exceed revenues, we accrue for the estimated loss on the arrangement.

For all of our software arrangements, we will not recognize revenue until persuasive evidence of an arrangement exists and delivery has occurred, the fee is fixed or determinable and collection is deemed probable. We evaluate each of these criteria as follows:

Evidence of an Arrangement. We consider a non-cancelable agreement signed by us and the customer to be evidence of an arrangement.

Delivery. We consider delivery to have occurred when media containing the licensed programs is provided to a common carrier or, in the case of electronic delivery, the customer is given access to the licensed programs. Our typical end-user license agreement does not include customer acceptance provisions.

Fixed or Determinable Fee. We consider the fee to be fixed or determinable unless the fee is subject to refund or adjustment or is not payable within our standard payment terms. We consider payment terms greater than 90 days to be beyond our customary payment terms. If the fee is not fixed or determinable, we recognize the revenue as amounts become due and payable.

Collection is Deemed Probable. We conduct a credit review for all significant transactions at the time of the arrangement to determine the creditworthiness of the customer. Collection is deemed probable if we expect that the customer will be able to pay amounts under the arrangement as payments become due. If we determine that collection is not probable, we defer the recognition of revenue until cash collection.

A customer typically prepays maintenance for the first twelve months, and the related revenues are deferred and recognized over the term of the initial maintenance contract. Maintenance is renewable by the customer on an annual basis thereafter. Rates for maintenance, including subsequent renewal rates, are typically established based upon a specified percentage of net license fees as set forth in the arrangement.

Professional services revenues primarily consist of integration and configuration services related to the installation of our products and training revenues. Our implementation services do not involve customization to, or development of, the underlying software code. Substantially all of our professional services arrangements are on a time-and-materials basis. To the extent we enter into a fixed-fee services contract, a loss will be recognized any time the total estimated project cost exceeds project revenues.

Certain arrangements result in the payment of customer referral fees to third parties that resell our software products. In these arrangements, license revenues are recorded, net of such referral fees, at the time the software license has been delivered to a third-party reseller and an end-user customer has been identified.

Allowance for Doubtful Accounts and Sales Return Reserve

We must make estimates of the uncollectibility of accounts receivable. The allowance for doubtful accounts, which is netted against accounts receivable on our balance sheets, totaled approximately $40,000 and $320,000 at June 30, 2005 and December 31, 2004, respectively. The decrease at June 30, 2005, was attributable to the write-off of a specifically reserved customer account. We

record an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. Management specifically analyzes accounts receivable and historical bad debt experience, customer creditworthiness, current economic trends, international situations (such as currency devaluation) and changes in our customer payment history when evaluating the adequacy of the allowance for doubtful accounts. Should any of these factors change, the estimates made by management will also change, which could affect the level of our future provision for doubtful accounts. Specifically, if the financial condition of our customers were to deteriorate, affecting their ability to make payments, an additional provision for doubtful accounts may be required and such provision may be material.

We generally guarantee that our services will be performed in accordance with the criteria agreed upon in the statement of work, which we generally execute with each applicable customer prior to commencing work. Should these services not be performed in accordance with the agreed upon criteria, we would provide remediation services until such time as the criteria are met. In accordance with Statement of Financial Accounting Standards (SFAS) 48, Revenue Recognition When Right of Return Exists, management must use judgments and make estimates of sales return reserves related to potential future requirements to provide remediation services in connection with current period service revenues. When providing for sales return reserves, we analyze historical experience of actual remediation service claims as well as current information on remediation service requests as they are the primary indicators for estimating future service claims. Material differences may result in the amount and timing of our revenues if for any period actual returns differ from management’s judgments or estimates. The sales return reserve balance, which is netted against our accounts receivable on our balance sheets, was approximately $305,000 and $537,000 at June 30, 2005 and December 31, 2004, respectively.

Stock-Based Compensation

We have adopted SFAS 123, Accounting for Stock-Based Compensation, but in accordance with SFAS 123, we have elected not to apply fair value-based accounting for our employee stock option plans. Instead, we measure compensation expense for our employee stock option plans using the intrinsic value method prescribed by Accounting Principles Board Opinion (APB) 25, Accounting for Stock Issued to Employees, and related interpretations. We record deferred stock-based compensation to the extent the fair value of our common stock for financial accounting purposes exceeds the exercise price of stock options granted to employees on the date of grant, and amortize these amounts to expense using the accelerated method over the vesting schedule of the options, generally four years. For options granted after our initial public offering, the fair value of our common stock is the closing price on the date of grant. For options which were granted prior to our initial public offering, the deemed fair value of our common stock was determined by our board of directors. The board of directors determined the deemed fair value of our common stock by considering a number of factors, including, but not limited to, our operating performance, significant events in our history, issuances of our convertible preferred stock, trends in the broad market for technology stocks and the valuation we expected to obtained in an initial public offering.

Stock-based compensation expense was $0.4 million and $0.9 million for the three and six months ended June 30, 2005, compared with approximately $2.7 million and $4.5 million for the three and six months ended June 30, 2004. We expect stock-based compensation expense to be $0.3 million for the three months ended September 30, 2005 due to amortization of deferred stock-based compensation. Had different assumptions or criteria been used to determine the deemed fair value of the stock options, materially different amounts of stock compensation expenses could have been reported. Please see our “Recent Accounting Pronouncements” for additional discussion of FASB Statement No. 123R.

As required by SFAS 123, as modified by SFAS 148, Accounting for Stock Based Compensation — Transition and Disclosure — an Amendment of FASB Statement No. 123, we provide pro forma disclosure of the effect of using the fair value-based method of measuring stock-based compensation expense. For purposes of the pro forma disclosure, we estimate the fair value of stock options issued to employees using the Black-Scholes option valuation model. This model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of subjective assumptions including the expected life of options and our expected stock price volatility. Therefore, the estimated fair value of our employee stock options could vary significantly as a result of changes in the assumptions used. See Note 1 to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q.

Income Taxes

We are subject to income taxes in both the United States and foreign jurisdictions and we use estimates in determining our provision for income taxes. Deferred tax assets, related valuation allowances and deferred tax liabilities are determined separately by tax jurisdiction. This process involves estimating actual current tax liabilities together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are recorded on the balance sheet. Our deferred tax assets consist primarily of net operating loss carryforwards. We assess the likelihood that deferred tax assets will be recovered from future taxable income, and a valuation allowance is recognized if it is more

likely than not that some portion of the deferred tax assets will not be recognized. We provided a full valuation allowance against our net deferred tax assets at June 30, 2005. In the event we determine that we will realize all or a portion of our deferred tax assets in the future, an adjustment to the valuation allowance would increase net income and stockholders’ equity in the period such determination was made. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgment that could become subject to audit by tax authorities in the ordinary course of business.

Recent Accounting Pronouncements

On December 16, 2004, FASB issued FASB Statement No. 123R (revised 2004), Share-Based Payment (SFAS 123R), which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Generally, the approach in SFAS 123R is similar to the approach described in SFAS 123. However, SFAS 123R 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 will no longer be an alternative. The new standard will be effective at the beginning of the first annual period beginning after June 15, 2005 and, accordingly, we must adopt the new accounting provisions effective January 1, 2006.

Upon the adoption of SFAS No. 123R, we can elect to recognize stock-based compensation related to employees’ equity awards in our consolidated statements of operations using the fair value method on a modified prospective basis and disclose the pro forma effect on net income or loss assuming the use of the fair value method in the notes to the consolidated financial statements for periods prior to adoption or we can elect to adopt the new principle on a retrospective basis. Further, we will be required to adopt one of the fair value methods described in SFAS 123R for measuring compensation expense. We believe we will use the Black-Scholes fair value method, however, we are still in the process of evaluating the transition methods and the fair value methods. Since we currently account for equity awards granted to employees using the intrinsic value method under APB No. 25, we expect the adoption of SFAS No. 123R will have a significant impact on our results of operations.

FSP No. 109-1 clarifies how to apply SFAS No. 109 to the new law’s tax deduction for income attributable to “domestic production activities.” The fully phased-in tax deduction is up to nine percent of the lesser of taxable income or “qualified production activities income,” as defined by the Jobs Act. The staff position requires that the deduction be accounted for as a special deduction in the period earned, not as a tax-rate reduction. FSP FAS 109-2 provides guidance on when an enterprise should recognize in its financial statements the effects of the one-time tax benefit of repatriation of foreign earnings under the Act, and specifies interim disclosure requirements. We do not expect the adoption of these new tax provisions to have a material impact on our consolidated financial position, results of operations or cash flows.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”), which replaces APB No. 20 “Accounting Changes”, and SFAS No. 3 “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle and applies to all voluntary changes in accounting principles, as well as changes required by an accounting pronouncement in the unusual instance it does not include specific transition provisions. Specifically, SFAS 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine the period-specific effects or the cumulative effect of the change. SFAS 154 is effective for us beginning January 1, 2006.

Results of Operations

Comparison of the Three and Six Months Ended June 30, 2005 and 2004

Revenue, cost of revenues and gross profit

The table below sets forth the changes in revenue, cost of revenue and gross profit from the three and six months ended March 31, 2004 to the three and six months ended June 30, 2005 (in thousands, except percentage data):


	Three Months Ended					Three Months Ended
	June 30, 2005					June 30, 2004
			% of total					% of total
	Amount		revenues			Amount		revenues			Year-Over-Year Change
Revenues:
License	$	1,295		10	%	$	1,889		14	%	($	594	)	(31	%)
Maintenance and service		11,320		90	%		11,345		86	%		(25	)	(0	%)

Total revenues	$	12,615		100	%	$	13,234		100	%	($	619	)	(5	%)


	% of related				% of related
Cost of revenues:	revenues				revenues
License	$	86	7	%	$	286	15	%	($	200	)	(70	%)
Maintenance and service		7,684	68	%		8,384	74	%		(700	)	(8	%)
Impairment of purchased technology		—				1,800				(1,800	)	(100	%)

Total cost of revenues		7,770	62	%		10,470	79	%		(2,700	)	(26	%)

Gross profit	$	4,845	38	%	$	2,764	21	%	$	2,081		75	%


	Six Months Ended					Six Months Ended
	June 30, 2005					June 30, 2004
			% of total					% of total
	Amount		revenues			Amount		revenues			Year-Over-Year Change
Revenues:
License	$	4,795		18	%	$	6,428		22	%	($	1,633	)	(25	%)
Maintenance and service		22,321		82	%		23,268		78	%		(947	)	(4	%)

Total revenues	$	27,116		100	%	$	29,696		100	%	($	2,580	)	(9	%)


	% of related				% of related
Cost of revenues:	revenues				revenues
License	$	183	4	%	$	549	9	%	($	366	)	(67	%)
Maintenance and service		14,864	67	%		16,994	73	%		(2,130	)	(13	%)
Impairment of purchased technology		—				1,800				(1,800	)	(100	%)

Total cost of revenues		15,047	55	%		19,343	65	%		(4,296	)	(22	%)

Gross profit	$	12,069	45	%	$	10,353	35	%	$	1,716		17	%

Revenues

License Revenues. License revenues decreased $0.6 million or 31% for the three months ended June 30, 2005 compared to June 30, 2004. For the six months ended June 30, 2005 license revenues decreased $1.6 million or 25% compared to the six months ended June 30, 2004. The three and six month decreases were primarily due to fewer large dollar transactions being completed and a continued challenging selling environment with longer selling cycles. Overall, we recognized fewer license deals in the second quarter of 2005 compared to the same quarter of 2004 which decreased our license revenue. We expect our license revenues to continue to fluctuate from quarter to quarter since we generally complete a relatively small number of transactions in a quarter and the license fees generated from those software transactions can vary widely.

Maintenance and Service Revenues. Maintenance and service revenues were relatively flat for the three months ended June 30, 2005 compared to June 30, 2004. For the six months ended June 30, 2005 maintenance and service revenues decreased $0.9 million or 4% compared to the six months ended June 30, 2004. The decrease for the six months ended June 30, 2005 was principally due to a reduction in new customer implementations as a result of the decrease in product license sales and a smaller number of customer upgrade projects during the period. Those decreases were partially offset by an increase in maintenance revenue of $1.1 million for the six months ended June 30, 2005 due to the additions of new customers in the six months ended June 30, 2005 compared to the same period in 2004. In addition, we also continued to experience a higher average billing rate for the three and six months ended June 30,

2005 compared to the three and six months ended June 30, 2004. We expect maintenance and service revenues to decrease in the third quarter of 2005 due to the decrease in new product license sales in the first half of the year.

Cost of Revenues and Gross Margin

Cost of License Revenues. Cost of license revenues decreased $0.2 million or 70% for the three months ended June 30, 2005 compared to the three months ended June 30, 2004. For the six months ended June 30, 2005 cost of license revenues decreased $0.4 million or 67% compared to the six months ended June 30, 2004. The decreases were largely attributable to reduced volume of license sales resulting in lower royalty payment obligations to third-parties. In addition, in the three and six months ended June 30, 2004 we amortized approximately $100,000 and approximately $200,000, respectively, of expenses related to the source code for the TruePerformance product that is now discontinued. We expect to maintain license margins at or above 95% through the end of 2005.

Cost of Maintenance and Service Revenues. Cost of maintenance and service revenues decreased $0.7 million or 8% for the three months ended June 30, 2005 compared to the three months ended June 30, 2004. Maintenance and service gross margin increased from 26% for the three months ended June 20, 2004 to 32% for the three months ended June 30, 2005. The maintenance and service gross margin benefited from higher maintenance revenues which have a higher gross margin compared to the lower gross margin service revenues. For the three months ended June 30, 2005, professional fees for sub-contractors decreased $0.7 million as we increasingly relied on our internal workforce to perform services. Travel expenses also decreased by $0.2 million in the three months ended June 30, 2005. These decreases were partially offset by an increase in third-party maintenance of $0.1 million.

For the six months ended June 30, 2005, cost of maintenance and service revenues decreased $2.1 million or 13% compared to the six months ended June 30, 2004. Maintenance and service gross margin increased from 27% for the six months ended June 30, 2004 to 33% for the six months ended June 30, 2005. The decrease in costs was a result of a decline in professional fees expense for sub-contractors of $1.7 million and travel expenses of $0.9 million. These decreases were offset by increases in personnel costs of $0.3 million as we relied more on our internal workforce and corporate support services of $0.2 million. For the third quarter of 2005, we expect to keep maintenance and service gross margins between 30% and 32%.

Impairment of Purchased Technology. For the three and six months ended June 30, 2004, we recorded an impairment charge equal to the remaining balance of the purchased TruePerformance source code of $1.8 million as a result of our discontinuance of the TruePerformance product. There were no similar charges during the three and six months ended June 30, 2005.

Gross Margin. Our gross margin increased to 38% for the three months ended June 30, 2005 from 21% for the three months ended June 30, 2004, and increased to 45% for the six months ended June 30, 2005 from 35% for the six months ended June 30, 2004. The increase in our gross margin is attributable primarily to lower third-party royalty obligations in connection with decreased license revenues, no amortization of the TruePerformance source code in fiscal year 2005 and lower cost of maintenance and service revenues resulting from a decrease in outside consultants and travel costs. In addition, we experienced an increase in maintenance and service gross margin primarily attributable to the mix of higher margin maintenance revenues compared to generally lower margin service revenues. In the future, we expect our gross margins to fluctuate depending on the mix of license versus maintenance and service revenues recorded.

Operating Expenses

The table below sets forth the changes in operating expenses from the three and six months ended June 30, 2004 to the three and six months ended June 30, 2005 (in thousands, except percentage data):


	Three Months Ended					Three Months Ended
	June 30, 2005					June 30, 2004
			% of total					% of total
	Amount		Revenues			Amount		revenues			Year-Over-Year Change
Operating expenses:
Sales and marketing	$	3,549		28	%	$	5,345		40	%	($	1,796	)	(34	%)
Research and development		2,838		22	%		3,876		29	%		(1,038	)	(27	%)
General and administrative		2,140		17	%		2,774		21	%		(634	)	(23	%)
Impairment of intangible assets		—		0	%		1,994		15	%		(1,994	)	(100	%)
Stock-based compensation		423		3	%		2,721		21	%		(2,298	)	(84	%)

Total operating expenses	$	8,950		70	%	$	16,710		126	%	($	7,760	)	(46	%)


	Six Months Ended					Six Months Ended
	June 30, 2005					June 30, 2004
			% of total					% of total
	Amount		revenues			Amount		revenues			Year-Over-Year Change
Operating expenses:
Sales and marketing	$	7,961		29	%	$	11,745		40	%	($	3,784	)	(32	%)
Research and development		5,789		21	%		7,586		26	%		(1,797	)	(24	%)
General and administrative		4,342		16	%		4,746		16	%		(404	)	(9	%)
Impairment of intangible assets		—		0	%		1,994		7	%		(1,994	)	(100	%)
Stock-based compensation		863		3	%		4,465		15	%		(3,602	)	(81	%)

Total operating expenses	$	18,955		69	%	$	30,536		104	%	($	11,581	)	(38	%)

Sales and Marketing. Sales and marketing expense decreased $1.8 million or 34% for the three months ended June 30, 2005 compared to the three months ended June 30, 2004. The decrease in sales and marketing expense in the three months ended June 30, 2005 was primarily attributable to declines in personnel costs of $1.0 million due to a reduction in headcount, outside professional fees of $0.2 million, marketing programs of $0.3 million and travel of $0.3 million due to reduced headcount.

For the six months ended June 30, 2005 sales and marketing expense decreased $3.8 million or 32% compared to the six months ended June 30, 2004. The decrease in sales and marketing expense was primarily attributable to declines in personnel costs of $1.8 million from lower headcount, outside professional fees of $0.5 million, travel expenses of $0.7 million and marketing programs of $0.7 million. We expect sales and marketing expenses to increase in the third quarter of 2005 compared to the second quarter of 2005 due to increases in commissions, headcount and our annual users’ conference which will be held in September.

Research and Development. Research and development expenses decreased $1.0 million or 27% for the three months ended June 30, 2005 compared to the three months ended June 30, 2004. The decrease in research and development expense in the three months ended June 30, 2005 was primarily due to declines in personnel costs from headcount reduction of $0.4 million and reduction of contract development fees of $0.3 million both of which are primarily related to our now discontinued TruePerformance product. In addition, we experienced a decrease in travel of $0.1 million in the three months ended June 30, 2005 compared to the three months ended June 30, 2004 due to the reduced headcount.

For the six months ended June 30, 2005, research and development expense decreased $1.8 million or 24% compared to the six months ended June 30, 2004. The $1.8 million decrease in research and development expense in the six months ended June 30, 2005 was primarily attributable to the discontinuation of our TruePerformance product including decreases in personnel costs from headcount reduction of $0.7 million, outside professional fees of $0.8 million and travel of $0.2 million due to the reduced headcount. We expect our research and development expense will increase slightly in the third quarter of 2005 compared to the second quarter of 2005 due to a planned increase in headcount associated with an acceleration of our product development plans.

General and Administrative. General and administrative expense decreased $0.6 million or 23% for the three months ended June 30, 2005 compared to the three months ended June 30, 2004. The decrease is attributable to a $0.4 million settlement with Gordon Food Service in 2004 and an additional insurance expense of $0.2 million recorded in 2004 related to the federal securities class action lawsuit filed against us. In addition, we had declines in legal expenses of $0.1 million and personnel costs of $0.1 million. These decreases were partially offset by an increase of $0.3 million of consulting expenses related to our Sarbanes-Oxley Act Section 404 certification project.

For the six months ended June 30, 2005, general and administrative expense decreased $0.4 million or 9% compared to the six months ended June 30, 2004. The $0.4 million decrease in general and administrative expense was primarily attributable to decreases in legal and accounting costs of $0.3 million and the $0.4 million settlement of the Gordon Foods matter in the corresponding 2004 period. These decreases were partially offset by an additional $0.4 million of consulting expenses related to our Sarbanes-Oxley Act Section 404 certification project incurred in the six months ended June 30, 2005. We expect our general and administrative expense to increase in the third quarter of 2005 compared to the second quarter of 2005 primarily due to increased personnel costs. We expect this increase will be partially offset by a decrease in consulting expenses related to our Sarbanes-Oxley Act Section 404 compliance project as a result of the Securities and Exchange Commission’s extension of the compliance deadline for non-accelerated filers that will postpone our compliance obligation to our fiscal year ended December 31, 2006.

Impairment of Intangible Assets. As a result of our discontinuance of our TruePerformance product in June 2004, we recorded an impairment charge equal to the remaining balance of the purchased assembled workforce of $1.9 million and approximately $66,000 of a favorable lease during the three months ended June 30, 2004. There was no similar charge during the six months ended June 30, 2005.

Stock-based Compensation. Stock-based compensation expense decreased $2.3 million or 84% for the three months ended June 30, 2005 compared to the three months ended June 30, 2004. For the six months ended June 30, 2005, stock compensation expense decreased $3.6 million or 81% compared to the six months ended June 30, 2004. The decrease of $3.6 million in stock-based compensation in the six months ended June 30, 2005 resulted in part from the incurrence of a $1.7 million expense in the six months ended June 30, 2004 related to the modification of stock options associated with the resignation of our former president and chief executive officer as well as a significant decrease in the amount of deferred compensation that remains to be amortized. Notwithstanding the reduction, we incurred stock-based compensation expense of $0.2 million in the six months ended June 30, 2005 related to the issuance of 100,000 warrants in May 2005 to a third party executive search firm related to the hiring of our new chief executive officer. These warrants vested on their grant date in May. In addition, we incurred stock compensation expense of $159,000 in the six months ended June 30, 2005 related to the modification of stock options associated with the resignation of our senior vice president, operations in the first quarter of 2005 and also reversed $116,000 of unamortized deferred stock-based compensation related to unvested options held by the same individual. We expect stock-based compensation to total approximately $0.3 million for the third quarter of 2005 due to amortization of stock-based compensation.

Interest Expense and Interest and Other Income, Net

The table below sets forth the changes in other income (expense) from the three and six months ended June 30, 2004 to the three and six months ended June 30, 2005 (in thousands, except percentage data):


	Three Months Ended						Three Months Ended
	June 30, 2005						June 30, 2004
				% of total						% of total
	Amount			revenues			Amount			revenues			Year-Over-Year Change
Other income (expense), net:
Interest expense	($	5	)		0	%	($	16	)		0	%	$	11		69	%
Interest and other income, net		358			3	%		272			2	%		86		32	%

Total other income, net	$	353			3	%	$	256			2	%	$	97		38	%

Provision (benefit) for income taxes	($	34	)		0	%	$	25			0	%	($	59	)	(236	%)


	Six Months Ended						Six Months Ended
	June 30, 2005						June 30, 2004
				% of total						% of total
	Amount			revenues			Amount			revenues			Year-Over-Year Change
Other income (expense), net:
Interest expense	($	16	)		0	%	($	95	)		0	%	$	79		83	%
Interest and other income, net		681			2	%		544			2	%		137		25	%

Total other income, net	$	665			2	%	$	449			2	%	$	216		48	%

Provision (benefit) for income taxes	($	9	)		0	%	$	50			0	%	($	59	)	(118	%)

Interest expense decreased approximately $11,000 or 69% for the three months ended June 30, 2005 compared to the three months ended June 30, 2004. For the six months ended June 30, 2005 interest expense decreased approximately $79,000 or 83% compared to the six months ended June 30, 2004. For the three and six months ended June 30, 2005, compared to the three and six months ended June 30, 2004, interest expense paid on outstanding debt decreased due to lower average outstanding debt balances. Amortization of loan discounts associated with warrants granted in connection with our credit facility also decreased by $59,000 in the six months ended June 30, 2005 compared to the six months ended June 30, 2004. These warrants were fully amortized as of December 31, 2004.

Interest and other income net increased approximately $86,000 or 32% for the three months ended June 30, 2005 compared to the three months ended June 30, 2004 and approximately $137,000 or 25% for the six months ended June 30, 2005 compared to the six months ended June 30, 2004. Interest and other income, net primarily includes interest income generated from cash and investment balances.

Provision(benefit) for Income Taxes

Provision (benefit) for income taxes was approximately ($34,000) and approximately $25,000 for the three months ended June 30, 2005 and 2004, respectively. For the six months ended June 30, 2005 and June 30, 2004 provision for income taxes was approximately ($9,000) and approximately $50,000, respectively. The provision (benefit) primarily relates to income taxes currently payable on income generated from non-U.S. tax jurisdictions and state net worth taxes. For the three and six months ended June 30, 2005, the provision (benefit) included a tax refund receivable of approximately $43,000 related to our 2003 amended tax return. We maintained a full valuation allowance against our deferred tax assets based on the determination that it was more likely than not that the deferred tax assets would not be realized.

Liquidity and Capital Resources

As of June 30, 2005, we had $11.6 million of cash and cash equivalents and short-term investments of $47.8 million.

Net Cash Used In Operating Activities. Net cash used in operating activities was $1.1 million and $6.6 million for the six months ended June 30, 2005 and 2004, respectively. The significant cash receipts and outlays for the two periods are as follows (in thousands):


	Six Months Ended June,
	2005			2004
Cash collections	$	31,734		$	34,067
Payroll related costs		(21,432	)		(22,526	)
Professional services costs		(4,042	)		(8,825	)
Employee expense reports		(2,619	)		(3,878	)
Facilities related costs		(1,931	)		(1,835	)
Third-party royalty payments		(528	)		(1,189	)
Other		(2,254	)		(2,391	)

Net cash used in operating activities	$	(1,072	)	$	(6,577	)

Net cash used in operating activities decreased $5.5 million for the six months ended June 30, 2005 compared to the six months ended June 30, 2004. The decrease was primarily attributable employee expense related costs of $1.3 million due in part to reduced travel costs and professional service costs of $4.8 million primarily resulting from a $3.6 million decrease in fees paid to outside contractors in our services organization. In addition, personnel costs decreased $1.1 million due to a 20% reduction in average headcount.

Net Cash Provided by/Used in Investing Activities. Net cash provided by investing activities was $3.6 million for the six months ended June 30, 2005 compared to net cash used of $2.4 million for the six months ended June 30, 2004. Our cash provided by investing activities during the six months ended June 30, 2005 was primarily due to net maturities of investments of $4.2 million compared to net purchases of investments of $0.5 million for the six months ended June 30, 2004. Purchases of equipment, software, furniture and leasehold improvements were $0.6 million and $1.6 million for the six months ended June 30, 2005 and June 30, 2004, respectively. Additionally, in 2004, we incurred $1.6 million related to our purchase of Cezanne Software’s assembled workforce, which has since been terminated.

Net Cash Provided by/Used in Financing Activities. Net cash provided by financing activities was approximately $1.6 million for the six months ended June 30, 2005, which was a result of proceeds from stock option exercises of approximately $1.9 million, partially offset by long-term debt paydowns of $0.3 million. Net cash used in financing activities was approximately $105,000 for the six months ended June 30, 2004, consisting of payments of $0.4 million for long-term debt partially offset by net proceeds from the issuance of common stock of $0.3 million.

We have no off-balance sheet arrangements, with the exception of operating lease commitments, which have not been recorded in our condensed consolidated financial statements.

Contractual Obligations and Commitments

The following table summarizes our contractual cash obligations and commercial commitments (in thousands) at June 30, 2005 and the effect such obligations are expected to have on liquidity and cash flow in future periods.


	Payments Due by Period
					Less than						More than
Contractual Obligations			Total		1 Year	1-3 Years		4-5 Years			5 Years
Long-term debt, including current maturities	$	221		$	221	$	—		$	—		$	—
Operating leases		10,032			1,000		4,025			3,780			1,227

Total contractual cash obligations	$	10,253		$	1,221	$	4,025		$	3,780		$	1,227

Other obligations include two letters of credit outstanding at June 30, 2005, totaling approximately $675,000 related to our New York, New York and San Jose, California offices.

We believe our existing cash and investment balances will be sufficient to meet our anticipated short and long term cash requirements, debt obligations and operating lease commitments. Our future capital requirements will depend on many factors, including our ability to achieve revenue growth, the timing and extent of spending to support product development efforts, sales and marketing activities, the timing of introductions of new products and enhancements to existing products, the continuing market acceptance of our products and our ability to achieve and sustain profitability.

Factors That Could Affect Future Results

We operate in a dynamic and rapidly changing environment that involves numerous risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Quarterly Report on Form 10-Q. Because of the following factors, as well as other variables affecting our operating results, past financial performance should not be considered a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.

RISKS RELATED TO OUR BUSINESS

We have a history of losses, and we cannot assure you that we will achieve and sustain profitability.

We incurred net losses of $25.5 million and $19.1 million in fiscal 2004 and fiscal 2002, respectively, and had net income of approximately $835,000 in fiscal 2003. For the three and six months ended June 30, 2005, we had net losses of $3.7 million and $6.2 million, respectively. Although, we have taken steps to reduce our expense levels to better track with our revenues, we expect to incur a loss in fiscal 2005 and cannot assure you that we will achieve or sustain profitability on a quarterly or annual basis. If we cannot increase our license revenues, our future results of operations and financial condition will be negatively impacted.

We recently experienced changes in our senior management team. The loss of other key personnel or the inability of replacements to quickly and successfully perform in their new roles could adversely affect our business.

We hired Robert Youngjohns in May 2005 as our new president and chief executive officer and are in the process of recruiting a new vice president of sales. In June 2004, Reed D. Taussig, who had served as our president and chief executive officer since 1997, resigned from Callidus and our board of directors. David B. Pratt, who joined our board of directors in May 2004, was thereafter appointed interim president and chief executive officer and served in that role until May 2005 when we hired Mr. Youngjohns. In September 2004, Daniel J. Welch, senior vice president of EMEA and general manager of TruePerformance left the Company and in February 2005, Christopher W. Cabrera, senior vice president, operations, also resigned. We currently have an acting vice president of sales.

Our success depends to a significant extent on the effective transition of our new president and chief executive officer and our ability to hire a vice president of sales. Moreover, all of our existing personnel, including our executive officers, are employed on an “at will” basis. If we lose or terminate the services of one or more of our current executives or key employees or if one or more of our current or former executives or key employees decides to join a competitor or otherwise compete directly or indirectly with us, this could harm our business and could affect our ability to successfully implement our business plan.

Additionally, if we are unable to timely hire qualified replacements for our executive and other key positions, our ability to execute our business plan would be harmed. Even if we are able to timely hire qualified replacements, we would expect to experience operational disruptions and inefficiencies in connection with assimilating the changes.

Our quarterly revenues and operating results are unpredictable and are likely to continue to fluctuate substantially, which may harm our results of operations.

Our revenues, particularly our license revenues, are extremely difficult to forecast and are likely to fluctuate significantly from quarter to quarter due to a number of factors, many of which are wholly or partially beyond our control. For example, in fiscal 2004 and the first six months of fiscal 2005, our license revenues were substantially lower than expected due to delays in purchasing by our customers and failures to close transactions resulting in significant net losses. Accordingly, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indicators of future performance.

Factors that may cause our quarterly revenue and operating results to fluctuate include:

	•		The discretionary nature of our customers’ purchase and budget cycles and changes in their budgets for software and related purchases;

	•		competitive conditions in our industry, including new products, product announcements and discounted pricing or special payment terms offered by our competitors;

	•		our ability to hire, train and retain appropriate sales and professional services staff;

	•		customers’ concerns regarding Sarbanes-Oxley Section 404 compliance and implementing large, enterprise-wide deployments of products, including our products;

	•		varying size, timing and contractual terms of orders for our products, which may delay the recognition of revenues;

	•		sales cycles;

	•		strategic decisions by us or our competitors, such as acquisitions, divestitures, spin-offs, joint ventures, strategic investments or changes in business strategy;

	•		our ability to timely complete our service obligations related to product sales;

	•		customer concerns regarding our success over the near- and long-terms;

	•		general weakening of the economy resulting in a decrease in the overall demand for computer software and services;

	•		the utilization rate of our professional services personnel and the degree to which we use third-party consulting services;

	•		changes in our pricing policies;

	•		changes in the average selling prices of our products;

	•		timing of product development and new product initiatives; and

	•		changes in the mix of revenues attributable to higher-margin product license revenues as opposed to substantially lower-margin service revenues.

Our quarterly license revenues are dependent on a relatively small number of transactions involving sales of our products to new customers, and any delay or failure in closing one or more of these transactions could adversely affect our results of operations.

If we are unable to substantially increase our license revenues, we many be unable to achieve and sustain profitability. Our quarterly license revenues are dependent upon a relatively small number of transactions involving sales of our products to new customers, and to date recurring license revenues from existing customers have not comprised a substantial part of our revenues. As such, variations in the rate and timing of conversion of our sales prospects into revenues could result in our failure to meet revenue objectives in future periods. In addition, based upon the terms of our customer contracts, we recognize the bulk of our license revenues for a given sale either at the time we enter into the agreement and deliver the product, or over the period in which we perform any services that are essential to the functionality of the product. Unexpected changes in the size of transactions or other contractual terms late in the negotiation process or changes in the mix of contracts we enter into could therefore materially and adversely affect our license revenues in a quarter. Delays or reductions in the amount of customers’ purchases would adversely affect our revenues, results of operations and financial condition and could cause our stock price to decline.

Our products have long sales cycles, which makes it difficult to plan our expenses and forecast our results.

The sales cycles for our products have historically averaged between six and twelve months to and longer in some cases, to complete. More recently, we have been experiencing lengthening selling cycles. It is therefore difficult to predict the quarter in which a particular sale will close and to plan our expenditures accordingly. The period between our initial contact with a potential customer and its purchase of our products and services is relatively long due to several factors, including:

	•		The complex nature of our products;

	•		the need to educate potential customers about the uses and benefits of our products;

	•		the requirement that a potential customer invest significant resources in connection with the purchase and implementation of our products;

	•		budget cycles of our potential customers that affect the timing of purchases;

	•		customer requirements for competitive evaluation and internal approval before purchasing our products;

	•		potential delays of purchases due to announcements or planned introductions of new products by us or our competitors; and

	•		the lengthy approval processes of our potential customers, many of which are large organizations.

The delay or failure to complete sales in a particular quarter would reduce our revenues in that quarter, as well as any subsequent quarters over which revenues for the sale would likely be recognized. Given that our license revenues are dependent on a relatively small number of transactions, any unexpected lengthening in general or for one or more large orders would adversely affect the timing and amount of our revenues. If we continue to experience longer sales cycles on one or more large orders, our operating results will continue to be adversely affected.

In addition, we make assumptions and estimates as to the timing and amount of future revenues in budgeting future operating costs and capital expenditures. Specifically, our sales personnel monitor the status of all proposals, including the estimated closing dates and potential dollar amounts of such transactions. Management aggregates these estimates periodically to generate our sales forecasts and then evaluates the forecasts to identify trends in our business. Although we have reduced expenses to better align our costs with the expected timing and amount of revenues, our costs are relatively fixed in the short term and a substantial portion of our license revenue contracts are completed in the latter part of a quarter. As a result, failure to complete one or more license transactions at the end of a quarter would cause our quarterly results of operations to be worse than anticipated. If our operating results fall below the expectations of securities analysts or investors, the trading price of our common stock would likely decline.

If we are unable to increase sales of new product licenses, our maintenance and service revenues will be materially and adversely affected.

While our license revenues have declined from 2003 levels, our maintenance and service revenues have remained relatively constant. A substantial portion of our maintenance and service revenues, however, is derived from providing professional integration and configuration services associated with product licenses sold in prior periods. As such, if we are unable to increase sales of our product licenses, our maintenance and service revenues will decline as well. For example, we expect maintenance and service revenues to decrease in the third quarter of 2005 due to the decrease in new product license sales in the first half of the year.

If we do not compete effectively with companies selling EIM software, our revenues may not grow and could decline.

We have experienced, and expect to continue to experience, intense competition from a number of software companies. We compete principally with vendors of EIM software, enterprise resource planning software, and customer relationship management software. Our competitors may announce new products, services or enhancements that better meet the needs of customers or changing industry standards. Increased competition may cause price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, results of operations and financial condition.

Many of our enterprise resource planning competitors and other potential competitors have significantly greater financial, technical, marketing, service and other resources than we have. Many of these companies also have a larger installed base of users, longer operating histories or greater name recognition than we have. Some of our competitors’ products may also be more effective than our products at performing particular EIM system functions or may be more customized for particular customer needs in a given market. Even if our competitors provide products with more limited EIM system functionality than our products, these products may incorporate other capabilities, such as recording and accounting for transactions, customer orders or inventory management data. A product that performs these functions, as well as some of the functions of our software solutions, may be appealing to some customers because it would reduce the number software applications used to run their business. Further, our competitors may be able to respond more quickly than we can to changes in customer requirements.

Our products must be integrated with software provided by a number of our existing or potential competitors. These competitors could alter their products in ways that inhibit integration with our products, or they could deny or delay access by us to advance software releases, which would restrict our ability to adapt our products to facilitate integration with these new releases and could result in lost sales opportunities.

Our maintenance and service revenues produce substantially lower gross margins than our license revenues, and decreases in license revenues relative to service revenues have harmed, and may continue to harm, our overall gross margins.

Our maintenance and service revenues, which include fees for consulting, implementation, maintenance and training, were 90%, 82%, 78% and 48% of our revenues for the three and six months ended June 30, 2005 and fiscal years 2004 and 2003, respectively. Our maintenance and service revenues have substantially lower gross margins than our license revenues. The decrease in the

percentage of total revenues represented by license revenues in the three and six months ended June 30, 2005 and fiscal 2004 as compared to fiscal 2003 has adversely affected our overall gross margins. Failure to increase our higher margin license revenues in the future would continue to adversely affect our gross margin and operating results.

Historically, maintenance and service revenues as a percentage of total revenues have varied significantly from period to period due to fluctuations in licensing revenues, economic changes, changes in the average selling prices for our products and services, our customers’ acceptance of our products, our sales force execution, and competitive service providers. In addition, the volume and profitability of services can depend in large part upon:

	•		Competitive pricing pressure on the rates that we can charge for our professional services;

	•		the complexity of the customers’ information technology environment;

	•		the resources directed by customers to their implementation projects; and

	•		the extent to which outside consulting organizations provide services directly to customers.

We expect maintenance and services revenue to continue to make up a substantial majority of our overall revenues for the foreseeable future and any erosion of our margins for our maintenance and service revenue would adversely affect our operating results.

Managing large-scale deployments of our products requires substantial technical implementation and support by us or third-party service providers. Failure to meet these requirements could cause a decline or delay in recognition of our revenues and an increase in our expenses.

Our customers may require large, enterprise-wide deployments of our products, which require a substantial degree of technical expertise to implement and support. It may be difficult for us to manage these deployments, including the timely allocation of personnel and resources by us or our customers. Failure to successfully manage the process could harm our reputation both generally and with the specific customer and may cause us to lose existing customers, face potential customer disputes or limit the number of new customers that purchase our products, each of which could adversely affect our revenues and increase our technical support and litigation costs.

Our software license customers have the option to receive implementation, maintenance, training and consulting services from our internal professional services organization or from outside consulting organizations. In the future, we may be required to increase our use of third-party service providers to help meet our implementation and service obligations. If we require a greater number of third-party service providers than we currently have available, we will be required to negotiate additional arrangements, which may result in lower gross margins for maintenance or service revenues.

If a customer selects a third-party implementation service provider and such implementation services are not provided successfully and in a timely manner, our customers may experience increased costs and errors, which may result in customer dissatisfaction and costly remediation and litigation, any of which could adversely impact our operating results and financial condition.

Our success depends upon our ability to develop new products and enhance our existing products. Failure to successfully introduce new or enhanced products to the market may adversely affect our operating results.

The enterprise application software market is characterized by:

	•		Rapid technological advances in hardware and software development;

	•		evolving standards in computer hardware, software technology and communications infrastructure;

	•		changing customer needs; and

	•		frequent new product introductions and enhancements.

To keep pace with technological developments, satisfy increasingly sophisticated customer requirements, achieve market acceptance and effectively respond to competitive product introductions, we must quickly identify emerging trends and requirements, accurately define and design enhancements and improvements for existing products and continue to introduce new products and services. Accelerated product introductions and short product life cycles require high levels of expenditures for research and development that could adversely affect our operating results. Further, any new products we develop may not be introduced in a timely manner and may not achieve the broad market acceptance necessary to generate significant revenues. For example, we

introduced our TruePerformance product in the first quarter of 2003 and discontinued it in June 2004. In connection with the discontinuation of the TruePerformance product line, we recorded impairment charges of approximately $3.8 million in the second quarter of 2004. If we are unable to successfully and in a timely fashion develop new products or enhance and improve our existing products or if we fail to position and/or price our products to meet market demand, our business and operating results will be adversely affected.

A substantial majority of our revenues are derived from TrueComp and related products and services and a decline in sales of these products and services could adversely affect our operating results and financial condition.

We derive a substantial majority of our revenues from TrueComp and related products and services, and revenues from these products and services are expected to continue to account for a substantial majority of our revenues for the foreseeable future. Because we generally sell licenses to our products on a perpetual basis and deliver new versions and enhancements to customers who purchase maintenance contracts, our future license revenues are substantially dependent on sales to new customers. In addition, substantially all of our TrueInformation product sales have historically been made in connection with TrueComp sales. As a result of these factors, we are particularly vulnerable to fluctuations in demand for TrueComp. Accordingly, if demand for TrueComp and related products and services declines significantly, our business and operating results will, be adversely affected as was in the case in 2004 and the first half of 2005.

If we reduce prices or alter our payment terms to compete successfully, our margins and operating results may be adversely affected.

The intensely competitive market in which we do business may require us to reduce our prices and/or modify our traditional licensing revenue generation strategies in ways that may include delayed revenue recognition. If our competitors offer deep discounts on competitive products or services in an effort gain market share or to sell other software or hardware products, we may be required to lower prices or offer other terms more favorable to our customers in order to compete successfully. For example, some of our competitors may bundle software products that compete with ours for promotional purposes or as a long-term pricing strategy or provide guarantees of prices and product implementations. These practices could, over time, limit the prices that we can charge for our products. Any such changes would likely reduce our margins and could adversely affect our operating results. If we cannot offset price reductions and other terms more favorable to customers with a corresponding increase in the number of sales or with decreased spending, then the reduced revenues resulting from lower prices or revenue recognition delays would adversely affect our margins and operating results.

We depend on the technology of third parties licensed to us for our rules engine and the analytics and web viewer functionality for our products and the loss or inability to maintain these licenses or errors in such software could result in increased costs or delayed sales of our products.

We license technology from several software providers for our rules engine, analytics and web viewer. We anticipate that we will continue to license technology from third parties in the future. This software may not continue to be available on commercially reasonable terms, if at all. Some of the products we license could be difficult to replace, and developing or integrating new software with our products could require months or years of design and engineering work. The loss of any of these technology licenses could result in delays in the license of our products until equivalent technology, if available, is developed or identified, licensed and integrated. In addition, our products depend upon the successful operation of third-party products in conjunction with our products, and therefore any undetected errors in these products could prevent the implementation or impair the functionality of our products, delay new product introductions and/or injure our reputation. Our use of additional or alternative third-party software would require us to enter into license agreements with third parties, which could result in higher royalty payments and a loss of product differentiation.

Errors in our products could, be costly to correct, adversely affect our reputation and impair our ability to sell our products.

Our products are complex and, accordingly, they may contain errors, or “bugs,” that could be detected at any point in their product life cycle. While we plan to continually test our products for errors and work with customers through our customer support services organization to timely identify and correct bugs, errors in our products may still be found in the future. Errors in our products could be extremely costly to correct, materially adversely affect our reputation, and impair our ability to sell our products in the future. Moreover, customers relying on our products to calculate and pay incentive compensation may have a greater sensitivity to product errors and security vulnerabilities than customers for software products in general. If we incur substantial costs to correct any product errors, our operating margins would be adversely affected.

Because our customers depend on our software for their critical business functions, any interruptions could result in:

	•		Lost or delayed market acceptance and sales of our products;

	•		product liability suits against us;

	•		diversion of development resources; and

	•		increased service and warranty costs.

While our software license agreements typically contain limitations and disclaimers that purport to limit our liability for damages for errors in our software, such limitations and disclaimers may not be enforced by a court or other tribunal or otherwise may not effectively protect us from such claims.

Potential customers that outsource their technology projects offshore may come to expect lower rates for professional services than we are able to provide profitably, which could impair our ability to win customers and achieve profitability.

Many of our potential customers have begun to outsource technology projects offshore to take advantage of lower labor costs, and we believe that this trend will continue. Due to the lower labor costs in some countries, these customers may demand lower hourly rates for the professional services we provide, which may erode our margins for our maintenance and service revenues or result in lost business.

Our revenues might be harmed by resistance to adoption of our software by information technology departments.

Some potential customers have already made a substantial investment in other third-party or internally developed software designed to model, administer, analyze and report on pay-for-performance programs. These companies may be reluctant to abandon these investments in favor of our software. In addition, information technology departments of potential customers may resist purchasing our software solutions for a variety of other reasons, particularly the potential displacement of their historical role in creating and running software and concerns that packaged software products are not sufficiently customizable for their enterprises. If the market for our products does not grow for any of these reasons, our revenues may be harmed.

We will not be able to achieve or sustain sales growth if we do not attract and retain qualified sales personnel.

We depend on our direct sales force for most of our sales and have made significant expenditures in past periods to expand our sales force. Despite our efforts to maintain and expand our sales force, we have experienced sales force attrition and otherwise found it difficult to retain qualified sales professionals. For example, our former head of sales resigned effective February 28, 2005. While it is our goal to hire and retain qualified replacements and to continue the development and expansion of our direct sales organization domestically and internationally, we face intense competition for sales personnel in the software industry and cannot be sure that we will be successful in hiring a new vice president of sales or in retaining key sales individuals in accordance with our plans. If we fail to successfully develop and maintain a strong sales force, our future sales will be adversely affected.

If we do not effectively manage our sales and marketing strategies and organizations, our results of operations may be harmed.

Effectively managing our sales organization and distribution channels is likely to become more complex as we begin implementing new, creative, and previously untested sales and marketing strategies for the increasingly competitive global EIM market. Any new strategies may be time-consuming to develop, difficult or costly to implement and ultimately prove unsuccessful or unjustified, any of which could negatively impact our results of operations.

We may lose sales opportunities and our business may be harmed if we do not successfully develop and maintain strategic relationships to implement and sell our products.

We have relationships with third-party consulting firms, systems integrators and software vendors. These third parties may provide us with customer referrals, cooperate with us in the design, sales and/or marketing of our products, provide valuable insights into market demands and provide our customers with systems implementation services or overall program management. However, we do not have formal agreements governing our ongoing relationship with certain of these third-party providers and the agreements we do have generally do not include obligations with respect to generating sales opportunities or cooperating on future business. Should any of these third parties go out of business or choose not to work with us, we may be forced to develop all or a portion of those capabilities internally, incurring significant expense and adversely affecting our operating margins. Any of our third-party providers may offer products of other companies, including products that compete with our products. If we do not successfully and efficiently establish, maintain, and expand our industry relationships with influential market participants, we could lose sales and service opportunities and adversely affect our results of operations.

For our business to succeed, we need to attract, train and retain qualified employees and manage our employee base effectively. Failure to do so may adversely affect our operating results.

Our success depends on our ability to hire, train and retain qualified employees and to manage our employee base effectively. Competition for qualified personnel is intense, particularly in the San Francisco Bay Area where our headquarters is located, and the high cost of living increases our recruiting and compensation costs. We cannot assure you that we will be successful in timely hiring, training or retaining qualified personnel. If we are unable to do so, our business and operating results will be adversely affected. Even if we are able to hire, train, and maintain qualified personnel, we expect to experience operational disruptions and inefficiencies.

If we fail to adequately protect our proprietary rights and intellectual property, we may lose valuable assets, experience reduced revenues and incur costly litigation to protect our rights.

Our success and ability to compete depend in part on our proprietary technology. We rely on a combination of copyrights, patents, trademarks, service marks, trade secret laws and contractual restrictions to establish and protect our proprietary rights in our products and services. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Despite our precautions, it may be possible for unauthorized third parties to copy and/or reverse engineer our products and use information that we regard as proprietary to create products and services that compete with ours. Some license provisions protecting against unauthorized use, copying, transfer and disclosure of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries. Further, the laws of some countries do not protect proprietary rights to the same extent as the laws of the United States. To the extent that we engage in international activities, our exposure to unauthorized copying and use of our products and proprietary information increases.

We enter into confidentiality or license agreements with our employees and consultants and with the customers and corporations with whom we have strategic relationships and business alliances. No assurance can be given that these agreements will be effective in controlling access to and distribution of our products and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our products. Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management resources, either of which could seriously harm our business.

Our results of operations may be adversely affected if we are subject to a protracted infringement claim or one that results in a significant damage award.

From time to time, we receive claims that our products or business infringe or misappropriate the intellectual property of third parties and with new releases of our products, the number of such claims we receive may increase. Our competitors or other third parties may challenge the validity or scope of our intellectual property rights. We believe that software developers will be increasingly subject to claims of infringement as the functionality of products in our market overlaps. A claim may also be made relating to technology that we acquire or license from third parties. If we were subject to a claim of infringement, regardless of the merit of the claim or our defenses, the claim could:

	•		Require costly litigation to resolve;

	•		absorb significant management time;

	•		cause us to enter into unfavorable royalty or license agreements;

	•		require us to discontinue the sale of all or a portion of our products;

	•		require us to indemnify our customers or third-party systems integrators; or

	•		require us to expend additional development resources to redesign our products.

We may also be required to indemnify our customers and third-party systems integrators for third-party products that are incorporated into our products and that infringe the intellectual property rights of others. Although many of these third parties are obligated to indemnify us if their products infringe the rights of others, this indemnification may not be adequate.

In addition, from time to time there have been claims challenging the ownership of open source software against companies that incorporate open source software into their products. We use a limited amount of open source software in our products and may use more open source software in the future. As a result, we could be subject to suits by parties claiming ownership of what we believe to be open source software. Any of this litigation could be costly for us to defend, have a negative effect on our results of operations and financial condition or require us to devote additional research and development resources to change our products.

If we do not adequately manage and evolve our financial reporting and managerial systems and processes, our ability to manage and grow our business may be harmed.

Our ability to successfully implement our business plan and comply with regulations, including the Sarbanes-Oxley Act of 2002, requires an effective planning and management process. We expect that we will need to continue to improve existing, and implement new, operational and financial systems, procedures and controls to manage our business effectively in the future. Any delay in the implementation of, or disruption in the transition to, new or enhanced systems, procedures or controls, could harm our ability to accurately forecast sales demand, manage our supply chain and record and report financial and management information on a timely and accurate basis.

Mergers of or other strategic transactions by our competitors could weaken our competitive position or reduce our revenues.

If one or more of our competitors were to merge or partner with another of our competitors, the change in the competitive landscape could adversely affect our ability to compete effectively. Our competitors may also establish or strengthen cooperative relationships with our current or future systems integrators, third-party compensation consulting firms or other parties with whom we have relationships, thereby limiting our ability to promote our products and limiting the number of consultants available to implement our software. Disruptions in our business caused by these events could reduce our revenues.

We may expand our international operations but do not have substantial experience in international markets, and may not achieve the expected results.

We may in the future expand our international operations. Any international expansion would require substantial financial resources and a significant amount of attention from our management. International operations involve a variety of risks, particularly:

	•		Unexpected changes in regulatory requirements, taxes, trade laws and tariffs;

	•		differing ability to protect our intellectual property rights;

	•		differing labor regulations;

	•		greater difficulty in supporting and localizing our products;

	•		changes in a specific country’s or region’s political or economic conditions;

	•		greater difficulty in establishing, staffing and managing foreign operations; and

	•		fluctuating exchange rates.

We have limited experience in marketing, selling and supporting our products and services abroad. If we invest substantial time and resources to grow our international operations and are unable to do so successfully and in a timely manner, our business and operating results could be seriously harmed.

Acquisitions and investments present many risks, and we may not realize the anticipated financial and strategic goals for any such transactions.

We may in the future acquire or make investments in other complementary companies, products, services and technologies. Such acquisitions and investments involve a number of risks, including:

	•		As was the case with our acquisition of an assembled workforce and source code license from Cezanne Software, we may find that the acquired business or assets do not further our business strategy, or that we overpaid for the business or assets, or that economic conditions change, all of which may generate a future impairment charge;

	•		we may have difficulty integrating the operations and personnel of the acquired business, and may have difficulty retaining the key personnel of the acquired business;

	•		we may have difficulty incorporating the acquired technologies or products with our existing product lines;

	•		there may be customer confusion where our products overlap with those of the acquired business;

	•		we may have product liability associated with the sale of the acquired business’ products;

	•		our ongoing business and management’s attention may be disrupted or diverted by transition or integration issues and the complexity of managing geographically and culturally diverse locations;

	•		we may have difficulty maintaining uniform standards, controls, procedures and policies across locations;

	•		the acquisition may result in litigation from terminated employees or third-parties; and

	•		we may experience significant problems or liabilities associated with product quality, technology and legal contingencies.

These factors could have a material adverse effect on our business, results of operations and financial condition or cash flows, particularly in the case of a larger acquisition or multiple acquisitions in a short period of time. From time to time, we may enter into negotiations for acquisitions or investments that are not ultimately consummated. Such negotiations could result in significant diversion of management time, as well as out-of-pocket expenses.

The consideration paid in connection with an investment or acquisition also affects our financial condition and operating results. If we were to proceed with one or more significant acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available cash to consummate such acquisitions. To the extent we issue shares of stock or other rights to purchase stock, including options or other rights, existing stockholders may be diluted and earnings per share may decrease. In addition, acquisitions may result in the incurrence of debt, large one-time write-offs (such as of acquired in-process research and development costs) and restructuring charges. They may also result in goodwill and other intangible assets that are subject to impairment tests, which could result in future impairment charges.

For instance, in December 2003, we purchased a non-exclusive license to copy, create, modify, and enhance the source code for our TruePerformance product, and in May 2004, we acquired a part of the development team of Cezanne Software in order to continue the development of the TruePerformance product. However, we made the decision to discontinue the TruePerformance product in June of 2004 and recorded a total impairment of intangible assets charge of $3.8 million.

Class action and derivative lawsuits have been filed against us and additional lawsuits may be filed.

In July 2004, a purported class action lawsuit was filed against us and certain of our current directors and officers, by or on behalf of persons claiming to be our shareholders and persons claiming to have purchased or otherwise acquired our securities during the period from November 19, 2003 through June 23, 2004. In addition, in each of July and October 2004 derivative lawsuits were filed against us and certain of our current directors and officers. In February 2005, the parties stipulated to a stay of the state derivative case in favor of the federal derivative case. In February 2005, we filed a motion to dismiss the amended complaint in the federal securities case. In May 2005 the court granted our motion and granted plaintiffs leave to amend. The plaintiffs failed to amend the complaint and the court thereafter entered a dismissal with prejudice on July 5, 2005. The remaining derivative cases are still pending and the

parties submitted a Joint Status Statement to the court on July 15, 2005 outlining the current status of the cases and presenting a proposed schedule for the cases going forward. Additional lawsuits may be filed against us in the future. We currently have director and officer insurance to cover claims that may arise in connection with these lawsuits and we believe that the claims are without merit. However, in the event of an adverse result in one of these cases, our insurance may not be sufficient to satisfy a damage award and thus such an adverse result could have a material negative financial impact on us. Regardless of the outcome of any of these actions, however, it is likely that such actions will cause a diversion of our management’s time and attention.

Natural disasters or other incidents may disrupt our business.

Our business communications, infrastructure and facilities are vulnerable to damage from human error, physical or electronic security breaches, power loss and other utility failures, fire, earthquake, flood, sabotage, vandalism and similar events. Although the source code for our software products is held by escrow agents outside of the San Francisco Bay Area, our internal-use software and back-up are both located in the San Francisco Bay Area. If a natural or man-made disaster were to hit this area, we may lose all of our internal-use software data. Despite precautions, a natural disaster or other incident could result in interruptions in our service or significant damage to our infrastructure. In addition, failure of any of our telecommunications providers could result in interruptions in our services and disruption of our business operations. Any of the foregoing could impact our provision of services and fulfillment of product orders, and our ability to process product orders and invoices and otherwise timely conduct our business operations.

RISKS RELATED TO OUR STOCK

Our stock price is likely to remain volatile.

The trading price of our common stock has in the past and may in the future be subject to wide fluctuations in response to a number of factors, including those listed in this “Risks Related to Our Business” section of this Quarterly Report above and in this section below. We receive only limited attention by securities analysts, and there frequently occurs an imbalance between supply and demand in the public trading market for our common stock due to limited trading volumes. Investors should consider an investment in our common stock as risky and should only purchase our common stock if they can withstand significant losses. Other factors that affect the volatility of our stock include:

	•		Our operating performance and the performance of other similar companies;

	•		announcements by us or our competitors of significant contracts, results of operations, projections, new technologies, acquisitions, commercial relationships, joint ventures or capital commitments;

	•		changes in our management team;

	•		publication of research reports about us or our industry by securities analysts;

	•		speculation in the press or investment community;

	•		developments with respect to intellectual property rights; and

	•		terrorist acts.

Additionally, some companies with volatile market prices for their securities have been subject to securities class action lawsuits filed against them, which could have a material adverse effect on our business, results of operations, financial condition and the price of our common stock.

Our current officers, directors and entities affiliated with us may be able to exercise control over matters requiring stockholder approval.

As of June 30, 2005, our current officers, directors and entities affiliated with us together beneficially owned or controlled approximately 12,008,967 shares or approximately 46% of our outstanding common stock. As a result, if some of these persons or entities act together, they have the ability to exercise significant control over all matters submitted to our stockholders for approval, including the election and removal of directors, amendments to our certificate of incorporation and bylaws and the approval of any business combination. This may delay or prevent an acquisition or otherwise discourage potential acquirers from attempting to obtain

control of us, which in turn could have an adverse effect on the market price of our common stock. Some of these persons or entities may have interests different from our other investors.

Future sales of substantial amounts of our common stock by us or our existing stockholders could cause our stock price to fall.

Additional equity financings or other share issuances by us could adversely affect the market price of our common stock. Sales by existing stockholders of a large number of shares of our common stock in the public trading market (or in private transactions) including sales by our executive officers, directors or venture capital funds or other persons or entities affiliated with our officers and directors or the perception that such additional sales could occur, could cause the market price of our common stock to drop.

Provisions in our charter documents, our stockholder rights plan and Delaware law may delay or prevent an acquisition of our company.

Our certificate of incorporation and bylaws contain provisions that could make it harder for a third party to acquire us without the consent of our board of directors. For example, if a potential acquirer were to make a hostile bid for us, the acquirer would not be able to call a special meeting of stockholders to remove our board of directors or act by written consent without a meeting. In addition, our board of directors has staggered terms, which means that replacing a majority of our directors would require at least two annual meetings. The acquirer would also be required to provide advance notice of its proposal to replace directors at any annual meeting, and would not be able to cumulate votes at a meeting, which would require the acquirer to hold more shares to gain representation on the board of directors than if cumulative voting were permitted. In addition, we are a party to a stockholder rights agreement, which effectively prohibits a person from acquiring more than 15% (subject to certain exceptions) of our common stock without the approval of our board of directors.

Furthermore, Section 203 of the Delaware General Corporation Law limits business combination transactions with 15% stockholders that have not been approved by the board of directors. All of these factors make it more difficult for a third party to acquire us without negotiation. These provisions may apply even if the offer may be considered beneficial by some stockholders.

Our board of directors could choose not to negotiate with an acquirer that it does not believe is in our strategic interests. If an acquirer is discouraged from offering to acquire us or prevented from successfully completing a hostile acquisition by these or other measures, you could lose the opportunity to sell your shares at a favorable price.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in interest rates and foreign exchange rates. We do not hold or issue financial instruments for trading purposes.

Interest Rate Risk. We invest our cash in a variety of financial instruments, consisting primarily of investments in money market accounts, high quality corporate debt obligations or United States government obligations. Our investments are made in accordance with an investment policy approved by our Board of Directors. All of our investments are classified as available-for-sale and carried at fair value, which is determined based on quoted market prices, with net unrealized gains and losses included in accumulated other comprehensive income in the accompanying condensed consolidated balance sheets.

Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities, which typically have a shorter duration, may produce less income than expected if interest rates fall. Due in part to these factors, our investment income may decrease in the future due to changes in interest rates. At June 30, 2005, the average maturity of our investments was four months. The following table presents certain information about our financial instruments at June 30, 2005 that are sensitive to changes in interest rates (in thousands, except for interest rates):


	Expected Maturity
	1 Year			More than		Principal		Fair
	or Less			1 Year		Amount		Value
Available-for-sales securities	$	51,835		$	—	$	51,835	$	51,755
Weighted average interest rate		2.55	%

Our exposure to market risk also relates to the increase or decrease in the amount of interest expense we must pay on our outstanding debt instruments. We have outstanding term loans totaling $0.2 million. The term loans bear a variable interest rate based on the lender’s prime rate and prime rate plus 0.50%, respectively. The risk associated with fluctuating interest expense is limited to these debt instruments. Due to our low amount of debt as of June 30, 2005, we do not believe that any change in the prime rate would have a significant impact on our interest expense.

Foreign Currency Exchange Risk. Our revenues and our expenses, except those related to our United Kingdom, German, Italian and Australian operations, are generally denominated in United States dollars. For the three and six months ended June 30, 2005, we derived approximately 5% and 9% of our revenues from our international operations, respectively. As a result, we have relatively little exposure to currency exchange risks and foreign exchange losses have been minimal to date. We expect to continue to do a majority of our business in United States dollars. We have not entered into forward exchange contracts to hedge exposure denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. In the future, if we believe our foreign currency exposure has increased, we may consider entering into hedging transactions to help mitigate that risk.

Item 4. Controls and Procedures

Our chief executive officer and chief financial officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this quarterly report of Callidus Software Inc. on Form 10-Q, have concluded that as of the end of the period covered by this report, our disclosure controls and procedures were adequate and designed to ensure that material information related to us and our consolidated subsidiaries would be made known to them by others within these entities.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

In addition, we are from time to time a party to various other litigation matters incidental to the conduct of its business, none of which, at the present time, we believe is likely to have a material adverse effect on the our future financial results.

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

On May 31, 2005 we issued a warrant for the purchase of 100,000 shares of our common stock to Heidrick & Struggles, Inc. in connection with executive recruiting services they performed related to the hiring of our new chief executive officer. The common stock shares underlying the warrant were fully vested on May 31, 2005 and are exercisable at a price of $3.45 per share through May 31, 2012. The warrant was issued in a transaction exempt from registration under the Securities Act of 1933, as amended, in reliance upon Section 4(2) thereof, as well as the qualification requirements of applicable state securities laws. Under the terms of the warrant agreement, the Company is not obligated to register the shares of common stock issuable upon exercise of the warrant.

We continue to use our net proceeds from our initial public offering for working capital and general corporate purposes, including expanding our sales efforts, research and development and international operations. Pending use for these or other purposes, we have invested the net proceeds of the offering in interest-bearing, investment-grade securities.

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

The Company’s Annual Meeting of Stockholders (the “Annual Meeting”) was held on June 7, 2005. Two matters were voted on at the Annual Meeting. A brief description of each of these matters, and the results of the votes thereon, are as follows:

Proposal 1. Election of Directors

Immediately prior to the commencement of the Annual Meeting, the Company’s Board of Directors consisted of seven members divided into three classes (Classes I through III). The Class II members of the Board of Directors were scheduled for election at the Annual Meeting, to serve until the 2008 annual meeting of stockholders, or until their successors are elected by the stockholders or appointed by the Board of Directors pursuant to the Company’s bylaws. The nominees of the Board to serve as Class II members were Terry L. Opdendyk and William B. Binch. There were no other nominees. Messrs. Opdendyk and Binch were each elected at the Annual Meeting as Class II directors by the following votes:


Nominee	For		Withheld
Terry L. Opdendyk		19,270,126		1,584,430
William B. Binch		20,815,704		38,852

The Company’s other directors whose terms of office continued after the Annual Meeting are George B. James, David B. Pratt and Robert H. Youngjohns (Class I) and Michael A. Braun and John R. Eickhoff (Class III).

Proposal 2. Ratification of the appointment of KPMG LLP as the Company’s independent public accountants for the fiscal year ending December 31, 2005.


For		Against		Abstain		Broker Non-Votes
	20,836,303		9,290		8,963		—

Item 6. Exhibits

(a) Exhibits


Exhibit
Number		Description
10.34		Employment Agreement by and between Robert H. Youngjohns and Callidus Software Inc. dated April 26, 2005 and effective May 31, 2005 (incorporated by reference herein from Exhibit 10.31 to the Company’s Form 8-K filed with the Commission on April 26, 2005).

10.35		Non-Qualified Stock Option Agreement by and between Robert H. Youngjohns and Callidus Software Inc. dated May 31, 2005.

10.36		Restricted Stock Agreement by and between Robert H. Youngjohns and Callidus Software Inc. dated June 7, 2005.

31.1		302 Certifications

32.1		906 Certification

Availability of this Report

We intend to make this quarterly report on Form 10-Q publicly available on our website (www.callidussoftware.com) without charge immediately following our filing with the Securities and Exchange Commission. We assume no obligation to update or revise any forward-looking statements in this quarterly report on Form 10-Q, whether as a result of new information, future events or otherwise, unless we are required to do so by law.


PART I FINANCIAL INFORMATION

Item 1. Financial Statements		3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		12
Item 3. Quantitative and Qualitative Disclosures About Market Risk		33
Item 4. Controls and Procedures		34

PART II OTHER INFORMATION

Item 1. Legal Proceedings		35
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		35
Item 4. Submission of Matters to a Vote of Security Holders		35
Item 6. Exhibits		36
Signatures		37
Exhibit Index
EXHIBIT 10.35
EXHIBIT 10.36
EXHIBIT 31.1
EXHIBIT 32.1


	CALLIDUS SOFTWARE INC.
	By:	/s/ RONALD J. FIOR
		Ronald J. Fior, Chief Financial Officer,
		Vice President Finance


Grant Number		1,721

Date of Grant		May 31, 2005

Vesting Commencement Date		May 31, 2005

Exercise Price per Share		$3.45

Total Number of Shares Granted		1,000,000

Total Exercise Price		$3,450,000

Type of Option:		Nonstatutory Stock Option

Expiration Date:		May 31, 2015


ROBERT H. YOUNGJOHNS [OPTIONEE]:		CALLIDUS SOFTWARE, INC.

/s/ Robert H. Youngjohns		/s/ Brian E. Cabrera

Signature		Brian E. Cabrera, VP Corporate Development and General Counsel


Submitted by OPTIONEE:		Accepted by CALLIDUS SOFTWARE INC.:


Signature		By


Print Name		Its

Address		Address:

		160 West Santa Clara Street, Suite 1500 San Jose, CA 95113

		Date Received:

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Grant Number		1,722

Date of Grant		June 7, 2005

Total Number of Shares Granted		28,000


RECIPIENT:		CALLIDUS SOFTWARE, INC.

/s/ Robert H. Youngjohns		By: /s/ Brian E. Cabrera

Signature		Brian E. Cabrera, VP Corporate Development and General Counsel

Robert Youngjohns
Print Name

	1.		I have reviewed this quarterly report of Callidus Software Inc. on Form 10-Q;

	2.		Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

	3.		Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

	4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

	(a)		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	(b)		Paragraph omitted pursuant to SEC Release Nos. 33-8238 and 34-47986;

	(c)		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

	(d)		Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of this annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and



	/s/ ROBERT H. YOUNGJOHNS
	Robert H. Youngjohns
	President and Chief Executive Officer

	(a)		All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

	(b)		Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.



	/s/ RONALD J. FIOR
	Ronald J. Fior
	Chief Financial Officer, Vice President, Finance

	1.		The Report fully complies with the requirements of Section 13(a) or 15(d) of the Exchange Act; and

	2.		The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of Callidus Software Inc.