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 September 30, 2006


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 Incorporation or Organization)		(I.R.S. Employer Identification Number)

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 reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer o Non-accelerated filer þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

There were 28,193,244 shares of the registrant’s common stock, par value $0.001, outstanding on November 7, 2006, 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)


	September 30,			December 31,
	2006			2005
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	14,157		$	23,705
Short-term investments		39,054			40,000
Accounts receivable, net		15,510			11,063
Prepaids and other current assets		3,164			1,581

Total current assets		71,885			76,349
Property and equipment, net		3,173			2,801
Deposits and other assets		1,233			1,494

Total assets	$	76,291		$	80,644


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	752		$	756
Accrued payroll and related expenses		4,417			6,383
Accrued expenses		2,600			2,043
Deferred revenue		11,370			12,205

Total current liabilities		19,139			21,387
Deferred rent		677			377
Long-term deferred revenue		594			729
Other liabilities		70			—

Total liabilities		20,480			22,493


Stockholders’ equity:
Common stock, $0.001 par value; 100,000 shares authorized; 28,132 and 26,854 shares issued and outstanding at September 30, 2006 and December 31, 2005, respectively		28			27
Additional paid-in capital		192,108			186,232
Deferred stock-based compensation		—			(445	)
Accumulated other comprehensive income		332			171
Accumulated deficit		(136,657	)		(127,834	)

Total stockholders’ equity		55,811			58,151

Total liabilities and stockholders’ equity	$	76,291		$	80,644

See accompanying notes to unaudited condensed consolidated financial statements.

CALLIDUS SOFTWARE INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
	(Unaudited)
Revenues:
License revenues	$	5,776		$	5,787		$	18,669		$	10,582
Maintenance and service revenues		11,649			11,311			33,377			33,632

Total revenues		17,425			17,098			52,046			44,214
Cost of revenues:
License revenues		105			76			389			259
Maintenance and service revenues⁽¹⁾		8,205			7,748			24,570			22,703

Total cost of revenues		8,310			7,824			24,959			22,962

Gross profit		9,115			9,274			27,087			21,252


Operating expenses:
Sales and marketing⁽¹⁾		5,570			5,208			17,929			13,358
Research and development⁽¹⁾		3,612			3,109			10,832			9,124
General and administrative⁽¹⁾		3,195			2,232			9,274			6,931

Total operating expenses		12,377			10,549			38,035			29,413


Operating loss		(3,262	)		(1,275	)		(10,948	)		(8,161	)
Interest expense		—			(4	)		—			(20	)
Interest and other income, net		754			411			1,997			1,092


Loss before provision for income taxes		(2,508	)		(868	)		(8,951	)		(7,089	)
Provision for income taxes		—			38			—			29

Loss before cumulative effect of a change in accounting principle		(2,508	)		(906	)		(8,951	)		(7,118	)


Cumulative effect of a change in accounting principle		—			—			128			—

Net loss	$	(2,508	)	$	(906	)	$	(8,823	)	$	(7,118	)


Net loss per share — basic
Loss before cumulative effect of a change in accounting principle	$	(0.09	)	$	(0.03	)	$	(0.33	)	$	(0.27	)
Cumulative effect of a change in accounting principle		—			—			0.01			—

Net loss per share	$	(0.09	)	$	(0.03	)	$	(0.32	)	$	(0.27	)

Net loss per share — diluted
Loss before cumulative effect of a change in accounting principle	$	(0.09	)	$	(0.03	)	$	(0.33	)	$	(0.27	)
Cumulative effect of a change in accounting principle		—			—			0.01			—

Net loss per share	$	(0.09	)	$	(0.03	)	$	(0.32	)	$	(0.27	)


Shares used in basic per share computation		27,888			26,425			27,500			26,636

Shares used in diluted per share computation		27,888			26,425			27,500			26,636

CALLIDUS SOFTWARE INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS — (Continued)
(In thousands, except per share data)


⁽¹⁾		Effective January 1, 2006, the Company adopted FASB Statement No. 123R (revised 2004), “Share-Based Payment” (SFAS 123R) under the modified prospective method. Accordingly, for the three and nine months ended September 30, 2006, stock-based compensation was accounted for under SFAS 123R, while for the three and nine months ended September 30, 2005, stock-based compensation was accounted for under Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees.” See Note 6 — Stock-based Compensation. The amounts above include stock-based compensation as follows:


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2006		2005			2006		2005
Cost of maintenance and service revenues	$	250	$	(2	)	$	760	$	89
Sales and marketing		264		55			794		244
Research and development		217		1			682		227
General and administrative		335		(3	)		1,429		354

See accompanying notes to unaudited condensed consolidated financial statements.

CALLIDUS SOFTWARE INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)


	Nine Months Ended
	September 30,
	2006			2005
	(Unaudited)
Cash flows from operating activities:
Net loss	$	(8,823	)	$	(7,118	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and other amortization		1,380			1,226
Provision for doubtful accounts and sales returns		598			476
Stock-based compensation		3,665			914
Non-cash expenses associated with non-employee options and warrants		—			4
Loss on disposal of property		10			2
Cumulative effect of a change in accounting principle		(128	)		—
Changes in operating assets and liabilities:
Accounts receivable		(4,998	)		2,302
Prepaids and other current assets		(1,305	)		250
Other assets		—			(229	)
Accounts payable		25			(838	)
Accrued payroll and related expenses		(1,990	)		62
Accrued expenses		675			359
Deferred revenue		(1,009	)		1,662

Net cash used in operating activities		(11,900	)		(928	)


Cash flows from investing activities:
Purchases of investments		(39,926	)		(22,685	)
Proceeds from maturities and sale of investments		40,950			31,250
Purchases of property and equipment		(1,511	)		(782	)
Change in deposits		(8	)		—

Net cash (used in) provided by investing activities		(495	)		7,783


Cash flows from financing activities:
Repayments of long-term debt		—			(519	)
Net proceeds from issuance of common stock and warrants		2,784			2,942

Net cash provided by financing activities		2,784			2,423

Effect of exchange rates on cash and cash equivalents		63			(120	)

Net (decrease) increase in cash and cash equivalents		(9,548	)		9,158
Cash and cash equivalents at beginning of period		23,705			7,651

Cash and cash equivalents at end of period	$	14,157		$	16,809


Supplemental disclosures of cash flow information:
Cash paid for income taxes	$	—		$	58

Cash paid for interest	$	—		$	16

See accompanying notes to unaudited condensed consolidated financial statements.

CALLIDUS SOFTWARE INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying 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, 2005. 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 the 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 September 30, 2006 and the three and nine months ended September 30, 2006 and 2005 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, 2005.

During the preparation of its Form 10-Q for the three months ended September 30, 2006, the Company determined that certain prepaid assets were understated by $127,000 as a result of excess amortization of prepaid royalties made to third parties in prior reporting periods. The Company recorded adjusting entries during the three months ended September 30, 2006 to increase prepaid assets on the unaudited condensed consolidated balance sheet and to decrease cost of maintenance and service revenues in the unaudited condensed consolidated statement of operations. The Company also determined that certain accrued expenses were overstated by $297,000 as a result of entries recorded in prior reporting periods that were either recorded in error or should have been reversed in prior reporting periods. The Company recorded adjusting entries during the three months ended September 30, 2006 to decrease accrued expenses on the unaudited condensed consolidated balance sheet and to decrease operating expenses, primarily sales and marketing, in the unaudited condensed consolidated statement of operations.

The Company does not believe these amounts are material to the reporting periods in which they should have been recorded, nor does it expect these amounts will be material to its consolidated operating results for the year ending December 31, 2006. Due to the adjusting entries, net loss was decreased by $424,000 ($$0.02 per share) for the three months ended September 30, 2006. The impact on prior reporting periods would be as follows: net loss for the year ended December 31, 2005 would be decreased by $251,000 ($0.01 per share), net loss for the three months ended March 31, 2006 would be decreased by $74,000 ($0.00 per share) and net loss for the three months ended June 30, 2006 would be decreased by $99,000 ($0.00 per share).

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, 2006.

Reclassifications

Certain amounts from prior periods have been reclassified to conform to the current period presentation. See Note 6 – Stock-based Compensation for further discussion of these reclassifications.

Cumulative Effect of a Change in Accounting Principle

time in nature and not expected to occur as part of our normal business on a regular basis. See Note 6 – Stock-based Compensation for further discussion.

Principles of Consolidation

The consolidated financial statements include the accounts of Callidus Software Inc. and its wholly owned subsidiaries (collectively, the Company), which include wholly-owned subsidiaries in the United Kingdom, Germany and Australia. 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 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 three and nine months ended September 30, 2006 and 2005, respectively (in thousands):


	Balance at		Provision,						Balance at
	Beginning		Net of						End of
	of Period		Recoveries			Write-Offs			Period
Allowance for doubtful accounts
Three months ended September 30, 2006	$	553	$	(90	)	$	—		$	463
Three months ended September 30, 2005		40		(5	)		—			35
Nine months ended September 30, 2006		480		(12	)		(5	)		463
Nine months ended September 30, 2005		320		34			(319	)		35


	Balance at				Remediation			Balance at
	Beginning				Service			End of
	of Period		Provision		Claims			Period
Sales return reserve
Three months ended September 30, 2006	$	281	$	112	$	(104	)	$	289
Three months ended September 30, 2005		305		191		(177	)		319
Nine months ended September 30, 2006		310		610		(631	)		289
Nine months ended September 30, 2005		537		442		(660	)		319

Restricted Cash

Included in deposits and other assets in the consolidated balance sheets at September 30, 2006 and December 31, 2005 is restricted cash of $570,000 and $676,000 respectively, related to security deposits on leased facilities for our New York, New York and San Jose, California offices. The restricted cash represents investments in certificates of deposit and secures letters of credit required by landlords to meet security deposit requirements for the leased facilities. Restricted cash is included in other assets based on the contractual term for the release of the restriction.

Revenue Recognition

The Company generates revenues primarily by licensing software and providing related software maintenance and professional services to its customers. The Company also generates revenue by providing its software application as a service through its on–demand offerings.

The Company recognizes revenues in accordance with accounting standards for software and service companies. The Company 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. The Company evaluates each of these criteria as follows:

Evidence of an Arrangement. The Company considers a non-cancelable agreement signed by it and the customer to be evidence of an arrangement.

Delivery. In perpetual licensing arrangements, the Company considers 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. The Company’s typical end-user license agreement does not include customer acceptance provisions. In on-demand arrangements, the Company considers delivery to have occurred when the service has been provided to the customer.

Fixed or Determinable Fee. The Company considers the fee to be fixed or determinable unless the fee is subject to refund or adjustment or is not payable within its standard payment terms. The Company considers payment terms greater than 90 days to be beyond its customary payment terms. If the fee is not fixed or determinable, the Company recognizes the revenue as amounts become due and payable.

Collection is Deemed Probable. The Company conducts 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 the Company expects that the customer will be able to pay amounts under the arrangement as payments become due. If the Company determines that collection is not probable, the Company defers the recognition of revenue until cash collection.

Perpetual Licensing. The Company’s perpetual software arrangements typically include: (i) an end-user license fee paid in exchange for the use of its products, 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 the Company is 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, the Company recognizes license revenues under either the residual or the contract accounting method.

Certain arrangements result in the payment of customer referral fees to third parties that resell the Company’s 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.

Residual Method. License fees are recognized upon delivery whether licenses are sold separately from or together with integration and configuration services, provided that (i) the criteria described above 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. The Company recognizes 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.

The Company allocates 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 the Company’s 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 the Company charges 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.” The Company generally uses the percentage-of-completion method because the Company is able to make reasonably dependable estimates relative to contract costs and the extent of progress toward completion. However, if the Company cannot make reasonably dependable estimates, the Company uses the completed-contract method. If total cost estimates exceed revenues, the Company accrues for the estimated loss on the arrangement.

In certain arrangements, the Company has provided for unique acceptance criteria associated with the delivery of consulting services. In these instances, the Company has recognized revenue in accordance with the provisions of SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” To the extent there is contingent revenue in these arrangements, the Company measures the level of profit that is expected based on the non-contingent revenue and the total expected project costs. If the Company is assured of a certain level of profit excluding the contingent revenue, the Company recognizes the non-contingent revenue on a percentage-of-completion basis.

Maintenance Revenue. A customer typically pre-pays maintenance for the first twelve months, and the related revenues are deferred and recognized ratably 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 Service Revenue. Professional service revenues primarily consist of configuration and integration services related to the installation of the Company’s products as well as training. The Company’s implementation services do not involve customization to, or development of, the underlying software code. Substantially all of the Company’s professional services arrangements are on a time and materials basis. For professional service arrangements with a fixed fee, the Company recognizes revenue utilizing the proportional performance method of accounting. The Company estimates the proportional performance on fixed fee contracts on a monthly basis utilizing hours incurred to date as a percentage of total estimated hours to complete the project. If the Company does not have a sufficient basis to measure progress toward completion, revenue is recognized upon completion of performance. To the extent the Company enters into a fixed-fee services contract, a loss will be recognized any time the total estimated project cost exceeds project revenues.

On-Demand Revenue. On-Demand revenues include both managed and hosted service offerings and are recorded as maintenance and services revenues in the Company’s statements of operations. The Company’s on-demand offerings allow its customers to outsource the operation and management of its software products to the Company. Managed services are generally sold under long-term renewable contracts with minimum purchase commitments. Revenues from the managed service offering are generally recognized on a time and materials basis for both the initial customer set-up and the ongoing operation and management of the software.

In hosted arrangements where the Company provides its software application as a service, the Company follows the provisions of SEC Staff Accounting Bulletin No. 104, “Revenue Recognition” and Emerging Issues Task Force Issue No. 00-21 (EITF 00-21), “Revenue Arrangements with Multiple Deliverables.” Customers will typically prepay for the Company’s hosted offering services, amounts which the Company will defer and recognize ratably over the non-cancellable term of the customer contract. The Company evaluates whether each of the elements in these arrangements represents a separate unit of accounting, as defined by EITF 00-21, using all applicable facts and circumstances, including whether (i) the Company sells or could readily sell the element unaccompanied by the other elements, (ii) the element has stand-alone value to the customer, (iii) there is objective reliable evidence of the fair value of the undelivered item and (iv) there is a general right of return.

If a consulting arrangement for implementation and configuration services associated with a hosted on-demand engagement does not qualify for separate accounting, the Company will recognize the revenue from implementation and configuration services ratably over the remaining non-cancellable term of the subscription contract once the implementation is complete. In addition, the Company defers the direct costs of the implementation and configuration services and amortizes those costs over the same time period as the related revenue is recognized. If the direct costs incurred for a contract exceed the contract value, then the Company would recognize a loss for incurred and projected direct costs in excess of the contract value. The deferred costs on the Company’s consolidated balance sheet for these consulting arrangements totaled $1.3 million and $0 at September 30, 2006 and December 31, 2005, respectively.

For sales of its on-demand services, the Company defers commission payments to the Company’s direct sales force and amortizes such commissions to sales expense over the non-cancellable term of the contract as the related subscription revenue is recognized. The commission payments are a direct and incremental cost of the revenue arrangements. The deferral of commission expenditures related to the Company’s hosted on-demand product offerings was $96,000 and $0 at September 30, 2006 and December 31, 2005, respectively.

Net Loss Per Share

Basic net loss per share is calculated by dividing net loss 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. For the three and

nine months ended September 30, 2006 and 2005, the diluted net loss per share calculation was the same as the basic net loss per share calculation as all potential common shares were anti-dilutive.

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


	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
Stock options		6,996		5,371		6,829		4,949
Stock subject to repurchase		—		28		16		13
Warrants		11		114		69		58

Totals		7,007		5,513		6,914		5,020

The weighted-average exercise price of stock options excluded during the three and nine months ended September 30, 2006 was $4.24 and $4.17 per share, respectively, as compared to the weighted average exercise price of stock options excluded during the three and nine months ended September 30, 2005 of $3.89 and $3.81 per share, respectively. The weighted average exercise price of warrants excluded was $20.19 and $6.09 per share during the three and nine months ended September 30, 2006, respectively, and was $5.48 and $7.38 per share during the three and nine months ended September 30, 2005, respectively.

Recent Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (FASB) ratified the Emerging Issues Task Force Issue No. 06-3 (EITF 06-3), “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation).” EITF 06-3 addresses the income statement presentation of taxes assessed by various governmental authorities. EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006. Earlier application is permitted. The Company is currently evaluating the effect that the adoption of EITF 06-3 will have on its consolidated financial statements but does not expect the effect to be material.

In June 2006, the FASB issued Interpretation No. 48 (FIN No. 48), “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” This interpretation prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of this interpretation is encouraged for companies that have not yet issued financial statements, including interim financial statements, in the period this interpretation is adopted. The Company is currently evaluating the effect that the adoption of FIN No. 48 will have on its consolidated financial statements but does not expect the effect to be material.

In September 2006, the FASB issued FASB Statement No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements, as the FASB had previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, SFAS 157 does not require any new fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. Earlier application is permitted. The Company will adopt the new accounting provisions as of January 1, 2008. The Company is currently evaluating the effect that the adoption of SFAS 157 will have on its consolidated financial statements but does not expect the effect to be material.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (SAB 108). The interpretations in SAB 108 express the SEC staff’s views regarding the process of quantifying financial statement misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006. Early application is encouraged for an interim period of the first fiscal year ending after November 15, 2006. The Company does not expect the adoption of SAB 108 to have a material impact on its consolidated financial position, results of operations or cash flows.

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 (loss) in the accompanying condensed consolidated financial statements. Interest is 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 were as follows for September 30, 2006 and December 31, 2005 (in thousands):


			Unrealized		Unrealized
September 30, 2006	Cost		Gains		Losses			Fair Value
Auction rate securities and preferred stock	$	30,775	$	—	$	—		$	30,775
Corporate notes and obligations		15,881		—		(11	)		15,870
US government and agency obligations		1,000		—		(2	)		998


Investments in debt and equity securities	$	47,656	$	—	$	(13	)	$	47,643


			Unrealized		Unrealized
December 31, 2005	Cost		Gains		Losses			Fair Value
Auction rate securities and preferred stock	$	20,575	$	—	$	—		$	20,575
Corporate notes and obligations		11,997		—		(35	)		11,962
US government and agency obligations		12,500		—		(56	)		12,444


Investments in debt and equity securities	$	45,072	$	—	$	(91	)	$	44,981


	September 30,		December 31,
	2006		2005
Recorded as:
Cash equivalents	$	8,589	$	4,981
Short-term investments		39,054		40,000


	$	47,643	$	44,981

There were no realized gains or losses on the sales of these securities for the nine months ended September 30, 2006 and 2005, respectively.

3. 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. Lead plaintiff and lead counsel were appointed by the Court and on November 29, 2004, plaintiff filed a consolidated amended class action complaint (“Complaint”). The Complaint alleged that the Company and certain individual defendants made materially false or misleading statements or omissions in violation of the federal securities laws during the period of January 22, 2004 through June 23, 2004 (the “Class Period”). The Complaint sought to recover damages on behalf of anyone who purchased or otherwise acquired the Company’s stock during the Class Period. Following the Company’s motion to dismiss, the complaint was initially dismissed with leave to amend in 2005 and, after plaintiffs’ acknowledgement that they could not amend, the action was dismissed with prejudice.

In July and October 2004, two derivative complaints were filed in state and federal court, respectively, by shareholders on behalf of the Company against certain of the Company’s present and former executives and directors (the “Derivative Complaints”). The Derivative Complaints alleged state law breach of fiduciary duty claims arising out of the underlying matters alleged in the securities Complaint identified above. The state court derivative plaintiff agreed to stay his case and joined in a first amended complaint filed in the federal derivative case.

Following a court-ordered settlement conference in early August 2006, a settlement was reached among plaintiffs in both derivative cases, the defendants, the Company and the Company’s primary directors and officers liability insurance carrier. The Stipulation of Settlement was executed by the parties and preliminarily approved by the Court on August 11, 2006. Under the settlement, the Company agreed to adopt, formalize and/or reconfirm certain enhancements to its corporate governance policies. In exchange, the Company, and plaintiffs and any other shareholders seeking to sue on its behalf, agreed to release all claims against the defendants and other officers and directors of the Company that were or could have been alleged in the derivative actions, and the Company’s insurance carrier agreed to pay all amounts directly under the settlement other than a nominal amount for the mailing of a notice to the Company’s shareholders. The Company will not incur any material expense as a result of the settlement.

The Court entered an Order and Final Judgment Approving the Stipulation of Settlement on October 27, 2006.

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, is likely to have a material adverse effect on the Company’s future financial results.

In accordance with SFAS No. 5, “Accounting for Contingencies” (SFAS 5), the Company records a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. The Company reviews the need for any such liability on a quarterly basis and records any necessary adjustments to reflect the effect of ongoing negotiations, settlements, rulings, advice of legal counsel, and other information and events pertaining to a particular case in the period they become known. At September 30, 2006, the Company had not recorded any such liabilities in accordance with SFAS 5. The Company believes that it has valid defenses with respect to the legal matters pending against the Company and that the probability of a loss under such matters is remote.

Other Contingencies

The Company generally warrants that its products shall perform to its standard documentation. Under the Company’s standard warranty, should a product not perform as specified in the documentation within the warranty period, the Company will repair or replace the product or refund the license fee paid. Such warranties are accounted for in accordance with SFAS 5. To date, the Company has not incurred material costs related to warranty obligations.

The Company’s product license agreements typically include a limited indemnification provision for claims by 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.

4. 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. The Company’s TrueComp Suite is its only product line, which includes all of its software application products.

The following table summarizes revenues for the three and nine months ended September 30, 2006 and 2005 by geographic areas (in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2006		2005		2006		2005
United States	$	13,718	$	16,497	$	41,933	$	41,268
Europe		2,589		394		4,902		1,232
Asia Pacific		1,118		207		5,211		1,714


	$	17,425	$	17,098	$	52,046	$	44,214

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.

The following table summarizes revenues to significant customers (including resellers when product is sold through them to an end user) as a percentage of total revenues:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Customer 1		18	%		—	%		6	%		—	%
Customer 2		12	%		12	%		14	%		11	%
Customer 3		3	%		25	%		5	%		10	%
Customer 4		2	%		9	%		3	%		12	%

5. Comprehensive Loss

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


	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006			2005
Net loss	$	(2,508	)	$	(906	)	$	(8,823	)	$	(7,118	)
Other comprehensive income (loss):
Change in unrealized loss on investments, net		18			58			78			133
Change in cumulative translation adjustments		—			(22	)		83			(132	)


Comprehensive loss	$	(2,490	)	$	(870	)	$	(8,662	)	$	(7,117	)

6. Stock-based Compensation

Effective January 1, 2006, the Company began recording compensation expense associated with stock options and other forms of equity compensation in accordance with FASB Statement No. 123R (revised 2004), “Share-Based Payment” (SFAS 123R), as interpreted by SEC Staff Accounting Bulletin No. 107 (SAB 107). SFAS 123R requires the recognition of the fair value of stock compensation in net income. Prior to January 1, 2006, the Company had adopted SFAS 123, “Accounting for Stock-Based Compensation” (SFAS 123), but in accordance with SFAS 123, had elected to account for stock options according to the provisions of Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Therefore, the Company recorded no related compensation expense for awards granted with no intrinsic value. In accordance with SFAS 123, the Company previously provided pro forma disclosure of the effect of using the fair value-based method of measuring stock-based compensation expense under SFAS 123 in its financial statement notes.

The Company elected the modified prospective transition method in adopting SFAS 123R. Under this method, the provisions of SFAS 123R apply only to awards granted or modified after the date of adoption. For awards granted prior to, but not yet vested at, the date of adoption of SFAS 123R, stock-based compensation is recognized in net income in the periods after the date of adoption based on the unrecognized expense calculated for pro-forma fair value disclosure under SFAS 123 using the same valuation method (i.e. Black-Scholes) and assumptions, as disclosed in the Company’s previous filings. In addition, the deferred stock-based compensation of $445,000 as of December 31, 2005, which was accounted for under APB No. 25, was reclassified into additional paid-in capital upon the adoption of SFAS 123R.

Upon adoption of SFAS 123R, compensation expense associated with stock options consists of the amortization related to the remaining unvested portion of all stock option awards granted prior to January 1, 2006 determined in accordance with SFAS 123 and the amortization related to all stock option awards granted subsequent to January 1, 2006 determined in accordance with SFAS 123R. In addition, the Company records expense over the offering period and the vesting term in connection with shares issued under its Employee Stock Purchase Plan (ESPP) and restricted stock. The compensation expense for stock-based compensation awards includes an estimate for forfeitures and is recognized over the expected term of the options using the straight-line method.

Prior to the adoption of SFAS 123R, benefits of tax deductions in excess of recognized compensation costs were reported as operating cash flows. SFAS 123R requires that they be recorded as a financing cash inflow rather than as a reduction of taxes paid. For the three and nine months ended September 30, 2006, the Company had no excess tax benefits generated from option exercises. Due to the full valuation allowance for its net deferred tax assets, the Company has not recorded any tax benefit attributable to compensation expense associated with stock options and other forms of equity compensation in accordance with SFAS 123R.

Also, upon the adoption of SFAS 123R, the Company recorded a cumulative effect of a change in accounting principle of $128,000. The cumulative effect of a change in accounting principle resulted from the requirement of SFAS 123R to reduce the amount of stock-based compensation expense by an estimated forfeiture rate or, in other words, the estimated number of shares that are not expected to vest as a result of an employee terminating prior to becoming fully vested in an award. Prior to the adoption of SFAS 123R, the Company did not reduce stock-based compensation expense based on an estimated forfeiture rate but rather recorded an adjustment to stock-based compensation as actual forfeitures occurred. The $128,000 recorded for the cumulative effect of a change in accounting principle represents the total reduction in stock-based compensation expense that would have been recorded under SFAS 123R had it been applied to the Company’s previously reported stock-based compensation expense for unvested options that were outstanding on the date of adoption of SFAS 123R.

Expense Summary

Under the provisions of SFAS 123R, $1.1 million and $3.7 million of stock compensation expense was recorded for the three and nine months ended September 30, 2006, respectively, in the unaudited condensed consolidated statements of operations. Of the total stock compensation expense, approximately $0.9 million and $3.2 million was related to stock options for the three and nine months ended September 30, 2006, respectively, and $0.2 million and $0.5 million was related to purchases of common stock under the ESPP for the three and nine months ended September 30, 2006, respectively. As of September 30, 2006, there was $7.0 million of total unrecognized compensation expense related to stock options. This expense is expected to be recognized over a weighted average period of 1.89 years.

In addition, SFAS 123R requires the Company to present pro forma information for the comparative period prior to the adoption of SFAS 123R as if all stock-based employee compensation was accounted for under the fair value method of SFAS 123. The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation for the three and nine months ended September 30, 2005, as previously reported (in thousands, except per share amounts):


	Three			Nine
	Months			Months
	Ended			Ended
	September 30,			September 30,
	2005			2005
Net loss as reported	$	(906	)	$	(7,118	)
Add: Stock-based employee compensation expense under APB No. 25 included in reported net loss, net of tax		51			914
Less: Stock-based employee compensation expense determined under the fair value method for all awards, net of tax		(730	)		(2,355	)

Pro forma net loss	$	(1,585	)	$	(8,559	)


Basic and diluted net loss per share, as reported	$	(0.03	)	$	(0.27	)
Pro forma basic and diluted net loss per share	$	(0.06	)	$	(0.32	)

Determination of Fair Value

The fair value of each option award is estimated on the date of grant using the Black-Scholes valuation model and the assumptions noted in the following table. Because the Company has limited available data, the expected life of options is based on the simplified method as allowed by SAB 107. This simplified method averages an award’s weighted average vesting period and its contractual term. Therefore, the expected life of the Company’s options decreased from the first quarter of 2006 due to the change in contractual term, as discussed below. The expected volatility of stock options is calculated using a

combination of the historical volatility of the price of the Company’s common stock as well as the historical stock price volatility and implied volatility of traded options for similar entities’ common stock. The Company believes that this blended approach provides a better estimate of the expected future volatility of the Company’s common stock over the expected life of its stock options. Prior to the first quarter of 2006, the Company had used its historical stock price volatility in accordance with SFAS 123 for purposes of its pro forma information disclosures of stock-based compensation expense. The expected volatility of ESPP shares is calculated using the historical volatility of the price of the Company’s common stock. Expected volatilities of both options and common stock issued pursuant to the ESPP are based upon the expected terms of the options and common stock ESPP shares, respectively. The risk-free interest rate is based on the implied yield on a U.S. Treasury zero-coupon issue with a remaining term equal to the expected term of the option. The dividend yield reflects that the Company has not paid any cash dividends since inception and does not intend to pay any cash dividends in the foreseeable future.


	Three Months Ended September 30,						Nine Months Ended September 30,
	2006			2005			2006		2005
Stock Option Plans
Expected life (in years)		3.50			3.17			2.50 to 6.00		3.10
Risk-free interest rate	4.69% to 5.07%				3.98	%	4.36% to 5.11%			3.81	%
Volatility		54	%		69	%	54% to 60%			69	%

Employee Stock Purchase Plan
Expected life (in years)		0.50 to 1.00			0.98			0.49 to 1.00		0.98
Risk-free interest rate	5.08% to 5.17%				3.76	%	4.68% to 5.17%			3.73	%
Volatility	37% to 39%				49	%	36% to 43%			50	%

Stockholder-Approved Stock Option Plans

The Company has two stock option plans approved by stockholders, the 1997 Stock Option Plan and the 2003 Stock Incentive Plan.

The incentive and nonstatutory options to purchase the Company’s common stock granted to employees under the 1997 Stock Option Plan generally vest over 4 years with a contractual term of 10 years. The vesting period generally equals the requisite service period of the individual grantees. Since the Company’s initial public offering, no options to purchase shares under the 1997 Stock Option Plan have been granted and all shares that remained available for future grant under this plan became available for issuance under the 2003 Stock Incentive Plan, as described below.

The 2003 Stock Incentive Plan became effective upon the completion of the Company’s initial public offering in November 2003. As of September 30, 2006, the Company was authorized to issue approximately 9,074,000 shares of common stock. Under the plan, the Company’s board of directors may grant stock options or other types of stock-based awards, such as restricted stock, restricted stock units, stock bonus awards or stock appreciation rights. Incentive stock options may be granted only to the Company’s employees. Nonstatutory stock options and other stock-based awards may be granted to employees, consultants or non-employee directors. These options vest as determined by the board, generally over 4 years. Formerly, the Company’s board of directors had approved a contractual term of 10 years, but effective April 24, 2006, the board of directors approved a reduction of the contractual term to 5 years for all future grants. The vesting period generally equals the requisite service period of the individual grantees. On July 1 of each year, the aggregate number of shares reserved for issuance under this plan increases automatically by a number of shares equal to the lesser of (i) 5% of the Company’s outstanding shares, (ii) 2,800,000 shares, or (iii) a lesser number of shares approved by the board.

A summary of the status of the Company’s options under the 1997 Stock Option Plan and the 2003 Stock Incentive Plan for the nine months ended September 30, 2006 is as follows:


									Weighted
	Shares						Weighted		Average
	Available						Average		Remaining		Aggregate
	for			Number of			Exercise		Contractual		Intrinsic
	Grant			Shares			Price		Term (Years)		Value
											(in thousands)
Outstanding as of December 31, 2005		2,886,508			5,325,143		$	4.11
Authorized		1,381,375			—
Granted		(2,349,992	)		2,349,992			4.63
Exercised		—			(519,376	)		1.53
Forfeited		432,622			(432,622	)		4.68
Expired		161,068			(161,068	)		9.24


Outstanding as of September 30, 2006		2,511,581			6,562,069		$	4.33		7.23	$	7,239

Vested and Expected to Vest as of September 30, 2006					6,001,244		$	4.32		7.23	$	6,946

Exercisable as of September 30, 2006					2,684,620		$	4.08		6.86	$	4,827

The weighted-average fair value of stock options granted during the three and nine months ended September 30, 2006 was $2.06 and $2.28 per share, respectively. For the three and nine months ended September 30, 2005, the weighted-average fair value of stock options granted was $1.78 and $1.76, respectively. The total intrinsic value of stock options exercised during the three and nine months ended September 30, 2006 was $0.4 million and $1.7 million, respectively. For the three and nine months ended September 30, 2005, the total intrinsic value of stock options exercised was $0.2 million and $2.1 million, respectively. The total cash received from employees as a result of stock option exercises was $0.2 million and $0.8 million for the three and nine months ended September 30, 2006, respectively. For the three and nine months ended September 30, 2005, the total cash received from employees as a result of stock option exercises was $0.1 million and $1.0 million, respectively. The Company settles employee stock option exercises with newly issued common shares.

Employee Stock Purchase Plan

In August 2003, the board of directors adopted the Employee Stock Purchase Plan (ESPP) which became effective upon the completion of the Company’s initial public offering and is intended to qualify as an “employee stock purchase plan” under Section 423 of the Internal Revenue Code. The ESPP is designed to enable eligible employees to purchase shares of the Company’s common stock at a discount on a periodic basis through payroll deductions. Except for the first offering period, each offering period will be for 12 months and will consist of two consecutive six-month purchase periods. The purchase price for shares of common stock purchased under the purchase plan will be 85% of the lesser of the fair market value of the Company’s common stock on the first day of the applicable offering period and the fair market value of the Company’s common stock on the last day of each purchase period. The Company issued approximately 375,000 and 725,000 shares during the three and nine months ended September 30, 2006. The weighted-average fair value of stock purchase rights granted under the ESPP during the three and nine months ended September 30, 2006 was $1.44 and $1.41 per share, respectively. During the three and nine months ended September 30, 2005, the weighted-average fair value of stock purchase rights granted under the ESPP was $1.11 and $1.20 per share, respectively.

Other Plan Awards

On June 7, 2005, the Company granted 28,000 shares of restricted stock to its chief executive officer. The shares were subject to repurchase until they fully vested on May 31, 2006. The restricted stock had a fair value of $3.50 per share on the date of grant. Compensation expense was amortized over the vesting period of one year and was $0 and $41,000 for the three and nine months ended September 30, 2006, respectively. As of September 30, 2006, unrecognized expense related to the restricted stock award was zero.

Additionally, on May 31, 2005, the Company granted its chief executive officer an option to purchase 1,000,000 shares of its common stock with an exercise price of $3.45 per share, which was the fair market value of the Company’s common stock on the date of grant. The option has a contractual term of 10 years and vests over four years, with 25% of the shares subject to the option vesting on the first anniversary of the grant date and 1/48^th vesting each month thereafter. The vesting period equals the requisite service period of the grant. A summary of the status of this option for the nine months ended September 30, 2006 is as follows:


							Weighted
	Shares				Weighted		Average
	Available				Average		Remaining		Aggregate
	for		Number of		Exercise		Contractual		Intrinsic
	Grant		Shares		Price		Term (Years)		Value
									(in thousands)
Outstanding as of December 31, 2005		—		1,000,000	$	3.45
Exercised		—		—		—
Forfeited		—		—		—
Expired		—		—		—


Outstanding as of September 30, 2006		—		1,000,000	$	3.45		8.67	$	1,410

Vested and Expected to Vest as of September 30, 2006				1,000,000	$	3.45		8.67	$	1,410

Exercisable as of September 30, 2006				333,333	$	3.45		8.67	$	470

The agreements granting both the 28,000 shares of restricted stock and the option to purchase 1,000,000 shares were approved by the Company’s Compensation Committee, which is made up entirely of independent directors. As disclosed in a press release issued on April 28, 2005, these agreements were issued without shareholder approval as inducement grants to a new employee under applicable Nasdaq Marketplace Rules.

7. Related Party Transactions

In 2005, the Company entered into a service agreement with Saama Technologies, Inc. for software consulting services. William Binch, who was appointed to the Company’s Board of Directors in April 2005, is also currently a member of Saama’s board of directors. The Company had expenses of approximately $404,000 and $719,000 for services rendered by Saama for the three and nine months ended September 30, 2006.

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, 2005 and with the condensed consolidated financial statements and the related notes thereto 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: changes in and expectations with respect to maintenance and service revenues (including on-demand) and license revenues and gross margins, future operating expense levels, the impact of quarterly fluctuations of revenue and operating results, levels of recurring revenues, market growth opportunities, staffing and expense levels, the adequacy of our capital resources to fund operations and growth and the impact of our adoption of one of the fair value methods for measuring stock-based compensation described in SFAS 123R. 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 “Risk Factors” 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 Nine Months Ended September 30, 2006

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 pursuant to perpetual or term software licenses. We also offer professional services, including configuration, integration and training, generally on a time and materials basis. We generate maintenance and support revenues associated with our product licenses, which are recognized ratably over the term of the maintenance agreement. In 2006, we began offering on-demand services to our customers. On-demand services allow customers to use our software products as a service by outsourcing the daily technical operation, maintenance, upgrades and other levels of support to us. We currently have two on-demand services offerings – hosted and managed services. Our hosted on-demand service allows customers to use our software products through a web interface rather than purchasing computer equipment and installing our software at their location. Our managed services on-demand offering allows customers with a managed services installation of our software to outsource the operation and management of our software products to us. Both of these on-demand offerings provide for recurring revenue streams, but remain subject to periodic adjustment or cancellation. Our managed services on-demand offering was launched in the first quarter of 2006 and our hosted on-demand offering was launched in the second quarter of 2006. Through the third quarter of 2006, revenues from our hosted on-demand services have not been material.

Revenue Growth

While our total revenues were essentially flat in the third quarter of 2006 compared to the same period in 2005, we have experienced revenue growth in the nine months ended September 30, 2006 compared to the same period in 2005. Total revenues increased by 2% to $17.4 million for the three months ended September 30, 2006 and increased by 18% to $52.0 million for the nine months ended September 30, 2006 compared to the same periods in 2005. The increase for the nine months ended September 30, 2006 was primarily the result of growth in license revenues during the first three quarters of 2006, where license

revenues increased by 76% compared to the same period in 2005. We attribute the license revenue growth to a number of factors, including increased spending on our sales and marketing efforts, a more strategic product offering that included the release of our Callidus TrueAnalytics product, and an improved macro-economic environment for software related spending. All of these factors contributed to a larger number of license revenue transactions for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005.

Our maintenance and service revenues increased by 3% to $11.6 million for the three months ended September 30, 2006 and decreased by 1% to $33.4 million for the nine months ended September 30, 2006 compared to the same periods in 2005. The increase for the three months ended September 30, 2006 compared to the same period in 2005 is due to our new managed services on-demand offering, which was launched in the first quarter of 2006. Our managed services on-demand offering generated $5.8 million of revenue in the first three quarters of 2006. No revenues were generated from our managed services on-demand offering in 2005. We believe our managed services on-demand offering is an important service offering for us, but the market for such services is limited to only our largest customers. Consequently, we do not expect to see significant revenue growth in this line of business. The reason for the decrease for the nine months ended September 30, 2006 compared to September 30, 2005 was a decline in our professional services revenue. However, this decline was partially offset by the growth in our managed services on-demand offering and our software maintenance revenues.

We launched our hosted on-demand service in the second quarter of 2006 for the TrueComp suite of products. Our hosted on-demand service allows our customers to use our software products through a web interface rather than purchasing computer equipment and installing software at a customer location. The hosted service is sold on a recurring fee basis with an initial contract term generally between one and three years. Generally, revenues will be recognized ratably over the contract term once an implementation is complete. We recognized an immaterial amount of hosted on-demand sales as part of our third quarter financial results.

Our on-demand revenues, together with software maintenance revenues, accounted for $6.6 million or 38% of total revenues for the three months ended September 30, 2006 and $18.7 million or 36% of total revenues for the nine months ended September 30, 2006. Both our on-demand and software maintenance services provide for recurring revenue streams, but remain subject to periodic adjustment or cancellation.

Increased Expenses to Support Growth Strategy

In an effort to accelerate revenue growth and extend our leadership position in the EIM market, we made a conscious decision to increase spending primarily in sales and marketing and software development during the year. Investments were made in expanding sales coverage both in the U.S. and internationally, the development and launch of new products including Callidus TrueAnalytics, on-demand solutions, and new value-added consulting services and increased marketing efforts.

As a result of these efforts and the impact of new accounting rules requiring the expensing of stock-based compensation costs, operating expenses increased by 17% to $12.4 million (including an increase in stock-based compensation of $0.8 million) for the three months ended September 30, 2006 and increased by 29% to $38.0 million (including an increase in stock-based compensation of $2.9 million) for the nine months ended September 30, 2006 compared to the same periods in 2005. Additionally, primarily as a result of our investments in international operations and on-demand offerings and increase in stock compensation expense due to the Company’s adoption of SFAS 123R, the gross margin related to maintenance and service revenues decreased from 32% for the three months ended September 30, 2005 to 30% for the three months ended September 30, 2006 and from 32% for the nine months ended September 30, 2005 to 26% for the nine months ended September 30, 2006. Excluding stock compensation expense, the gross margin would have been 32% and 29% for the three and nine months ended September 30, 2006, respectively. Management believes these investments are in the best interests of the business.

Because of the increased expenses, our net loss increased to $2.5 million for the third quarter of 2006, compared with a net loss of $0.9 million for the third quarter of 2005. The increase in the net loss occurred

in part due to a $1.0 million increase in stock-based compensation expense in the third quarter of 2006. For the nine months ended September 30, 2006, our net loss was $8.8 million compared to $7.1 million for the same period in 2005. Stock based compensation increased $2.8 million in the nine months ended September 30, 2006.

Growth Strategy Continues but Expense Growth Should be Slower

For the remainder of 2006 and into 2007, we expect to maintain our management and operational focus on revenue growth. We expect to increase operating expenses as we continue to expand our sales force and prepare to comply with Section 404 of the Sarbanes-Oxley Act of 2002.

Other Business Highlights

During the third quarter of 2006, we entered into a revenue sharing arrangement with SAP for the promotion and marketing by SAP of our TrueComp and TrueInformation products in the United States and Canada. In addition, our TrueComp and TrueInformation products earned “Powered by SAP NetWeaver” status, indicating an even higher level of product integration on the SAP NetWeaver platform.

In addition, we entered into an agreement with Hyperion to sublicense part of its System 9 technology for our new Quota Management product. This product, currently under development, is an operational revenue planning application that creates quota targets and assists in quota planning and assignment to sales management and field representatives.

We had no sales under the above arrangements during the quarter ended September 30, 2006.

Challenges and Risks

From a business perspective, we have a number of sales opportunities in process and additional opportunities coming from our sales pipeline; however, we continue to experience wide variances in the timing and size of our license transactions and the timing of revenue recognition resulting from greater flexibility in licensing terms, including our customers’ ability to select the delivery of our software via on-demand services. We believe one of our major challenges that remain is increasing prospective customers’ prioritization of purchasing our products and services over competing IT projects. To address these challenges, our goals include expanding our sales efforts, promoting our new on-demand services, and continuing to developing new products and enhancements to our TrueComp suite of products. We believe these initiatives will, over time, help us better realize the market opportunity ahead of us.

If we are unable to grow our revenues, we may be unable to return to profitability. In addition to these risks, our future operating performance is subject to the risks and uncertainties described in “Risk Factors”.

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 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 has reviewed 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. We also generate revenue by providing our software application as a service through our on–demand offerings.

We recognize revenues in accordance with accounting standards for software and service companies. 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. In perpetual licensing arrangements, 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. In on-demand arrangements, we consider delivery to have occurred when the service has been provided to the customer.

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.

Perpetual Licensing. Our perpetual software arrangements typically include: (i) an end-user license fee paid in exchange for the use of our products, 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.

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.

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 our 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.

In certain arrangements, we have provided for unique acceptance criteria associated with the delivery of consulting services. In these instances, we have recognized revenue in accordance with the provisions of SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” To the extent there is contingent revenue in these arrangements, we measure the level of profit that is expected based on the non-contingent revenue and the total expected project costs. If we are assured of a certain level of profit excluding the contingent revenue, we recognize the non-contingent revenue on a percentage-of-completion basis.

Professional Service Revenue. Professional service revenues primarily consist of configuration and integration services related to the installation of our products as well as training. 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. For professional service arrangements with a fixed fee, we recognize revenue utilizing the proportional performance method of accounting. We estimate the proportional performance on fixed fee contracts on a monthly basis utilizing hours incurred to date as a percentage of total estimated hours to complete the project. If we do not have a sufficient basis to measure progress toward completion, revenue is recognized upon completion of performance. 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.

On-Demand Revenue. On-Demand revenues include both managed and hosted service offerings and are recorded as maintenance and services revenues in our statements of operations. Our on-demand offerings allow our customers to outsource the operation and management of our software products to us. Managed services are generally sold under long-term renewable contracts with minimum purchase commitments.

Revenues from the managed service offering are generally recognized on a time and materials basis for both the initial customer set-up and the ongoing operation and management of the software.

In hosted arrangements where we provide our software application as a service, we follow the provisions of SEC Staff Accounting Bulletin No. 104, “Revenue Recognition” and Emerging Issues Task Force Issue No. 00-21 (EITF 00-21), “Revenue Arrangements with Multiple Deliverables.” Customers will typically prepay for our hosted offering services, amounts which we will defer and recognize ratably over the non-cancellable term of the customer contract. We evaluate whether each of the elements in these arrangements represents a separate unit of accounting, as defined by EITF 00-21, using all applicable facts and circumstances, including whether (i) we sell or could readily sell the element unaccompanied by the other elements, (ii) the element has stand-alone value to the customer, (iii) there is objective reliable evidence of the fair value of the undelivered item and (iv) there is a general right of return.

If a consulting arrangement for implementation and configuration services associated with a hosted on-demand engagement does not qualify for separate accounting, we will recognize the revenue from implementation and configuration services ratably over the remaining non-cancellable term of the subscription contract once the implementation is complete. In addition, we defer the direct costs of the implementation and configuration services and amortize those costs over the same time period as the related revenue is recognized. If the direct costs incurred for a contract exceed the contract value, then we would recognize a loss for incurred and projected direct costs in excess of the contract value. The deferred costs on our consolidated balance sheet for these consulting arrangements totaled $1.3 million and $0 at September 30, 2006 and December 31, 2005, respectively.

For sales of our on-demand services, we defer commission payments to our direct sales force and amortize such commissions to sales expense over the non-cancellable term of the contract as the related subscription revenue is recognized. The commission payments are a direct and incremental cost of the revenue arrangements. The deferral of commission expenditures related to our hosted on-demand product offerings was $96,000 and $0 at September 30, 2006 and December 31, 2005, respectively.

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 condensed consolidated balance sheets, totaled approximately $463,000 and $480,000 at September 30, 2006 and December 31, 2005, respectively. 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 warrant that our services will be performed in accordance with the criteria agreed upon in a 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 typically 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 condensed consolidated balance sheets, was approximately $289,000 and $310,000 at September 30, 2006 and December 31, 2005, respectively.

Stock-Based Compensation

Effective January 1, 2006, we began recording stock-based compensation expense associated with stock options and other forms of equity compensation in accordance with FASB Statement No. 123R (revised 2004), “Share-Based Payment” (SFAS 123R), as interpreted by SEC Staff Accounting Bulletin No. 107 (SAB 107). SFAS 123R requires the recognition of the fair value of stock-based compensation in net income. SFAS 123R is a new and very complex accounting standard, the application of which requires significant judgment and the use of estimates, particularly surrounding Black-Scholes assumptions such as estimated option volatility, expected option lives and expected option forfeiture rates, to estimate the fair value of stock options and related stock-based compensation. There is little experience or guidance available with respect to developing these assumptions and models. There is also uncertainty as to how the standard will be interpreted and applied as more companies adopt the standard and companies and their advisors gain experience with the standard. Refer to Note 6 – Stock-based Compensation in our notes to our unaudited condensed consolidated financial statements included elsewhere in this quarterly report on Form 10-Q for further discussion of our adoption of SFAS 123R.

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. 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 our balance sheet. Our deferred tax assets consist primarily of net operating loss carry forwards. 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 maintained a full valuation allowance against our net deferred tax assets at September 30, 2006. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future, an adjustment to the deferred tax assets would increase net income in the period such determination was made. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgment and is subject to audit by tax authorities in the ordinary course of business.

Recent Accounting Pronouncements

In June 2006, the FASB ratified the Emerging Issues Task Force Issue No. 06-3 (EITF 06-3), “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation).” EITF 06-3 addresses the income statement presentation of taxes assessed by various governmental authorities. EITF 06-3 is effective for interim and annual reporting periods beginning after December 15, 2006. Earlier application is permitted. We are currently evaluating the effect that the adoption of EITF 06-3 will have on our consolidated financial statements but do not expect that the effect will be material.

In June 2006, the FASB issued Interpretation No. 48 (FIN No. 48), “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of this interpretation is encouraged for companies that have not yet issued financial statements, including interim financial statements, in the period this interpretation is adopted. We are currently evaluating the effect that the adoption of FIN No. 48 will have on our consolidated financial statements but do not expect that the effect will be material.

In September 2006, the FASB issued FASB Statement No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements, as the FASB had previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, SFAS 157 does not require any new fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. Earlier application is permitted. We will adopt the new accounting provisions as of January 1, 2008. We are currently evaluating the effect that the adoption of SFAS 157 will have on our consolidated financial statements but do not expect the effect to be material.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (SAB 108). The interpretations in SAB 108 express the SEC staff’s views regarding the process of quantifying financial statement misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006. Early application is encouraged for an interim period of the first fiscal year ending after November 15, 2006. We do not expect the adoption of SAB 108 to have a material impact on our consolidated financial position, results of operations or cash flows.

Results of Operations

Comparison of the Three and Nine Months Ended September 30, 2006 and 2005

Revenues, cost of revenues and gross profit

The table below sets forth the changes in revenues, cost of revenues and gross profit for the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005 (in thousands, except percentage data):


	Three					Three								Percentage
	Months					Months								of Dollar
	Ended		Percentage			Ended		Percentage			Year to Year			Change
	September 30,		of Total			September 30,		of Total			Increase			Year over
	2006		Revenues			2005		Revenues			(Decrease)			Year
Revenues:
License	$	5,776		33	%	$	5,787		34	%	$	(11	)		(0	)%
Maintenance and service		11,649		67	%		11,311		66	%		338			3	%


Total revenues	$	17,425		100	%	$	17,098		100	%	$	327			2	%


	Three					Three								Percentage
	Months					Months								of Dollar
	Ended		Percentage			Ended		Percentage			Year to Year			Change
	September 30,		of Related			September 30,		of Related			Increase			Year over
	2006		Revenues			2005		Revenues			(Decrease)			Year
Cost of revenues:
License	$	105		2	%	$	76		1	%	$	29			38	%
Maintenance and service		8,205		70	%		7,748		68	%		457			6	%


Total cost of revenues	$	8,310				$	7,824				$	486


Gross profit	$	9,115		52	%	$	9,274		54	%	$	(159	)		(2	)%


	Nine					Nine								Percentage
	Months					Months								of Dollar
	Ended		Percentage			Ended		Percentage			Year to Year			Change
	September 30,		of Total			September 30,		of Total			Increase			Year over
	2006		Revenues			2005		Revenues			(Decrease)			Year
Revenues:
License	$	18,669		36	%	$	10,582		24	%	$	8,087			76	%
Maintenance and service		33,377		64	%		33,632		76	%		(255	)		(1	)%


Total revenues	$	52,046		100	%	$	44,214		100	%	$	7,832			18	%


	Nine					Nine							Percentage
	Months					Months							of Dollar
	Ended		Percentage			Ended		Percentage			Year to Year		Change
	September 30,		of Related			September 30,		of Related			Increase		Year over
	2006		Revenues			2005		Revenues			(Decrease)		Year
Cost of revenues:
License	$	389		2	%	$	259		2	%	$	130		50	%
Maintenance and service		24,570		74	%		22,703		68	%		1,867		8	%


Total cost of revenues	$	24,959				$	22,962				$	1,997


Gross profit	$	27,087		52	%	$	21,252		48	%	$	5,835		27	%

Revenues

License Revenues. License revenues remained essentially flat for the three months ended September 30, 2006 compared to the three months ended September 30, 2005. For the nine months ended September 30, 2006, license revenues increased $8.1 million or 76% compared to the nine months ended September 30, 2005. The nine month increase was primarily due to an increase in license sales transactions to new and existing customers. 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 revenue on those software license sales can vary widely.

Maintenance and Service Revenues. Maintenance and service revenues increased $0.3 million or 3% for the three months ended September 30, 2006 compared to the three months ended September 30, 2005. For the nine months ended September 30, 2006, maintenance and service revenues decreased $0.2 million or 1% compared to the nine months ended September 30, 2005. The increase for the three months ended September 30, 2006 reflects the growth of our on-demand managed service and software maintenance revenues, partially offset by decreases in configuration and implementation engagements and other services performed by our consulting organization. From the third quarter of 2005 to the third quarter of 2006, on-demand managed service revenues, together with software maintenance revenues, increased by $2.9 million, or 80%, while consulting and other service revenues decreased by $2.6 million, or 34%. The decrease in maintenance and service revenues for the nine months ended September 30, 2006 compared to 2005 is due to the decrease in configuration and implementation services performed by our consulting organization, partially offset by increases in our on-demand managed service and software maintenance revenues. From the first nine months of 2005 to the first nine months of 2006, consulting and other service revenues decreased by $8.0 million, or 35%, while on-demand managed service revenues, together with software maintenance revenues, increased by $7.8 million, or 71%. We plan to continue to invest in our new hosted on-demand and other services offerings, but we can not predict how quickly, if at all, these

offerings will achieve market acceptance. In addition, service revenues may be negatively affected to the extent our customers select a third-party to implement our software rather than us. We expect continued growth in maintenance revenues in 2006 driven by product sales to new customers and renewals of existing contracts.

Cost of Revenues and Gross Margin

Cost of License Revenues. Cost of license revenues increased $29,000 or 38% and $130,000 or 50% for the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005. The increase was primarily the result of royalties paid on license revenues related to our Callidus TrueAnalytics product which was released in December 2005 and on the increased number of license transactions as discussed above. Other than the agreement with Hyperion that we entered into for the sublicense of part of its System 9 technology for our new Quota Management product, we do not anticipate any changes in 2006 to our third-party technology agreements, under which we license rights to certain technologies incorporated into our products. Accordingly, unless sales of our Quota Management product become significant, we expect license gross margins to remain at or above 95% for the remainder of 2006.

Cost of Maintenance and Service Revenues. Cost of maintenance and service revenues increased $0.5 million or 6% and $1.9 million or 8% for the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005. The increase, both in absolute dollars and as a percentage of related revenues, is primarily due to the introduction of our on-demand and other new service offerings coupled with an increase in stock-based compensation resulting from the adoption of SFAS 123R.

In addition, during the preparation of our Form 10-Q for the three months ended September 30, 2006, we determined that certain prepaid assets were understated by $127,000 as a result of excess amortization of prepaid royalties made to third parties in prior reporting periods. We recorded adjusting entries during the three months ended September 30, 2006 to increase prepaid assets on the unaudited condensed consolidated balance sheet and to decrease cost of maintenance and service revenues in the unaudited condensed consolidated statement of operations. We do not believe these amounts are material to the reporting periods in which they should have been recorded, nor do we expect these amounts will be material to our consolidated operating results for the year ending December 31, 2006.

Gross Margin. Our overall gross margin was 54% and 48% for the three and nine months ended September 30, 2005, respectively. For the three and nine months ended September 30, 2006, our overall gross margin was 52% and 52%, respectively. The decrease from the three months ended September 30, 2005 to the three months ended September 30, 2006 was primarily due to our investment in our new on-demand service offerings. The increase from the nine months ended September 30, 2005 to nine months ended September 30, 2006 is attributable primarily to the shift in revenue mix to higher margin license revenues, which represented 36% of our total revenues in the nine months ended September 30, 2006, compared to 24% of total revenues in the nine months ended September 30, 2005. In the future, we expect our gross margins to fluctuate depending on the mix of license versus maintenance and service revenues recorded as well as stock-based compensation resulting from the adoption of SFAS 123R on January 1, 2006. In addition, because of the relatively higher costs associated with the launch of our on-demand and other new service offerings, our maintenance and service gross margins may be adversely affected.

Operating Expenses

The table below sets forth the changes in operating expenses for the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005 (in thousands, except percentage data):


	Three					Three							Percentage
	Months					Months							of Dollar
	Ended		Percentage			Ended		Percentage			Year to Year		Change
	September 30,		of Total			September 30,		of Total			Increase		Year over
	2006		Revenues			2005		Revenues			(Decrease)		Year
Operating expenses:
Sales and marketing	$	5,570		32	%	$	5,208		30	%	$	362		7	%
Research and development		3,612		21	%		3,109		18	%		503		16	%
General and administrative		3,195		18	%		2,232		13	%		963		43	%


Total operating expenses	$	12,377		71	%	$	10,549		62	%	$	1,828		17	%


	Nine					Nine							Percentage
	Months					Months							of Dollar
	Ended		Percentage			Ended		Percentage			Year to Year		Change
	September 30,		of Total			September 30,		of Total			Increase		Year over
	2006		Revenues			2005		Revenues			(Decrease)		Year
Operating expenses:
Sales and marketing	$	17,929		34	%	$	13,358		30	%	$	4,571		34	%
Research and development		10,832		21	%		9,124		21	%		1,708		19	%
General and administrative		9,274		18	%		6,931		16	%		2,343		34	%


Total operating expenses	$	38,035		73	%	$	29,413		67	%	$	8,622		29	%

Sales and Marketing. Sales and marketing expenses increased $0.4 million, or 7%, for the three months ended September 30, 2006 compared to the three months ended September 30, 2005. The increase was primarily attributable to increases in personnel costs of $0.4 million, resulting from an increase in headcount. The increase was also driven by increases in stock-based compensation expense of $0.2 million resulting from the adoption of SFAS 123R and travel and related expenses of $0.2 million. The increases were offset by a decrease in marketing and advertising expenses of $0.4 million due to the Company’s annual user conference being held during the third quarter in 2005 and during the fourth quarter in 2006.

Sales and marketing expenses increased $4.6 million, or 34%, for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005. The increase was primarily attributable to increases in personnel costs of $3.4 million, resulting from an increase in headcount and an increase in commission payments resulting from increased sales. The increase was also driven by increases in travel and related expenses of $0.6 million and stock-based compensation expense of $0.6 million resulting from the adoption of SFAS 123R. Excluding commissions, which vary as a function of sales, we expect sales and marketing expenses to increase over the remainder of 2006 as we invest in sales and marketing efforts to drive further revenue growth and due to the annual user conference.

Research and Development. Research and development expenses increased $0.5 million, or 16%, for the three months ended September 30, 2006 compared to the three months ended September 30, 2005. The increase was primarily due to increases in personnel costs of $0.3 million due to headcount increases and stock-based compensation expense of $0.2 million resulting from the adoption of SFAS 123R.

Research and development expenses increased $1.7 million, or 19%, for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005. The increase was primarily due to increases in personnel costs of $1.0 million resulting from headcount increases, professional fees of $0.2 million and stock-based compensation expense of $0.5 million resulting from the adoption of SFAS 123R. We expect our research and development expense to remain essentially flat over the remainder of 2006.

General and Administrative. General and administrative expenses increased $1.0 million, or 43%, for the three months ended September 30, 2006 compared to the three months ended September 30, 2005. The increase was primarily due to an increase of $0.8 million in professional fees which included $0.5 million in professional fees incurred in our efforts to comply with Section 404 of the Sarbanes-Oxley Act. In addition, there was an increase of $0.3 million due to the expensing of stock-based compensation resulting from the adoption of SFAS 123R. The increases were offset by a decrease in personnel costs of $0.1 million.

General and administrative expenses increased $2.3 million, or 34%, for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005. The increase was primarily due to increases of $1.1 million due to the expensing of stock-based compensation resulting from the adoption of SFAS 123R, $0.6 million in personnel costs due to headcount increases and $0.6 million in professional fees. We expect general and administrative expenses to increase over the remainder of 2006 primarily due to external audit and professional fees, including the anticipated costs to comply with Section 404 of the Sarbanes-Oxley Act.

In addition, during the preparation of our Form 10-Q for the three months ended September 30, 2006, we determined that certain accrued expenses were overstated by $297,000 as a result of entries recorded in prior reporting periods that were either recorded in error or should have been reversed in prior reporting periods. We recorded adjusting entries during the three months ended September 30, 2006 to decrease accrued expenses on the unaudited condensed consolidated balance sheet and to decrease operating expenses, primarily sales and marketing, in the unaudited condensed consolidated statement of operations. We do not believe these amounts are material to the reporting periods in which they should have been recorded, nor do we expect these amounts will be material to our consolidated operating results for the year ending December 31, 2006.

Stock-Based Compensation

The following table sets forth a summary of our stock compensation expenses in absolute dollars and expressed as a percentage of total revenues for the three and nine months ended September 30, 2006 and 2005, respectively.


	Three		Three					Percentage
	Months		Months					of Dollar
	Ended		Ended			Year to Year		Change
	September 30,		September 30,			Increase		Year over
	2006		2005			(Decrease)		Year
Stock-based compensation:
Cost of maintenance and service revenues	$	250	$	(2	)	$	252		(12,600	)%
Sales and marketing		264		55			209		380	%
Research and development		217		1			216		21,600	%
General and administrative		335		(3	)		338		(11,267	)%

Total stock-based compensation	$	1,066	$	51		$	1,015		1,990	%


	Nine		Nine				Percentage
	Months		Months				of Dollar
	Ended		Ended		Year to Year		Change
	September 30,		September 30,		Increase		Year over
	2006		2005		(Decrease)		Year
Stock-based compensation:
Cost of maintenance and service revenues	$	760	$	89	$	671		754	%
Sales and marketing		794		244		550		225	%
Research and development		682		227		455		200	%
General and administrative		1,429		354		1,075		304	%


Total stock-based compensation	$	3,665	$	914	$	2,751		301	%

For the three and nine months ended September 30, 2006, we accounted for stock-based compensation under SFAS 123R, while for the three and nine months ended September 30, 2005, we accounted for stock-based compensation under APB No. 25. Under APB No. 25, we were generally required to record compensation expense only if there were positive differences between the market value of our common stock and the exercise price of the options granted to employees on the date of the grant. Under SFAS 123R, however, we record compensation expense for all share-based payments made to employees based on the fair value at the date of the grant. The amounts are not comparable because they were recorded under different accounting standards (see Note 6 – Stock-based Compensation).

We expect our stock-based compensation expense for the fourth quarter of 2006 to approximate the amount recorded in each of the first three quarters of 2006, subject to the grant of new options, cancellation of existing options due to employee turnover and changes in the assumptions and estimates to calculate fair value.

Other Items

The table below sets forth the changes in other items for the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005 (in thousands, except percentage data):


	Three		Three						Percentage
	Months		Months						of Dollar
	Ended		Ended			Year to Year			Change
	September 30,		September 30,			Increase			Year over
	2006		2005			(Decrease)			Year
Other income (expense), net:
Interest expense	$	—	$	(4	)	$	4			(100	)%
Interest and other income, net		754		411			343			83	%


Total other income, net	$	754	$	407		$	347			85	%


Provision for income taxes	$	—	$	38		$	(38	)		(100	)%


	Nine		Nine						Percentage
	Months		Months						of Dollar
	Ended		Ended			Year to Year			Change
	September 30,		September 30,			Increase			Year over
	2006		2005			(Decrease)			Year
Other income (expense), net:
Interest expense	$	—	$	(20	)	$	20			(100	)%
Interest and other income, net		1,997		1,092			905			83	%


Total other income, net	$	1,997	$	1,072		$	925			86	%


Provision for income taxes	$	—	$	29		$	(29	)		(100	)%


Cumulative effect of a change in accounting principle	$	128	$	—		$	128			100	%

Interest Expense and Interest and Other Income, Net

Interest expense decreased $4,000, or 100%, and $20,000, or 100%, for the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005, respectively. We did not have any outstanding debt during the three and nine months ended September 30, 2006. In the third quarter of 2005, we repaid all of our outstanding term loans in full.

Interest and other income, net increased $0.3 million, or 83%, and $0.9 million, or 83%, for the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005, respectively. The increase was primarily attributable to the increase in interest income generated on our investments as a result of higher interest rates in the three and nine months ended September 30, 2006 compared to the three and nine months ended September 30, 2005.

Provision for Income Taxes

Provision for income taxes was zero for the three and nine months ended September 30, 2006. Provision for income taxes was $38,000 and $29,000 for the three and nine months ended September 30, 2005. 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.

Cumulative Effect of a Change in Accounting Principle

Cumulative effect of a change in accounting principle was $0 and $128,000 for the three and nine months ended September 30, 2006, respectively, and resulted from the change in accounting principle from APB No. 25 to SFAS 123R. The cumulative effect of a change in accounting principle resulted from the requirement of SFAS 123R to reduce the amount of stock-based compensation expense by an estimated forfeiture rate or, in other words, the estimated number of shares that are not expected to vest as a result of an employee terminating prior to becoming fully vested in an award. Prior to the adoption of SFAS 123R, we did not reduce stock-based compensation expense based on an estimated forfeiture rate but rather recorded an adjustment to stock-based compensation as actual forfeitures occurred. The cumulative effect of a change in accounting principle is generally one time in nature and not expected to occur as part of our normal business on a regular basis. See Note 6 – Stock-based Compensation for further discussion.

Liquidity and Capital Resources

As of September 30, 2006, we had $53.2 million of cash, cash equivalents and short-term investments.

Net Cash Used in Operating Activities. Net cash used in operating activities was $11.9 million for the nine months ended September 30, 2006 and $0.9 million for the nine months ended September 30, 2005. The significant cash receipts and outlays for the two periods are as follows (in thousands):


	Nine Months Ended September 30,
	2006			2005
Cash collections	$	47,012		$	49,327
Payroll related costs		(41,121	)		(33,585	)
Professional services costs		(6,084	)		(4,233	)
Employee expense reports		(4,970	)		(6,221	)
Facilities related costs		(2,724	)		(2,820	)
Third-party royalty payments		(483	)		(562	)
Other		(3,530	)		(2,834	)

Net cash used in operating activities	$	(11,900	)	$	(928	)

Net cash used in operating activities increased $11.0 million for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005. The increase was primarily attributable to an increase in payroll related costs of $7.5 million due to increased sales commissions and headcount. Other factors were an increase in professional services of $1.9 million and a reduction in collections of $2.3 million, partially offset by a decrease in employee expenses of $1.3 million.

Net Cash Used in/Provided by Investing Activities. Net cash used in investing activities was $0.5 million for the nine months ended September 30, 2006 while net cash provided by investing activities was $7.8 million for the nine months ended September 30, 2005. Net cash used in investing activities during the nine months ended September 30, 2006 was primarily due to purchases of investments of $40.0 million and purchases of property and equipment of $1.5 million, partially offset by proceeds from maturities and sale of investments of $41.0 million compared to purchases of investments of $22.7 million and purchases of property and equipment of $0.8 million, offset by proceeds from maturities and sale of investments of $31.3 million for the nine months ended September 30, 2005.

Net Cash Provided by Financing Activities. Net cash provided by financing activities was approximately $2.8 million and $2.4 million for the nine months ended September 30, 2006 and 2005, respectively. Net cash provided by financing activities for the nine months ended September 30, 2006 was a result of proceeds from stock option exercises of approximately $2.8 million. Net cash provided by financing activities for the nine months ended September 30, 2005 was due to stock option exercises of approximately $2.9 million, partially offset by long-term debt payments of $0.5 million.

Contractual Obligations and Commitments

The following table summarizes our contractual cash obligations (in thousands) at September 30, 2006. Contractual cash obligations that are cancelable upon notice and without significant penalties are not included in the following table. In addition, we have unconditional purchase commitments for goods and services where payments are based, in part, on volume or type of services we require. In those cases, we only included the minimum volume or purchase commitment in the table below.


	Payments due by Period
			Remaining										2011
Contractual Obligations	Total		2006		2007		2008		2009		2010		and beyond
Operating lease commitments	$	9,069	$	553	$	2,363	$	2,441	$	2,219	$	1,493	$	—


Unconditional purchase commitments	$	322	$	138	$	146	$	38	$	—	$	—	$	—

With the exception of the above contractual cash obligations, we have no material off-balance sheet arrangements that have not been recorded in our condensed consolidated financial statements.

For our New York, New York and San Jose, California offices, we have two certificates of deposit totaling approximately $570,000 and $676,000 respectively as of September 30, 2006 and December 31, 2005, pledged as collateral to secure letters of credit required by our landlords for security deposits.

We believe our existing cash and investment balances will be sufficient to meet our anticipated short-term and long-term cash requirements as well as the contractual obligations listed above. Our future capital requirements will depend on many factors, including revenues we generate, the timing and extent of spending to support product development efforts, the expansion of sales and marketing activities, the timing of introductions of new products and enhancements to existing products, market acceptance of our on-demand service offering, and the continuing market acceptance of our other products.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market risk represents the risk of loss that may affect 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 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 affected due to a rise in interest rates, while floating rate securities, that 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 September 30, 2006, the average maturity of our investments was approximately three months and all investment securities had maturities of less than twelve months. The following table presents certain information about our financial instruments at September 30, 2006 that are sensitive to changes in interest rates (in thousands, except for interest rates):



	Expected Maturity						Total		Total
	1 Year			More Than			Principal		Fair
	or Less			1 Year			Amount		Value
Available-for-sale securities	$	47,656		$	—		$	47,656	$	47,643
Weighted average interest rate		5.25	%		—	%

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. As of September 30, 2006, we had no outstanding indebtedness for borrowed money. Therefore, we currently have no exposure to market risk related to debt instruments. To the extent we enter into or issue debt instruments in the future, we will have interest expense market risk.

Foreign Currency Exchange Risk. Our revenues and our expenses, except those related to our United Kingdom, Germany and Australia operations, are generally denominated in United States dollars. For the three and nine months ended September 30, 2006, we earned approximately 21% and 19% of our revenue from our international operations. Of this revenue from our international operations, 20% and 44% was denominated in United States dollars. 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, 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 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. Lead plaintiff and lead counsel were appointed by the Court and on November 29, 2004, plaintiff filed a consolidated amended class action complaint (“Complaint”). The Complaint alleged that the Company and certain individual defendants made materially false or misleading statements or omissions in violation of the federal securities laws during the period of January 22, 2004 through June 23, 2004 (the “Class Period”). The Complaint sought to recover damages on behalf of anyone who purchased or otherwise acquired our stock during the Class Period. Following the Company’s motion to dismiss, the complaint was initially dismissed with leave to amend in 2005 and, after plaintiffs’ acknowledgement that they could not amend, the action was dismissed with prejudice.

alleged in the derivative actions, and the Company’s insurance carrier agreed to pay all amounts directly under the settlement other than a nominal amount for the mailing of a notice to the Company’s shareholders. The Company will not incur any material expense as a result of the settlement.

The Court entered an Order and Final Judgment Approving the Stipulation of Settlement on October 27, 2006.

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 is likely to have a material adverse effect on the Company’s future financial results.

Item 1A. Risk Factors

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 $8.6 million and $25.5 million in 2005 and 2004, respectively, and had net income of approximately $0.8 million in 2003. For the three and nine months ended September 30, 2006, we had a net loss of $2.5 million and $8.8 million, respectively. We expect that our reported expenses will increase in 2006 as we expand our operations domestically and internationally, continue to invest in new products and services, such as our on-demand offering, continue to expense stock-based compensation in accordance with SFAS 123R and incur expenses related to compliance with Section 404 of the Sarbanes-Oxley Act. Consequently, we expect to incur a loss in 2006 and are not sure that we will achieve or sustain profitability on a quarterly or annual basis in the future. If we cannot increase our revenues to compensate for our greater operating expenses, our future results of operations and financial condition will be negatively affected.

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.

Our quarterly license revenues are typically dependent upon the closing of a relatively small number of transactions involving sales of our products to new customers. As such, variations in the rate and timing of conversion of sales prospects into revenues could result in our failure to meet revenue objectives or achieve or maintain profitability in future periods. We generally 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. However, under our new on-demand service offering, we will generally recognize revenues ratably over the term of the contract, and these revenues will be recognized as maintenance and service revenues, not as license revenues. 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, including any shift toward on-demand contracts at the expense of the traditional license contracts, could therefore materially and adversely affect our license revenues in a quarter. Delays or reductions in the amount of customers’ purchases of licenses or when we recognize revenues would adversely affect our revenues, results of operations 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 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 timely 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. If we are unable to successfully and timely develop new products or enhance existing products or if we fail to position and price our products to meet market demand, our business and operating results will be adversely affected.

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 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 the first nine months of 2005 and throughout 2004, our license revenues were substantially lower than expected due to purchasing delays by our customers and failures to close transactions resulting in significant net losses. In addition, we have experienced lower than expected maintenance and service revenues in recent quarters as we have had fewer configuration and implementation engagements than we had forecast. Conversely, our license revenues for the last six months of 2005 and first nine months of 2006 were greater than in prior periods primarily as a result of the closing several larger transactions, but there is no assurance that we will continue the recent revenue growth.

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;

	•		the priority our customers place on the purchase of our products as compared to other information technology and capital acquisitions;

	•		market acceptance of our new on-demand services;

	•		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;

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

	•		indeterminate and often lengthy sales cycles;

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

	•		merger and acquisition activities among our customers which may alter their buying patterns;

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

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

	•		the extent to which our customers elect to engage us versus third parties for configuration and implementation engagements;

	•		changes in the average selling prices of our products;

	•		timing of product development and new product initiatives;

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

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

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, and longer in some cases, to complete. It is therefore difficult to predict the quarter in which a particular sale will close and to plan 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 and services;

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

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

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

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

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

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

The 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 of the sales cycle in general or for one or more large orders would adversely affect the timing and amount of our revenues.

In addition, our management makes assumptions and estimates as to the timing and amount of future revenues in budgeting future operating costs and capital expenditures based on estimated closing dates and potential dollar amounts of transactions. Management aggregates these estimates periodically to generate our sales forecasts and then evaluates the forecasts to identify trends. As a result, failure to complete one or more license transactions during a particular quarter would cause our quarterly results of operations to be worse than anticipated.

If our on-demand service offering is unsuccessful, our business and operating results could be adversely affected.

We launched our managed services on-demand offering in the first quarter of 2006 and our hosted on-demand service offering in the second quarter of 2006. We are investing substantial resources to introduce this new offering, and we may not realize the return we expect on this investment. In particular, we expect that our gross margins for on-demand revenues will be lower than gross margins on our other maintenance and service revenue, until this offering achieves greater scale. In addition, our on-demand offering is an alternative to our substantially higher margin software licensing business. If sales of our on-demand service have an adverse effect on demand for our software licenses, our business and operating results could be materially and adversely affected.

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, until recent quarters, remained relatively constant. In recent quarters, however, maintenance and service revenues have been lower than expected due to fewer configuration and implementation engagements than we had forecast. 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 likely decline.

Professional services comprise a substantial portion of our revenues and to the extent our customers choose to use other services providers, our revenues and operating results may decline.

A substantial portion of our revenues are derived from the performance of professional services, primarily implementation, configuration, training and other consulting services in connection with new product licenses and other ongoing projects. However, there are a number of third party service providers available who offer these professional services and we do not require that our customers use our professional services. To the extent our customers choose to use third party service providers over us, as has happened in recent quarters, our revenues and operating income have been and may continue to be adversely affected, possibly significantly.

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

We have been expanding our international operations in 2006. For example, we have begun increasing the number of sales personnel in our subsidiaries overseas. International expansion may 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;

	•		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 fail to do so successfully and timely, our business and operating results could be seriously harmed.

Our latest product features and functionality may require existing customers to migrate from their existing versions to more recent versions of our software. If existing customers fail or delay to migrate, our revenues may be harmed.

We plan to pursue sales of new product modules to existing customers of our TrueComp software. For most of these customers to take advantage of new features and functionality in our latest modules, they will need to migrate to a more current version of our products at additional cost, which they may decline to do or delay. If a sufficient number do not migrate, our ability to sell additional products to these customers, and as a result, our revenues and operating income, may be harmed, possibly significantly.

If we do not compete effectively with competitors, 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 do. Many also have a larger installed base of users, longer operating histories or greater name recognition. Some of our competitors’ products may also be more effective 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 of software applications used to run their business.

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 our access to advance software releases, which would restrict our ability to adapt our products for integration with their 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 again harm, our overall gross margins in the future.

Our maintenance and service revenues, which include fees for consulting, implementation, maintenance, on-demand services and training, were 71%, 78% and 48% of our revenues for years 2005, 2004 and 2003, respectively. In addition, maintenance and service revenues were 64% of our revenues in the first nine months of 2006. 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 first three quarters of 2006 and the years 2005 and 2004 as compared to 2003 adversely affected our overall gross margins. Failure to maintain and 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, changes in the average selling prices for our products and services, 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.

As an example of more recent competitive pressure on our services offerings, many of our potential customers have begun to outsource technology projects offshore to take advantage of lower labor costs. Consequently, we expect some customers to 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.

We expect maintenance and services revenue to continue to comprise a substantial majority of our overall revenues for the foreseeable future. To the extent our on-demand and other new service offerings are successful, maintenance and service revenues could increase significantly, and our maintenance and service gross margin may be adversely affected. 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 regularly require large, often enterprise-wide deployments of our products, which require a substantial degree of technical and logistical 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 and our customers. Failure to successfully manage the process could harm our reputation both generally and with specific customers 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 are currently 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 reputation, operating results and financial condition.

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, and expect to continue to derive, a substantial majority of our revenues from our TrueComp product and related products and services. Because we have historically sold our product licenses on a perpetual basis and delivered new versions and enhancements to customers who purchase maintenance

contracts, our future license revenues are substantially dependent on new customer sales. We have recently introduced our products as an on-demand subscription model, but these services still consist substantially of providing our TrueComp product. 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.

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 delay revenue recognition on all or a portion of our licensing transactions. For example, our recently introduced on-demand offering of our product is targeted at customers that are not interested in purchasing a perpetual license. If our competitors offer deep discounts on competitive products or services, we may be required to lower prices or offer other terms more favorable to our customers in order to compete successfully. Some of our competitors may bundle their competitive software products with their other products and services 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. If we cannot offset price reductions and other terms more favorable to our customers with a corresponding increase in the number of sales or decreased spending, then the reduced revenues resulting from lower prices or revenue recognition delays would adversely affect our margins and operating results.

Our products depend on the technology of third parties licensed to us 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 and we anticipate that we will continue to do so. For example, we recently entered into an agreement with Hyperion to sublicense part of its System 9 technology for our new Quota Management product. 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 is developed or, if available, is 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 continually test our products for errors and work with customers to timely identify and correct bugs, errors in our products are likely to be found in the future. Any errors could be extremely costly to correct, materially and adversely affect our reputation, and impair our ability to sell our products. 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

	•		substantially greater service and warranty costs.

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.

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

During 2005, we experienced numerous changes in our executive management team, most notably the hiring of Robert Youngjohns as our new president and chief executive officer, Shanker Trivedi as our vice president, chief marketing officer, and Leslie Stretch as our vice president of worldwide sales. 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 joins a competitor or otherwise competes with us, it could harm our business and 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 can timely hire qualified replacements, we would expect to experience operational disruptions and inefficiencies during any transition.

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 which would adversely affect our results of operations.

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 is significantly dependent on the proprietary technology embedded in our products. We rely on a combination of copyrights, patents, trademarks, service marks, trade secret

laws and contractual restrictions to establish and protect our proprietary rights. We cannot protect our intellectual property if we are unable to enforce our rights or if we do not detect its unauthorized use. 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. 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 rights of third parties and our competitors or other third parties may challenge the validity or scope of our intellectual property rights. We believe that claims of infringement are likely to increase as the functionality of our products expands and as new products are introduced. 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.

In addition, we use a limited amount of open source software in our products and may use more in the future. 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. As a result, we could be subject to suits by parties claiming ownership of what we believe to be open source software.

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 will be required to certify our internal controls over financial reporting under Section 404 of the Sarbanes-Oxley Act for the first time in our Annual Report for the year ending December 31, 2006. 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 system integrators and other third party service vendors and record and report financial and management information on a timely and accurate basis. Additionally, as we prepare to comply with Section 404 of the Sarbanes-Oxley Act, we may identify one or more material weaknesses in our financial controls. The existence or disclosure of any such material weaknesses could adversely affect our stock price.

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 the “Risks Related to Our Business” section 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; and

	•		developments with respect to intellectual property rights.

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

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

We continue to use the net proceeds of 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.

On June 7, 2006, 33,933 shares of the Company’s common stock were issued upon the net issue exercise of a warrant previously issued. The issuance of the warrant and the common stock underlying the warrant was exempt from registration under the Securities Act of 1933, as amended, pursuant to Section 4(2) of that Act.

Item 6. Exhibits

(a) Exhibits


Exhibit
Number		Description
31.1		302 Certification

31.2		302 Certification

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.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized on November 14, 2006.


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


PART I. FINANCIAL INFORMATION
Item 1. Financial Statements			3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			21
Item 3. Quantitative and Qualitative Disclosures About Market Risk			37
Item 4. Controls and Procedures			38

PART II. OTHER INFORMATION
Item 1. Legal Proceedings			38
Item 1A. Risk Factors			39
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities			49
Item 6. Exhibits			49
Signatures			49
Exhibit Index			50
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1