Quarterly Report on Form 10-Q

-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, MXLJUauQq/NP5WVKE6YPIgRx/UBCb+4ZNbNl/NkW28nS/G/SM6fzL8VhW89xyIB4 BSfura8XJpM7krKmdbrlQw== 0001193125-06-171295.txt : 20060814 0001193125-06-171295.hdr.sgml : 20060814 20060811211620 ACCESSION NUMBER: 0001193125-06-171295 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20060630 FILED AS OF DATE: 20060814 DATE AS OF CHANGE: 20060811 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PHARSIGHT CORP CENTRAL INDEX KEY: 0001040853 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 770401273 STATE OF INCORPORATION: CA FISCAL YEAR END: 0331 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-31253 FILM NUMBER: 061026616 BUSINESS ADDRESS: STREET 1: 321 E. EVELYN AVENUE STREET 2: 3RD FLOOR CITY: MOUNTAIN VIEW STATE: CA ZIP: 94041 BUSINESS PHONE: 6503143800 MAIL ADDRESS: STREET 1: 321 E. EVELYN AVENUE STREET 2: 3RD FLOOR CITY: MOUNTAIN VIEW STATE: CA ZIP: 94041 10-Q 1 d10q.htm QUARTERLY REPORT ON FORM 10-Q Quarterly Report on Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended June 30, 2006

¨	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: 000-31253

PHARSIGHT CORPORATION

(Exact name of Registrant as specified in its charter)

Delaware

77-0401273

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification Number)

321 E. Evelyn Ave., 3^rd Floor

Mountain View, CA 94041-1530

(Address of principal executive offices, including zip code)

(650) 314-3800

(Registrant’s telephone number, including area code)

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

Indicate by 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 ¨ Accelerated filer ¨ Non-accelerated filer x

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

The number of shares of Registrant’s Common Stock outstanding as of August 8, 2006: 19,675,829

TABLE OF CONTENTS


		Page

PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)	3

	Condensed Consolidated Balance Sheets – June 30, 2006 and March 31, 2006	3

	Condensed Consolidated Statements of Operations – Three Months Ended June 30, 2006 and 2005	4

	Condensed Consolidated Statements of Cash Flows – Three Months Ended June 30, 2006 and 2005	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	28

Item 4.	Controls and Procedures	28

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	29

Item 1A.	Risk Factors	29

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	38

Item 3.	Defaults Upon Senior Securities	38

Item 4.	Submission of Matters to a Vote of Security Holders	38

Item 5.	Other Information	38

Item 6.	Exhibits	38

	Signatures	39

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Pharsight Corporation

Condensed Consolidated Balance Sheets

(Unaudited)

(in thousands, except shares and per share amounts)


	June 30, 2006			March 31, 2006
ASSETS
Current assets:
Cash and cash equivalents	$	8,911		$	10,832
Short-term investments		1,259			—
Accounts receivable, net of allowances of $20 at June 30, 2006 and March 31, 2006		3,394			4,585
Prepaid and other current assets		428			298

Total current assets		13,992			15,715

Property and equipment, net		1,883			2,025
Other assets		46			46

TOTAL ASSETS	$	15,921		$	17,786

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ DEFICIT
Current liabilities:
Accounts payable	$	250		$	794
Accrued expenses		914			1,035
Accrued compensation		1,533			2,152
Deferred revenue		7,411			7,605
Current portion of notes payable		1,300			1,519

Total Current Liabilities		11,408			13,105

Deferred revenue, long term		36			54
Notes payable, less current portion		316			392
Other long term liabilities		235			253

Redeemable convertible preferred stock, $0.001 par value:
Authorized shares - 3,200,000 (2,000,000 designated as Series A and 1,200,000 designated as Series B) at June 30, 2006 and March 31, 2006
Issued and outstanding shares - 1,941,653 and 1,923,511 at June 30, 2006 and March 31, 2006 respectively (1,814,662 designated as Series A at June 30, 2006 and March 31, 2006, 126,991 and 108,849 designated as Series B at June 30, 2006 and March 31, 2006 respectively) - Aggregate redemption and liquidation value - $7,709		6,752			6,641
Stockholders’ deficit:
Preferred stock, $0.001 par value:
Authorized shares - 1,800,000 at June 30, 2006 and March 31, 2006
Issued and outstanding shares - none at June 30, 2006 and March 31, 2006
Common stock, $0.001 par value:
Authorized shares - 120,000,000 at June 30, 2006 and March 31, 2006
Issued and outstanding shares - 19,673,620 and 19,594,684 at June 30, 2006 and March 31, 2006 respectively		19			19
Additional paid-in capital		73,870			73,790
Accumulated other comprehensive loss		(22	)		(13	)
Accumulated deficit		(76,693	)		(76,455	)

Total stockholders’ deficit		(2,826	)		(2,659	)

TOTAL LIABILITIES, REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY	$	15,921		$	17,786

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

Pharsight Corporation

Condensed Consolidated Statements of Operations

(Unaudited)

(in thousands, except per share amounts)


	Three Months Ended
	June 30, 2006			June 30, 2005
Revenues:
License	$	1,218		$	884
Renewal		1,289			1,160
Maintenance		236			191
Services		2,685			3,459

Total revenues		5,428			5,694

Costs of revenues:
License, renewal, maintenance		59			80
Services (1)		1,697			1,807

Total cost of revenues		1,756			1,887

Gross profit		3,672			3,807
Operating expenses:
Research and development (1)		955			872
Sales and marketing (1)		1,563			1,278
General and administrative (1)		1,488			1,370

Total operating expenses		4,006			3,520

Income (loss) from operations		(334	)		287
Other income (expense):
Interest expense		(40	)		(37	)
Interest income		160			44
Other expense, net		(17	)		(19	)

Total other income (expense)		103			(12	)

Net income (loss) before income taxes		(231	)		275
Provision for income taxes		(7	)		(21	)

Net income (loss)		(238	)		254
Preferred stock dividend		(184	)		(145	)

Net income (loss) attributable to common stockholders	$	(422	)	$	109

Net income (loss) per share attributable to common stockholders:
Basic	$	(0.02	)	$	0.01

Diluted	$	(0.02	)	$	0.00

Shares used to compute net income (loss) per share attributable to common stockholders:
Basic		19,646			19,345

Diluted		19,646			22,043

___________
(1) Allocation of stock-based compensation expense:

Cost of revenues	$	44
Research and development		17
Sales and marketing		73
General and administrative		75

Total	$	209

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

Pharsight Corporation

Condensed Consolidated Statements of Cash Flows

(in thousands)

(Unaudited)


	Three Months Ended
	June 30, 2006			June 30, 2005
Cash Flows from Operating Activities:
Net income (loss)	$	(238	)	$	254
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Depreciation		184			96
Stock-based compensation expense		209			—
Changes in operating assets and liabilities:
Accounts receivable		1,191			86
Prepaid expenses and other		(130	)		39
Accounts payable		(544	)		(133	)
Accrued liabilities		(140	)		(82	)
Accrued compensation		(619	)		(404	)
Deferred revenue		(212	)		(544	)

Net cash used in operating activities		(299	)		(688	)

Cash Flows from Investing Activities:
Purchases of property and equipment		(42	)		(497	)
Purchases of investments		(1,259	)		—

Net cash used in investing activities		(1,301	)		(497	)

Cash Flows from Financing Activities:
Repayment of notes payable, net		(294	)		(243	)
Proceeds from exercises of stock options		55			10
Dividends paid in cash to preferred stockholders		(73	)		(145	)

Net cash used in financing activities		(312	)		(378	)

Effect of change in exchange rates on cash		(9	)		19
Net change in cash and cash equivalents		(1,921	)		(1,544	)
Cash and cash equivalents, beginning of period		10,832			10,579

Cash and cash equivalents, end of period	$	8,911		$	9,035

Supplemental disclosures of non cash activities:
Issuance of dividend to preferred stockholders in form of stock		111			—
Accrued preferred stock dividend		48			48

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

PHARSIGHT CORPORATION

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business

Pharsight Corporation (“Pharsight” or the “Company”) develops and markets software and provides strategic consulting services that help pharmaceutical and biotechnology companies improve the efficiency of the drug development decision making process, by reducing the costs and time requirements of their drug discovery, development, and commercialization efforts. Pharsight’s products include proprietary software for clinical trial simulation and computer-aided trial design, for the statistical analysis and mathematical modeling of data, and for the storage, management, and regulatory reporting of derived data and models in data repositories. Both the Company’s software products and its services leverage expertise in the sciences of pharmacology, drug and disease modeling, human genetics, biostatistics and strategic decision-making. Pharsight Corporation was incorporated in California in April 1995 and reincorporated in Delaware in June 2000.

Pharsight operates in two operating segments, which are also its reportable segments: Software Products and Strategic Consulting. These segments were determined based on how management and the Company’s Chief Operating Decision Maker, (“CODM”), who is the Company’s Chief Executive Officer, view and evaluate the business.

Basis of Presentation

The accompanying financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. These financial statements should be read in conjunction with our financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2006.

The interim financial statements are unaudited but reflect all normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the results of these periods. The results of operations for the three months ended June 30, 2006 are not necessarily indicative of results to be expected for the fiscal year ending March 31, 2007, or any other period.

Basis of Consolidation

The condensed consolidated financial statements include the accounts of Pharsight and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated.

Use of Estimates

Pharsight’s financial statements are prepared in accordance with GAAP. These accounting principles require the Company to make certain estimates, judgments and assumptions. The Company believes that the estimates, judgments and assumptions upon which they rely are reasonable based upon information available to them at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, the Company’s financial statements will be affected.

Cash, Cash Equivalents and Short-term Investments

Cash equivalents consist of highly liquid investments with original maturities from the date of purchase of three months or less. Investments with an original maturity at the time of purchase of over three months are classified as short-term investments regardless of maturity date as all investments are classified as available-for-sale and can be readily liquidated to meet current operational needs. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in interest income.

Revenue Recognition

Our revenues are derived from two primary sources: (1) initial and renewal fees for term-based and perpetual product licenses, and post-contract customer support (PCS), and (2) services related to scientific and training consulting and software deployment.

Our revenue recognition policy is in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” or SOP 97-2, as amended. For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, collection is probable, and no significant post-delivery obligations remain unfulfilled. If any of these criteria are not met, we defer revenue recognition until such time as all of the criteria are met. We do not currently offer, have not offered in the past, and do not expect to offer in the future, extended payment term arrangements. If we do not consider collectability to be probable, we defer recognition of revenue until the fee is collected.

We enter into arrangements for one-year software licenses (initial and renewal fees) bundled with post-contract support services, or PCS, from which we receive solely license and renewal fees. We do not have vendor specific objective evidence to allocate the fee to the separate elements, as we do not sell PCS separately. Therefore, we include PCS revenue as part of license revenue and do not present PCS revenue separately, as we do not believe allocation methodologies, namely allocation based on relative costs, provide a meaningful and supportable allocation between license and PCS revenues. We recognize each of the initial and renewal license fees and PCS fees ratably over the one-year period of the license during which the PCS is expected to be provided as required by paragraph 12 of SOP 97-2.

We also enter into arrangements that consist of perpetual and term-based licenses, PCS and implementation/installation services. For arrangements involving a significant amount of services related to installation and implementation of our software products, we recognize revenue for the entire arrangement ratably over the remaining period of the PCS term once the implementation and installation services are completed and accepted by the customer. We currently do not have vendor specific objective evidence for PCS, however revenues from maintenance renewals on perpetual licenses are classified as maintenance revenue and deferred revenue on our income statement and balance sheet, respectively.

We also enter into arrangements consisting of perpetual or one-year licenses, one-year PCS, implementation/installation services and optional scientific consulting services. We recognize revenue attributable to license, PCS and implementation/installation ratably over the remaining period of the PCS term once the implementation and installation services are completed and accepted by the customer. The optional scientific consulting services meet the criteria of paragraph 65 of SOP 97-2 for separate accounting, as they are not essential to the functionality of the delivered software, are described and priced separately in the arrangement and are sold separately. We recognize fees from optional scientific consulting services (equal to the fee amounts set forth separately in the contracts) as revenue as these services are provided or upon their acceptance, as applicable.

For arrangements consisting solely of services, we recognize revenue as consulting services are performed. Arrangements for consulting services may be charged at daily rates for different levels of consultants and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee contracts, with payments based on milestones or acceptance criteria, we recognize revenue as such milestones are achieved, or if customer acceptance of the milestone’s completion is required, upon such customer acceptance, which approximates the level of services provided. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.

We have two international distributors. There is no right of return or price protection for sales to the international distributors. Revenue on sales to these distributors is recognized ratably over the license term when the software is delivered to the distributor and other revenue recognition criteria are met.

Judgments affecting revenue recognition. Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter. We recognize revenue in accordance with GAAP rules that have been prescribed for the software industry. The accounting rules related to revenue recognition are complex and are affected by interpretations of the rules and an understanding of industry practices, both of which are subject to change. Consequently, the revenue recognition accounting rules require management to make significant judgments.

We do not record revenue on sales to customers whose ability to pay is in doubt at the time of sale. Rather, we recognize revenue from these customers as cash is collected. The determination of a customer’s ability to pay requires significant judgment. In this regard, management considers the international region of the customer and the financial viability of the customer in assessing a customer’s ability to pay.

We generally do not consider revenue arrangements with extended payment terms to be fixed or determinable and, accordingly, we do not generally recognize revenue on these arrangements until the customer payments become due. The determination of whether extended payment terms are fixed or determinable requires management to exercise significant judgment, including assessing such factors as the past payment history with the individual customer and evaluating the risk of concessions over an extended payment period. The determinations that we make can materially impact the timing of recognition of revenues. Our normal payment terms currently range from “net 30 days” to “net 60 days,” which are not considered by us to be extended payment terms.

The majority of our PKS software arrangements include software deployment services. We defer revenue for software deployment services, along with the associated license revenue, until the services are completed. If there is significant uncertainty about the project completion or receipt of payment for the professional services, we defer revenue until the uncertainty is sufficiently resolved.

Additionally, for fixed fee strategic consulting contracts, with payments based on milestones or acceptance criteria, we recognize revenue as such milestones are achieved, or if customer acceptance is required, upon customer acceptance, which approximates the level of services provided. Management makes a number of estimates related to recognizing revenue for such contracts, as discussed further above. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.

Deferred Revenue

Deferred revenue is comprised of deferred license fees (initial and renewal), which are recognized ratably over the one-year period of the license. In addition, deferred revenue includes services and training revenue, which will be recognized as services are performed. Deferred revenue also includes deferred license and service fees for arrangements that include significant implementation services, which have not yet been completed. Long term deferred revenue represents amounts received for maintenance and support services to be provided beginning in periods after one year from the balance sheet date.

The principal components of deferred revenue were as follows (in thousands):


	June 30, 2006		March 31, 2006
License	$	3,117	$	3,078
Renewals		3,135		3,473
Training		—		4
Maintenance		418		557
Services		777		547

Total deferred revenue	$	7,447	$	7,659

Short term deferred revenue		7,411		7,605
Long term deferred revenue		36		54

Total deferred revenue	$	7,447	$	7,659

Net Income (Loss) Per Share

Basic net income (loss) per share attributable to common stock is computed by dividing net income or loss attributable to common stockholders for the period by the weighted-average number of shares of vested common stock (i.e. not subject to a right of repurchase) outstanding during the period.

Diluted net income (loss) per share attributable to common stockholders is computed by dividing net income or loss attributable to common stockholders for the period by the weighted-average number of shares of vested common stock outstanding and, where dilutive, weighted average number of shares of unvested common stock outstanding. Diluted net income (loss) per share attributable to common stockholders also gives effect, as applicable, to the potential dilutive effect of outstanding stock options and warrants to purchase common stock using the treasury stock method, and convertible preferred stock using the as-if-converted method, as of the beginning of the period presented or the original issuance date, if later.

The following table presents the calculation of basic and diluted net income (loss) per share (in thousands, except per share data):


	Three Months Ended
	June 30, 2006			June 30, 2005
Net income (loss)	$	(238	)	$	254
Preferred stock dividend		(184	)		(145	)

Net income attributable to common for basic computation	$	(422	)	$	109

Weighted average common shares outstanding		19,646			19,345
Diluted effect of:
Stock options and stock-based awards and as-if converted preferred stock in the periods ended		—			2,698

Dilutive weighted-average common shares outstanding		19,646			22,043

Net income (loss) per share attributable to common stockholders
Basic	$	(0.02	)	$	0.01

Dilutive	$	(0.02	)	$	0.00

All potential common shares including preferred stock (on an as-if-converted basis), have been excluded from the computation of diluted earnings per share in the period ended June 30, 2006 as the effect of including such shares would be antidilutive due to the net loss recorded in that period.

The number of potential common stock shares excluded from the calculation of net income (loss) per share attributable to common stockholders at June 30, 2006 and 2005 due to antidilution is detailed in the following table (in thousands):


	June 30,
	2006	2005
Outstanding options	3,843	2,794
Warrants	412	123
Redeemable convertible preferred stock	7,718	7,476

	11,973	10,393

Stock-Based Compensation

Adoption of SFAS 123R

The Company has adopted several stock plans that provide equity instruments to our employees and non-employee directors. Our plans include incentive and non-statutory stock options and restricted stock awards. Stock options generally vest ratably over a four-year period on the anniversary date of the grant, and expire ten years after the grant date. The Company also has employee stock purchase plans that allow qualified employees to purchase Company shares at 85% of the fair market value on specified dates.

Prior to April 1, 2006, we accounted for stock-based employee compensation plans under the measurement and recognition provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25, and related Interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation,” or SFAS 123. We generally recorded no stock-based compensation expenses during periods prior to April 1, 2006 as all stock-based grants had exercise prices equal to the fair market value of our common stock on the date of grant. We also recorded no compensation expense in connection with our employee stock purchase plans as they qualified as non-compensatory plans following the guidance provided by APB 25. In accordance with SFAS 123 and SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” we disclosed our net income or loss and net income or loss per share for the quarter ended June 30, 2006 as if we had applied the fair value based method in measuring compensation expense for our stock-based compensation programs. Under SFAS 123, we elected to calculate our compensation expense by applying the Black-Scholes valuation model, applying the graded vesting expense attribution method and recognizing forfeited awards in the period that they occurred.

Effective April 1, 2006, we adopted the fair value recognition provisions of SFAS 123R using the modified prospective transition method. Under that transition method, compensation expense that we recognized for the quarter ended April 1, 2006 included: (a) compensation expense for all share-based payments granted prior to but not yet vested as of April 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation expense for all share-based payments granted or modified on or after April 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Compensation expense is recognized only for those awards that are expected to vest, whereas prior to the adoption of SFAS 123R, we recognized forfeitures as they occurred. In addition, we elected the straight-line attribution method as our accounting policy for recognizing stock-based compensation expense for all awards that are granted on or after April 1, 2006. For awards subject to graded vesting that were granted prior to the adoption of SFAS 123R, we use an accelerated expense attribution method. Results in prior periods have not been restated.

We estimate the fair value of options granted using the Black-Scholes option valuation model and the assumptions shown in Note 1, “Stock-Based Compensation,” to the condensed consolidated financial statements. We estimate the expected term of options granted based on the history of grants, exercises and post-vesting cancellations in our option database. Contractual term expirations have not been significant. We estimate the volatility of our common stock at the date of grant based on a combination of historical volatilities, consistent with SFAS 123R and SEC Staff Accounting Bulletin No. 107. Prior to the adoption of SFAS 123R, we relied exclusively on the historical prices of our common stock in the calculation of expected volatility. We base the risk-free interest rate that we use in the Black-Scholes option valuation model on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon issues with remaining terms equivalent to the expected term of our option grants. We have never paid any cash dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. For options granted before April 1, 2006, we estimated the fair value using the multiple option approach and we are amortizing the fair value on a graded vesting basis. For options granted on or after April 1, 2006, we estimate the fair value using a single option approach and amortize the fair value on a straight-line basis. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods. We may elect to use different assumptions under the Black-Scholes option valuation model in the future if our current experience indicates that a different measure is preferable, which could materially affect our net income or loss and net income or loss per share.

The following table presents the impact of our adoption of SFAS 123R on the selected condensed consolidated statement of operations line items for the quarter ended June 30, 2006 (in thousands, except per share data):


	Three Months Ended June 30, 2006
	Using Previous Accounting			SFAS 123 (R) Adjustments			As Reported
Income (loss) from operations	$	(125	)	$	(209	)	$	(334	)
Income (loss) before income taxes		(22	)		(209	)		(231	)
Net income (loss)		(213	)		(209	)		(422	)

Basic income (loss) per share attributable to common stockholders	$	(0.01	)	$	(0.01	)	$	(0.02	)

Diluted income (loss) per share attributable to common stockholders	$	(0.01	)	$	(0.01	)	$	(0.02	)

Cash flows from operating activities	$	(299	)		—		$	(299	)
Cash flows from financing activities	$	(312	)		—		$	(312	)


	Three Months Ended June 30, 2005
Net income (loss) attributable to common stockholders, as reported	$	109
Less:
Total stock-based employee compensation expense determined under the fair value method for all awards		(221	)

Pro forma net loss attributable to common stockholders	$	(112	)

Basic net income (loss) per share attributable to common stockholders
As reported	$	0.01

Pro forma	$	(0.01	)

Diluted net income (loss) per share attributable to common stockholders
As reported	$	0.00

Pro forma	$	(0.01	)

Valuation Assumptions for Stock Options and ESPP

The Company estimates the fair value of its options using the Black-Scholes option value model, which was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. The Company’s employee stock options have characteristics significantly different than those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimates. The fair value of options granted and the option component of the employee purchase plan shares were estimated at the date of grant, assuming no expected dividends, and with the following weighted average assumptions:


	ESPP Three Months Ended June 30,				Options Three Months Ended June 30,
	2006		2005		2006		2005
Expected life (years)	0.49		0.49		2.69		4.00
Expected stock price volatility	79.22	%	111.7	%	125.36	%	203.8	%
Risk-free interest rate	5.24	%	3.34	%	5.18	%	3.67	%

Stock Options

The following is a summary of stock option activity during the quarter ended June 30, 2006:


	Number of Options Outstanding (in thousands)		Weighted Average Exercise Price per Share		Weighted Average Remaining Contractual Term	Aggregate Intrinsic Value as of 06/30/06 (in thousands)
Balance at March 31, 2006	4,385		$	1.20
Options granted	1,218		$	1.35
Options exercised	(79	)	$	1.38
Options canceled	(139	)	$	1.28

Balance at June 30, 2006	5,385		$	1.24	7.75	$	2,321

Options vested and expected to vest at June 30, 2006	4,721		$	1.23	0.54	$	2,243

Options exercisable at June 30, 2006	2,843		$	1.17	6.56	$	1,874

The weighted average remaining amortization period was 1.55 years as of June 30, 2006. The Company had 2,843,000 exercisable options and the unamortized stock compensation was $ 1.9 million as of June 30, 2006.

Comprehensive Income (Loss)

SFAS No. 130, “Reporting Comprehensive Income” (“SFAS 130”), requires Pharsight to display comprehensive income (loss) and its components as part of the financial statements. Comprehensive income (loss) includes certain changes in equity that are excluded from net income (loss). Pharsight’s comprehensive income (loss) consists of net income (loss) adjusted for the effect of unrealized foreign exchange gains or losses and unrealized gains or losses on available-for-sale investments. The foreign currency translation adjustments for the three months ended June 30, 2006 were $9,000. The accumulated other comprehensive loss at June 30, 2006 was $22,000.

Concentrations of Credit Risk

The Company receives a substantial majority of its revenue from a limited number of customers. For the three months ended June 30, 2006 and 2005 sales to the Company’s top two customers accounted for 24% and 44% of total revenue, respectively, and sales to its top five customers in the same periods accounted for 40% and 59% of total revenue, respectively. One customer accounted for 13% and 32% of total revenues for the three months ended June 30, 2006 and 2005, respectively. Another customer accounted for 11% and 12% of total revenues for the three months ended June 30, 2006 and 2005, respectively. For fiscal 2006, 2005 and 2004, sales to our top two customers accounted for 42%, 45% and 28% of total revenue, respectively, and sales to the top five customers in the same periods accounted for 52%, 62% and 50% of total revenue.

Two customers each comprised 10% of accounts receivable at June 30, 2006. Three customers comprised 23%, 14% and 10% of accounts receivable at March 31, 2006.

Recent Accounting Pronouncements.

In June 2006, the FASB issued FASB Interpretation No. 48, or FIN 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Financial Accounting Standards Board Statement No. 109, or FAS 109, Accounting for Income Taxes. FIN 48 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. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 will be effective for fiscal years beginning after December 15, 2006. Earlier adoption is permitted as of the beginning of an enterprise’s fiscal year, provided the enterprise has not yet issued financial statements, including financial statements for any interim period, for that fiscal year. The Company will adopt FIN 48 in the first quarter of fiscal 2008 and currently does not expect that the adoption of FIN 48 will have material effect on its consolidated results of operations and financial condition.

2. NOTES PAYABLE

The Company has a secured term loan outstanding, payable over 48 months, with monthly payments that commenced in July 2002. The balance was paid off as of June 30, 2006. In February 2005, the Company secured an additional term loan for the purchase of a new financial system, which was added to the existing term loan. The $300,000 additional term loan is payable over 36 months. The balance outstanding on the additional term loan as of June 30, 2006 was $167,000. In addition, we secured an equipment credit facility through June 2006 for up to $600,000. Each advance will be payable over 36 months. As of June 30, 2006, the current balance on this equipment credit facility was $450,000.

The Company has a credit facilities with Silicon Valley Bank, providing for up to $3.0 million in borrowings, secured against 80% of eligible domestic accounts receivable. The current balance of this credit facility is $1.0 million as of June 30, 2006.

On June 12, 2006, the Company and Silicon Valley Bank (the “Bank”) entered into the Fifth Amendment (the “Loan Amendment”) to the Loan and Security Agreement, effective as of May 24, 2004 by and between Silicon Valley Bank and the Company, as amended (the “Loan and Security Agreement”). The Loan Amendment amends in part Section 2.4 of the Loan and Security Agreement to provide that interest due on the Committed Revolving Line is payable on the 25^th day of each month and amends Section 13.1 of the Loan and Security Agreement by changing the “Revolving Maturity Date” to May 26, 2007. In addition, the Loan Amendment amends in part Section 6.7 of the Loan and Security Agreement by replacing the profitability/loss financial covenant with a covenant requiring the Company to maintain a minimum tangible net worth, computed as redeemable convertible preferred stock plus stockholders’ deficit, in an amount not less than $3.0 million. Furthermore, the Loan Amendment also provides for additional representations and warranties by the Company to induce the Bank to enter into the Loan Amendment.

In addition, the Company must maintain a minimum modified quick ratio (defined as cash and cash equivalents and investments plus accounts receivable, divided by total current liabilities, including all bank debt but excluding deferred revenue) of 2:1. Interest on our revolving lines of credit is accrued at 0.5% above prime and is payable monthly from the date of borrowing. Interest on our term loans is accrued at 1.25% above prime and is payable monthly from the date of borrowing. Certain of the Company’s assets, excluding intellectual property, secure both facilities. The Company is in compliance with all financial covenants as of June 30, 2006.

3. REDEEMABLE CONVERTIBLE PREFERRED STOCK

Series B Redeemable Convertible Preferred Stock

The holders of the Series A Preferred are entitled to receive cumulative dividends in preference to any dividend on the common stock, payable quarterly at the rate of 8% per annum, either in cash or in shares of Series B redeemable convertible preferred stock (the “Series B Preferred”) at the election of the holder. The Series B Preferred has identical rights, preferences and privileges as the Series A Preferred, except that the Series B Preferred is not entitled to the dividend payment right. Due to the nature of the redemption features of the Series B Preferred, we have excluded the Series B Preferred from stockholders’ equity in our financial statements. (Please refer to the discussion of the Preferred Stock Financing in Note 7 – Preferred Stock, in the Notes to Financial Statements contained in our Annual Report on Form 10-K for the year ended March 31, 2006, filed with SEC on June 26, 2006) During the three months ended June 30, 2006, we paid cash dividends of $73,000 to our Series A Preferred stockholders and issued dividends of 18,142 shares of Series B Preferred Stock to Series A holders with a fair value of $6.12 per share.

The following table depicts activities for Series B Preferred Stock for two years ended March 31, 2006 and quarter ended June 30, 2006:


		Number of shares of Series B
Balance at March 31, 2004		36,281

Preferred Series B issued June 1, 2004		18,142

Balance at March 31, 2005		54,423
Preferred Series B issued September 1, 2005		18,142
Preferred Series B issued December 1, 2005		18,142
Preferred Series B issued March 1, 2006		18,142

Balance at March 31, 2006		108,849
Preferred Series B issued June 1, 2006		18,142

Balance at June 30, 2006		126,991

The amount of the Series B Preferred dividend was determined based on the estimated per share fair value of the Series B Preferred. To record the fair value of the Series B Preferred, the Company performed a valuation based on its 5-day average stock price leading up to and including the Valuation Date. Various factors including, but not limited to, deemed time to liquidity and form of dividend payment were considered in the valuation of the Series B Preferred.

The following table depicts the estimated fair value of Series B Preferred Stock issued in each quarterly period beginning in the quarter ended March 31, 2005:


Date of Stocks Issued	Number of Shares of Series B	Price per Share		Total Estimated Fair Value
March 31, 2004	36,281	$	6.00	$	217,686
June 1, 2004	18,142		5.61		101,777
September 1, 2005	18,142		7.80		141,508
December 1, 2005	18,142		6.47		117,379
March 1, 2006	18,142		6.38		115,746
June 1, 2006	18,142		6.12		111,029

	126,991			$	805,125

4. SEGMENT INFORMATION

Segment information is presented in accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This standard is based on a management approach, which requires segmentation based upon the Company’s internal organization and reporting of revenue and operating income based upon internal accounting methods. The Company’s financial reporting systems present various data for management to run the business, including internal profit and loss statements prepared on a basis not consistent with accounting principles generally accepted in the United States. Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for the Company to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.

The Company’s CODM, as defined by SFAS No. 131, is its Chief Executive Officer. The CODM allocates resources to and assesses the performance of each operating segment using information about their revenue and operating profit before interest and taxes. The Company’s segments are designed to promote better alignment of strategic objectives between development, sales, marketing and services organizations; provide for more timely and rational allocation of development, sales and marketing resources within businesses; and for long-term planning efforts on key objectives and initiatives. The segments are used to allocate resources internally and provide a framework to determine management responsibility. Intersegment sales costs are estimated by management and used to compensate or charge each segment for such shared costs, and to incent shared efforts. Management will continually evaluate the alignment of sales and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.

The Company operates in two operating segments, which is also its reportable segments: Software Products and Strategic Consulting. These segments were determined based on how management and its CODM view and evaluate Pharsight’s business.

The Company’s Software Products segment consists of software products and software deployment and integration services that provide the analytical tools and conceptual framework to help clinical researchers optimize the decision-making required to perform the clinical testing needed to bring drugs to market. By applying mathematical modeling and simulation to all available information regarding the compound being tested, researchers can clarify and quantify which trial and treatment design factors will influence the success of clinical trials.

The Company’s Strategic Consulting segment consists of consulting, training and process redesign conducted by its clinical and decision scientists in the application and implementation of its core decision methodology. The Company’s methodology enables customers to identify which uncertainties are greatest and matter most, and then to design development programs, trial sequences, and individual trials in such a way that those trials systematically reduce the identified uncertainties, in the most rapid and cost-effective manner possible.

Summarized financial information on the Company’s reportable segments is shown in the following table (in thousands):


	Three Months Ended June 30,
	2006								2005
	Software Products		Strategic Consulting			Total			Software Products			Strategic Consulting		Total
Revenues:
License and renewal	$	2,743	$	—		$	2,743		$	2,235		$	—	$	2,235
Services		303		2,382			2,685			255			3,204		3,459

Total revenues	$	3,046	$	2,382		$	5,428		$	2,490		$	3,204	$	5,694

Gross profit	$	2,803	$	869		$	3,672		$	2,095		$	1,712	$	3,807

Income (loss) from operations	$	142	$	(476	)	$	(334	)	$	(85	)	$	372	$	287

5. CONTINGENCIES AND GUARANTEES

Contingencies

From time to time and in the ordinary course of business, the Company may be subject to various claims, charges, and litigation. In the opinion of management, final judgments from such pending claims, charges, and litigation, if any, against the Company, would not have a material adverse effect on the Company’s financial position, result of operations, or cash flows.

Guarantees

From time to time, the Company enters into certain types of contracts that contingently require it to indemnify parties against third party claims. These obligations relate to certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationship. Other obligations relate to certain commercial agreements with its customers, under which the Company may be required to indemnify such parties against liabilities and damages arising out of claims of patent, copyright, trademark or trade secret infringement by its software. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. Because the obligated amounts of these types of agreements often are not explicitly stated, the overall maximum amount of the obligations cannot be reasonably estimated. Historically, the Company has not had to make any payments for these obligations, and no liabilities have been recorded for these obligations on the Company’s condensed consolidated balance sheets as of June 30, 2006 and March 31, 2006.

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

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections, including statements regarding the benefits of our products and services, anticipated revenue or operating expenses, anticipated product development, trends in customer demand, expansion opportunities for our products and services, revenue from sales to certain customers and our competitive position. In some cases, these forward-looking statements can be identified by words such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “assume,” “potential,” “continue,” “intend,” “hope,” “can,” or the negative of such terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including without limitation the business risks discussed in Part II – Item 1A – “Risk Factors” in this Quarterly Report on Form 10-Q. These forward-looking statements involve risks and uncertainties that could cause our, or our industry’s, actual results, levels of activity, performance or achievements to differ materially from any future results, levels of activities, performance or achievements expressed or implied in such forward-looking statements. These business risks should be considered in evaluating our prospects and future financial performance. Although we believe that expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Our expectations are as of the date we file this Quarterly Report on Form 10-Q, and we do not intend to update any of the forward-looking statements after the date we file this Quarterly Report on Form 10-Q to conform these statements to actual results, unless required by law.

Overview

Pharsight Corporation develops and markets software and provides strategic consulting services that help pharmaceutical and biotechnology companies improve the efficiency of the drug development decision making process, by reducing the costs and time requirements of their drug discovery, development, and commercialization efforts. Our products include proprietary software for visualization of drug and disease model outputs, for clinical trial simulation and computer-aided trial design, for the statistical analysis and mathematical modeling of data, and for the storage, management, validation, and regulatory reporting of derived data and models in data repositories. Both our software products and our services utilize expertise in the sciences of pharmacology, drug and disease modeling, biostatistics and strategic decision-making. Our service offerings use this expertise to interpret and improve the design of scientific experiments and clinical trials, and to optimize clinical trial design and portfolio decisions. By integrating scientific, clinical, and business decision criteria into a dynamic model-based methodology, we help our customers to optimize the value of their drug development programs and portfolios from discovery to post-launch marketing.

The use of our software and methodology is on the leading edge of the traditional drug-development process, which is heavily dependent upon clinical trials and patient testing. Although our methodology does not displace the use of human trials in drug development, we believe our software and our methodology renders human trials more efficient and relevant. The continued growth of our customer base, the increase in the number of contracts with our customers, and the increase in our average contract values over time have shown a trend that we believe demonstrates increased acceptance of our methodology and an increased demand for its use. We believe that these trends, in addition to increasing regulatory requirements from the FDA and FDA’s emphasis on modeling and simulation found in the Critical Path Initiative, demonstrate a potential for increased revenue growth resulting from increased demand for our current products and services, as well as long-term opportunities to expand the breadth and coverage of both our consulting services and software product offerings.

For reporting purposes, we operate in two business segments: Software Products and Strategic Consulting. Our Software Products segment consists of software products and software deployment and integration services that provide the analytical tools and conceptual framework to help clinical researchers optimize the decision-making required to perform clinical testing needed to bring drugs to market. Our Strategic Consulting segment consists of consulting, training and process redesign conducted by our clinical and decision scientists in the application and implementation of our core decision methodology. These segments were determined based on how management and our Chief Operating Decision Maker, or CODM, who is our Chief Executive Officer, view and evaluate our business.

Challenges and Risks

We achieved our first quarter of profitability in the fourth quarter of fiscal 2004 and had annual profitability during fiscal 2005 and 2006. Prior to that time we had incurred losses since inception. We currently have an accumulated deficit of approximately $76.7 million. To meet increased demand for our products and services, we may be required to invest further in our operations, technology and infrastructure, which may result in our inability to sustain profitability. Despite the recent decrease in service revenue we believe we are still experiencing increased demand for our consulting services. However, we may have difficulty expanding our capacity to deliver such services in a profitable manner, if at all.

We achieved positive operating cash flow in fiscal 2004 and continued to have positive operating cash flow in fiscal 2005 and 2006; however, we experienced negative operating cash flow in the first quarter of fiscal 2007. Although we believe that our current cash balances are sufficient to meet our working capital needs for the next twelve months, our ability to generate positive net cash flow and sustain positive operating cash flow on a quarterly and annual basis is based on a number of factors, including some which are outside of our control, such as the state of the overall economy, the demand for our products and the length and lack of predictability of our sales cycle. As a result, we may need to raise additional funds through public or private financings or other sources to fund our operations. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, these equity securities might have rights, preferences or privileges senior to our common stock and preferred stock. In addition, the necessity of raising additional funds could force us to incur debt on terms that could restrict our ability to make capital expenditures and to incur additional indebtedness.

In the three months ended June 30, 2006, we generated 51% of our total revenues, or $2.7 million, from software license and renewal fees, compared to 39% of total revenues, or $2.2 million, in the three months ended June 30, 2005. Software services revenue decreased to $2.7 million or 49% of total revenue, compared to $3.5 million or 61% of total revenue for the three months ended June 30, 2005. While we expect that the overall long-term revenue trend in our software business will continue to increase in response to customer demand, the software revenue in individual quarters may fluctuate significantly, based upon timing of completion of large software installations and related revenue recognition. Unanticipated delays in software project deployment schedules may have significant impact on the timing of revenue recognition and may have corresponding significant impact on our net income in that quarter.

We generate a significant portion of our revenue from a limited number of clients. We expect that a significant portion of our revenue will continue to depend on sales to a small number of clients. In addition, the worldwide pharmaceutical industry has undergone, and may in the future undergo, substantial consolidation, which may reduce the number of our existing and potential clients. The loss of one of our large clients would hurt our business and prevent us from achieving or sustaining profitability.

Our strategic consulting customers range in size from the largest pharmaceutical companies to small biopharmaceutical companies, and the focus of our work differs depending upon the size and maturity of the customer. In our smaller and medium-sized customers, we tend to engage in discrete projects often with challenging analytic and design problems, where modeling and simulation can be particularly valuable. This kind of work may or may not lead to subsequent engagements. By contrast, at our largest customers, we tend to have ongoing relationships which are more strategic in nature, and we focus on helping improve the process by which they develop drugs, broadening and deepening the application of modeling and simulation over time, with the intent of achieving systematic, lasting performance improvement.

Our clients may also expand their internal drug development organizations to include functions and individuals that might perform services similar to those performed by our strategic consulting group. As a result, our consulting business could have difficulty sustaining its current levels of revenues, or increasing its revenues in the future. Unanticipated delays in consulting project schedules may have significant impact to the timing of revenue recognition and may have corresponding significant impact on our net income in that quarter.

The pharmaceutical industry in general has recently experienced, and may continue to experience, forced withdrawal of certain drugs from the public market due to unforeseen safety risks, more time-consuming safety testing requirements in drug development, and patent expiries on significant portions of their marketed drugs. Our clients may, as a result, experience declines in their revenues, which may lead to reductions in their current level of spending on software solutions and strategic consulting services. This could adversely affect our business and prevent us from increasing or sustaining our software and strategic consulting revenues.

Critical Accounting Policies and Estimates

We prepare our financial statements in accordance with U.S. generally accepted accounting principles, or GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The primary critical accounting policies that currently affect our financial condition and results of operations are revenue recognition and allowance for doubtful accounts, which impact revenue. We believe that this accounting policy is critical to fully understand and evaluate our reported financial results.

Revenue Recognition

Our revenues are derived from two primary sources: (1) initial and renewal fees for term-based and perpetual product licenses, and post-contract customer support, and (2) services related to scientific and training consulting and software deployment.

evidence to allocate the fee to the separate elements, as we do not sell PCS separately. Therefore, we do not present PCS revenue separately, and we do not believe other allocation methodologies, namely allocation based on relative costs, provide a meaningful and supportable allocation between license and PCS revenues. We recognize each of the initial and renewal license fees ratably over the one-year period of the license during which the PCS is expected to be provided as required by paragraph 12 of SOP 97-2.

We enter into arrangements consisting of perpetual or one-year licenses, one-year PCS, implementation/installation services and optional scientific consulting services. We recognize revenue attributable to license, PCS and implementation/installation ratably over the remaining period of the PCS term once the implementation and installation services are completed and accepted by the customer. The optional scientific consulting services meet the criteria of paragraph 65 of SOP 97-2 for separate accounting, as they are not essential to the functionality of the delivered software, are described and priced separately in the arrangement and are sold separately. We recognize fees from optional scientific consulting services (equal to the amounts set in the contracts) as revenue as these services are provided or upon their acceptance, as applicable.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than the full payment on our currently outstanding receivables. We make judgments as to our ability to collect receivables and provide allowances for the portion of receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding invoices and evaluation of historical trends of write-offs of accounts we deem uncollectible. In determining these percentages, we analyze our historical collection experience and current economic trends.

Accounting for Stock-Based Compensation.

Effective April 1, 2006, we began accounting for stock-based compensation arrangements in accordance with the provisions of SFAS 123R. Under SFAS 123), compensation cost is established by determining the fair value of the option on the date of grant. The compensation cost is then amortized on a straight-line basis over the vesting period. We use the Black Scholes option pricing model to determine the fair value of the stock options at the date of grant. Black Scholes requires us to estimate key assumptions such as expected term, volatility, dividend yield and risk-free interest rate. The estimate of these key assumptions is based on historical information and judgment regarding market factors and trends. If actual results are not consistent with our assumptions and judgment used in estimating the key assumptions, we may be required to increase or decrease compensation expense or income tax expense, which could be material to our results of operations.

Results of Operations

The following table sets forth, for the periods given, selected unaudited consolidated financial data by reportable segment as a percentage of our revenue and the percentage of period-over-period change. The table and the discussion below should be read in connection with the consolidated financial statements and the notes thereto which appear elsewhere in this report. All percentage calculations set forth in this section have been made using figures presented in the consolidated financial statements, and not from the rounded figures referred to in the text of this management discussion and analysis.


	For Three Months Ended
	June 30, 2006				June 30, 2005
(in thousands, except percentages)	Amount		% of Total		Amount		% of Total		(%) Change
Total revenues:
License, renewal and maintenance	$	2,743	51	%	$	2,235	39	%	23	%
Services		2,685	49	%		3,459	61	%	-22	%

Total revenues	$	5,428	100	%	$	5,694	100	%	-5	%

Software products segment revenues:
License, renewal and maintenance	$	2,743	51	%	$	2,235	39	%	23	%
Services		303	6	%		255	4	%	19	%

Total software products segment revenues	$	3,046	56	%	$	2,490	44	%	22	%

Strategic consulting segment revenues	$	2,382	44	%	$	3,204	56	%	-26	%

Comparison of Three Months Ended June 30, 2006 and 2005

Total revenues

Revenue for the first quarter of fiscal 2007 decreased approximately 5 % to $5.4 million, compared to $5.7 million in the first quarter of fiscal 2006. This decrease was primarily attributable to a 26% decline in consulting services revenue, largely driven by the decline in the combined revenue from our largest two customers, Lilly and Pfizer, offset by an increase in initial PKS revenue.

Software Products segment revenues

License, renewal and maintenance revenues. For the first quarter of fiscal 2007, software product revenues increased to $2.7 million from $2.2 million in the first quarter of fiscal 2006, primarily as a result of an increase in our installed base in the first quarter of fiscal 2007 compared to the previous year, and our ability to maintain a high rate of license renewals during the first quarter of fiscal 2007. In addition, we introduced two new products in the third quarter of fiscal 2006, validation suites for PKS and WNL. We saw an increase in revenue from the sales of these new products in the first quarter of fiscal 2007 by $116,000.

PKS software products revenues increased to $663,000 in the first quarter of fiscal 2007, from $495,000 in the first quarter of fiscal 2006. The increase in PKS software products revenues is due to an increase of $296,000 of initial and additional license purchases by new customers and existing customers who purchased additional licenses.

DMX software revenues were $196,000 in the first quarter of fiscal 2007, compared to $174,000 in the first quarter of fiscal 2006. The increase in DMX software revenues is due to the addition of 4 new customers during fiscal 2006 and one in the first quarter of fiscal 2007.

Services revenues. Software services revenues were $303,000 in the first quarter of fiscal 2007, compared to $255,000 in the first quarter of fiscal 2006. The increase is due to an increase in training revenue during the first quarter of 2007.

Strategic Consulting segment revenues

Strategic Consulting segment revenues were $2.4 million in the first quarter of fiscal 2007, compared to $3.2 million in the first quarter of fiscal 2006, primarily due to the decreased spending on consulting services by our two largest customers, Pfizer and Eli Lilly. While in the first quarter of fiscal 2007 we did not achieve the same level of revenue in the first quarter of 2006 due to the slowdown at Pfizer, revenue as in the first quarter of 2007 was relatively consistent compared to the fourth quarter of 2006. In addition, for the second consecutive quarter, consulting revenue from customers other than our two largest customers increased by 27% or $299,000.

Cost of revenues


							% of Total Revenues
	Three Months Ended				(%) Change		Three Months Ended
(in thousands)	June 30, 2006		June 30, 2005		(%) Change		June 30, 2006		June 30, 2005
Total revenues:	$	5,428	$	5,694	(5	)%

License, renewal and maintenance		59		80	(26	)%	1	%	1	%
Services		1,697		1,807	(6	)%	31	%	32	%

Total cost of revenues	$	1,756	$	1,887	(7	)%	32	%	33	%

Cost of software products segments revenues:
License, renewal and maintenenance		59		80	(26	)%	1	%	1	%
Services		184		315	(42	)%	3	%	6	%

Total software products segment	$	243	$	395	(38	)%	4	%	7	%

Cost of strategic consulting segment revenues	$	1,513	$	1,492	1	%	28	%	26	%

Total cost of revenues

Total cost of revenues were $1.8 million for the first quarter of fiscal 2007, compared to $1.9 million in the first quarter of fiscal 2006. Cost of revenues is comprised mainly of payroll and payroll related expenses plus royalty expense and shipping costs. Also included is the allocation of $44,000 of stock-based compensation expense related to adoption of SFAS 123R in the first quarter of 2007.

Software Products segment

Cost of license, renewal and maintenance revenues. Cost of license, renewal and maintenance revenues primarily consists of royalty expense for third-party software included in our products, and cost of materials for both initial products and product updates provided for in our annual license agreements. Cost of license, renewal and maintenance revenues was $59,000 for the first quarter of fiscal 2007, compared to $80,000 in the first quarter of fiscal 2006. The decrease in cost of license, renewal and maintenance revenues in absolute dollars and as a percentage of revenue, in the first quarter of fiscal 2007 is due to timing of purchases of disks and manuals as well as a decrease in royalty payments of $20,000.

Cost of services revenues. Cost of services revenues consists of payroll and related costs, travel expenses, and facilities and overhead costs associated with our deployment services group. Cost of services revenue was $184,000 for the first quarter of fiscal 2007, compared to $315,000 in the first quarter of fiscal 2006. The decrease is due to deferral of costs associated with deferred revenues on projects under the ongoing deployment of six PKS installation projects.

Strategic Consulting segment

Cost of services for our strategic consulting segment consists of payroll and payroll related costs, travel expenses, and facilities and overhead costs associated with our strategic consulting personnel. Cost of services for our strategic consulting segment was $1.5 million for the first quarter in fiscal 2007 and 2006. Costs were relatively constant, as headcount has remained consistent year over year.

Operating expenses

Research & development


(in thousands)	Three Months Ended						(%) Change
(in thousands)	June 30, 2006			June 30, 2005			(%) Change

Total revenues	$	5,428		$	5,694		(5	)%


Software products segment	$	955		$	872		10	%
Strategic consulting segment		—			—		—

Total R&D Expenses	$	955		$	872		10	%

R&D as a percentage of revenue		18	%		15	%

Research and development expenses consist mainly of payroll, payroll related expenses and third-party consulting expenses. Also included is the allocation of $17,000 of stock-based compensation expense related to adoption of SFAS 123R in the first quarter of fiscal 2007.

Software Products segment

Research and development expenses were $955,000 for the first quarter of fiscal 2007 compared to $872,000 for the first quarter of fiscal 2006. The increase in research and development expenses in absolute dollars, and as a percentage of revenue, for the first quarter of fiscal 2007 compared to the first quarter of fiscal 2006 was primarily due to an increase in payroll related expense of $74,000 and $168,000 of intra department allocation of payroll costs due to the various research and development projects the Company has in process offset by third party consulting expense of $158,000.

Strategic Consulting segment

The Strategic Consulting segment does not engage in research and development activities, nor is any such expense allocable to the segment, therefore it does not incur research and development related expenses.

Sales and marketing


(in thousands)	Three Months Ended						(%) Change
(in thousands)	June 30, 2006			June 30, 2005			(%) Change

Total revenues	$	5,428		$	5,694		(5	)%


Software products segment	$	898		$	729		23	%
Strategic consulting segment		665			549		21	%

Total sales and marketing	$	1,563		$	1,278		22	%

Sales and marketing as a percentage of revenues		29	%		22	%

Sales and marketing expenses consist primarily of personnel costs, including salaries, commissions for sales, corporate marketing, facilities related costs and travel related costs. Also included is the allocation of $73,000 of stock-based compensation expense related to adoption of SFAS 123R in the first quarter of fiscal 2007.

Total sales and marketing expenses

Sales and marketing expenses were $1.6 million in the first quarter of fiscal 2007, compared to $1.3 million in the first quarter of fiscal 2006. The increase in sales and marketing expense in absolute dollars in the first quarter of fiscal 2006 was primarily the result of an increase in payroll and payroll related expenses of $182,000 due to increased headcount, increase in travel expense of $24,000 and increase in allocation of facilities related expenses of $44,000. Sales and marketing expenses as a percentage of revenue increased in the first quarter of fiscal 2007, compared to the first quarter of fiscal 2006 as the we continue to invest in sales and marketing efforts and the fact that total revenues decreased period over period. The Software Products and Strategic Consulting segments both have dedicated sales and marketing resources, as well as a shared pool of sales and marketing resources which are allocated to the segments based on each segment’s revenue as a relative percentage of total revenues. Inter-segment sales and marketing costs related to the shared pool of resources are estimated by management and used to compensate or charge each segment for such shared costs, and to incent shared efforts. Management will continually evaluate the alignment of sales and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.

Software Products segment

Sales and marketing expenses for the software products segment were $898,000 in the first quarter of fiscal 2007, compared to $729,000 in the first quarter of fiscal 2006. The increase in sales and marketing expense in absolute dollars in the first quarter of fiscal 2007 as compared to the same period in fiscal 2006 was primarily the result of increase in the allocation of sales and marketing cost to the software product segment as a result of higher relative percentage of software product revenue to total revenue.

Strategic Consulting segment

Sales and marketing expenses for the strategic consulting segment were $665,000 in the first quarter of fiscal 2007, compared to $549,000 in the first quarter of fiscal 2006. The increase in sales and marketing expenses in absolute dollars was primarily the result of an increase of $116,000 in payroll and payroll related expenses due to increased headcount.

General and administrative


(in thousands)	Three Months Ended						(%) Change
(in thousands)	June 30, 2006			June 30, 2005			(%) Change

Total revenues	$	5,428		$	5,694		(5	)%


Software products segment	$	808		$	579		40	%
Strategic consulting segment		680			791		(14	)%

Total general and administrative	$	1,488		$	1,370		9	%


G&A as a percentage of revenues		27	%		24	%

General and administrative expenses consist primarily of personnel costs of executive officers and support personnel, facilities, investor relations, insurance, legal and accounting fees. Also included is the allocation of $75,000 of stock-based compensation expense related to adoption of SFAS 123R in the first quarter of fiscal 2007.

Total general and administrative expenses

General and administrative expenses were $1.5 million in the first quarter of fiscal 2007 compared to $1.4 million in the first quarter of fiscal 2006. The increase in absolute dollars in the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 was primarily the result of an increase of approximately $128,000 in third party consulting expense and approximately $35,000 from payroll and payroll related expenses, offset by a decrease of approximately $51,000 in legal expenses.

Software products segment

General and administrative expenses for the software products segment were $808,000 in the first quarter of fiscal 2007 compared to $579,000 in the first quarter of fiscal 2006. The increase in general and administrative expense in absolute dollars in the first quarter of fiscal 2007 was primarily the result of increase in the allocation of general and administrative cost to the software product segment as a result of higher relative percentage of software product revenue to total revenue.

Strategic consulting segment

General and administrative expenses for the strategic consulting segment were $680,000 in the first quarter of fiscal 2007 compared to $791,000 in the first quarter of fiscal 2006. The decrease in general and administrative expense in absolute dollars and as a percentage of revenue for the first quarter of fiscal 2007 compared to the same period in fiscal 2006 was primarily the result of a decrease in the allocation of general and administrative costs to the strategic consulting segment as the result of a lower relative percentage of strategic consulting segment revenues to total revenues.

Provision for Income Taxes

Year over year comparison for the three months ended June 30, 2006 (in thousands):


	Three Months Ended June 30,
	2006			2005
Provision for income taxes	$	(7	)	$	(21	)

Provisions for income taxes were recorded for the three months ended June 30, 2006 and 2005. These provisions/benefit were attributable to federal and state alternative minimum taxes, other state taxes and foreign income tax. The amounts provided were at rates less than the combined U.S. federal and state statutory rates due to the utilization of federal and state net operating loss carry forwards.

Liquidity and Capital Resources

From our inception through the initial public offering of our common stock, we funded operations through the private sale of preferred stock, with net proceeds of approximately $38 million, limited borrowings and equipment leases. In August 2000, we completed our initial public offering of 3,000,000 shares of common stock, at a price of $10.00 per share, all of which were issued and sold by us for net proceeds of $26.4 million, net of underwriting discounts and commissions of $2.1 million and expenses of $1.5 million. We paid $6.1 million to holders of our Series C preferred stock at the closing of the offering as required by the terms of the Series C preferred stock. After this payment, our net proceeds were $20.3 million. In June and September of fiscal 2003, we completed a private placement of preferred stock to several of our investors, raising additional net proceeds of $7.2 million, as further described below.

Summarized cash, working capital and cash flow information is as follows (dollars in thousands):


	June 30, 2006			% Change		March 31, 2005
Cash and cash equivalents	$	8,911		(18	)%	$	10,832

Working capital	$	2,584		(1	)%	$	2,610


	Three Months Ended June 30,
	2006			% Change		2005
Cash flows from operating activities	$	(299	)	57	%	$	(688	)

Cash flows from investing activities	$	(1,301	)	(162	)%	$	(497	)

Cash flows from financing activities	$	(312	)	18	%	$	(378	)

Cash, Cash Equivalents and investments. As of June 30, 2006, our cash and cash equivalents consisted primarily of demand deposits and money market funds. The decrease in our cash and cash equivalents in the three months ended June 30, 2006 was primarily due to $1.3 million cash used in purchases of investments, $294,000 of cash used in financing activities to pay down notes payable and $73,000 of cash payment for dividends. The largest use of cash from operating activities was due to a decrease in accounts payable and accrued expenses due to the timing of payments and a decrease in deferred revenue.

Cash Flows From Operating Activities. Cash used in operating activities decreased in the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 primarily due to net loss, a decrease in accounts receivables from our cash collection efforts, and decreases in accounts payable, accrued expenses, and deferred revenue.

Cash Flows From Investing Activities. Cash used in investing activities during the first quarter of fiscal 2007 were primarily related to purchases of short-term investments and miscellaneous asset purchases of capital equipment necessary for our ongoing operations.

Cash Flows From Financing Activities. Cash used in financing activities in the first three months of fiscal 2007 were primarily a result of payments against our outstanding loan facilities with Silicon Valley Bank and payments of dividends to our preferred stockholders. Cash flows used in financing activities in the first three months of fiscal 2006 were primarily a result of payments against our outstanding loan facilities with Silicon Valley Bank.

Credit Facilities. The Company has a secured term loan outstanding, payable over 48 months, with monthly payments that commenced in July 2002. The balance was paid off as of June 30, 2006. In February 2005, the Company secured an additional term loan for the purchase of a new financial system, which was added to the existing term loan. The $300,000 additional term loan is payable over 36 months. The balance outstanding on the additional term loan as of June 30, 2006 was $166,000. In addition, we secured an equipment credit facility through June 2006 for up to $600,000. Each advance will be payable over 36 months. As of June 30, 2006, the current balance on this equipment credit facility was $450,000.

In addition, we must maintain a minimum modified quick ratio (defined as cash and cash equivalents and investments plus accounts receivable, divided by total current liabilities, including all bank debt but excluding deferred revenue) of 2:1. Interest on our revolving lines of credit is accrued at 0.5% above prime and is payable monthly from the date of borrowing. Interest on our term loans is accrued at 1.25% above prime and is payable monthly from the date of borrowing. Certain of our assets, excluding intellectual property, secure both facilities. We were in compliance with all financial covenants as of June 30, 2006.

Preferred Stock Financing. On June 26, 2002 and September 11, 2002, we completed private placements of our securities to certain entities affiliated with Alloy Ventures, Inc. and the Sprout Group, both of which were existing stockholders, pursuant to a Preferred Stock and Warrant Purchase Agreement (the “Purchase Agreement”). Pursuant to the Purchase Agreement, we sold an aggregate of 1,814,662 units (each a “Unit,” and collectively the “Units”). Each Unit consisted of one share of our Series A redeemable convertible preferred stock (the “Series A Preferred”) and a warrant to purchase one share of our common stock. The purchase price for each Unit was $4.133, which is the sum of $4.008 (four times the underlying average closing price for our common stock over the five trading days prior to the initial closing (i.e., $1.002)) and $0.125 for each share of Series A Preferred and warrant, respectively. The second closing, which occurred on September 11, 2002, was subject to stockholder approval, which was obtained on September 6, 2002.

The Series A Preferred is redeemable at any time after five years from the date of issuance upon the affirmative vote of at least 75% of the holders of Series A Preferred, at a price of $4.008 per share plus any unpaid dividends. Each share of Series A Preferred is convertible into four shares of our common stock at the election of the holder or upon the occurrence of certain other events. The holders of Series A Preferred are entitled to receive, but only out of legally available funds, quarterly cumulative dividends at the rate of 8% per year commencing in September 2002, which are payable in cash or shares of Series B redeemable convertible preferred stock (the “Series B Preferred” and, together with the Series A Preferred, the “Preferred Stock”), at the election of the holder. The terms of the Series B Preferred are identical to the Series A Preferred, except that the Series B Preferred is not entitled to receive the 8% dividends. In the event of any liquidation or winding up of the company, the holders of the Series A Preferred and Series B Preferred shall be entitled to receive in preference to the holders of the common stock a per share amount equal to the greater of (a) the original issue price, plus any accrued but unpaid dividends and (b) the amount that such shares would receive if converted to common stock immediately prior thereto (the “Liquidation Preference”). After the payment of the Liquidation Preference to the holders of Preferred Stock, the remaining assets shall be distributed ratably to the holders of the common stock. A merger, acquisition, sale of voting control of the company in which our stockholders do not own a majority of the outstanding shares of the surviving corporation, or a sale of all or substantially all of our assets, shall be deemed to be a liquidation.

The holders of Series A Preferred and Series B Preferred are entitled to vote together with the common stock. Each share of Preferred Stock has a number of votes equal to the number of shares of common stock then issuable upon conversion of such share of Preferred Stock. In addition, consent of the holders of at least 75% of the then outstanding Preferred Stock is required for certain actions, including any action that amends our charter documents so as to adversely affect the Preferred.

The warrants are exercisable for a period of five years from issuance with an exercise price of $1.15 per share.

The Series A Preferred Stock is entitled to receive an annual dividend of 8% payable quarterly in cash or shares of Series B Preferred Stock, at the election of the holder of the Series A Preferred Stock. The Series B Preferred Stock has identical rights, preferences and privileges to the Series A Preferred Stock except that the Series B Preferred Stock is not entitled to 8% dividends. These quarterly dividends commenced in September 2002. During the first quarter of fiscal 2007, we paid $73,000 in cash dividends to the Series A Preferred stockholders and we recorded an additional $48,000 in accrued dividends payable as of June 30, 2006.

Contractual Commitments. As of June 30, 2006, we had operating leases of our facilities that expire at various times through fiscal years 2010 and 2011. These arrangements allow us to obtain the use of the equipment and facilities without purchasing them. If we were to acquire these assets, we would be required to obtain financing and record a liability related to the financing of these assets or we would need to utilize upfront cash flow to purchase them. During the three months ended June 30, 2006, we recorded lease expense related to these arrangements of $92,000.

The following is a summary of our contractual commitments associated with our debt and lease obligations as of June 30, 2006 (in thousands):


Contractual Obligations	Payments Due by Period
Contractual Obligations	Total		Less Than 1 Year		1-3 Years		3-5 Years
Redeemable convertible preferred stock (1)	$	582	$	582	$	—	$	—
Notes payable		1,616		1,300		316		—
Operating leases		2,068		426		912		730

Total commitments	$	4,266	$	2,308	$	1,228	$	730

(1)

The holders of the preferred stock may elect to have us redeem $7.7 million of the preferred stock immediately after it becomes redeemable in June 2007. However, if this does not occur then we will continue to pay dividends in the aggregate amount of approximately $582,000 per year. Further, the terms of the preferred stock provide that it will automatically convert to common stock in the event of a public offering meeting certain minimum conditions, and if this were to occur, our obligation to pay dividends or redeem the preferred stock would cease at that time. Any of these outcomes is beyond our control and the probability of any of these outcomes is highly subjective. The amounts presented in the table above reflect only our contractual obligations related to dividend payments to the holders of the preferred stock up to June 2007, at which point the stock may or may not be redeemed.

Short Term and Long Term Liquidity. We believe that the combination of our cash and cash equivalents and currently anticipated cash flow from operations should be adequate to sustain operations through the next twelve months. We are managing the business to achieve positive cash flow utilizing existing assets. Although operating expenses have increased, which is consistent with the growth of the company over the past several fiscal years, we generated positive annual operating cash flow for fiscal 2006 and 2005. There is no assurance that we can continue to maintain positive cash flow. We are committed to the successful execution of our operating plan and we will take continued actions as necessary to ensure our cash resources are sufficient to fund our working capital requirements at least through fiscal 2007.

Our long-term liquidity and capital requirements will depend on numerous factors including our future revenues and expenses, growth or contraction of operations and general economic pressures. We may not be able to maintain our current market share, or continue to expand our business, without investing in our operations, technology, or product and service offerings. In order to do so, we may need to raise additional funds through public or private financings or other sources to fund our operations. However, our common stock is not listed on an exchange or the NASDAQ National Market, and until it is listed it will be difficult for us to make sales of our equity stock. In addition, the terms of our preferred stock may prevent us from issuing additional shares of preferred stock on terms that investors would require in order to invest in our preferred stock. The necessity of raising additional funds could require us to incur debt on terms that could restrict our ability to make capital expenditures and incur additional indebtedness. As a result, we may not be able to obtain additional funds on commercially reasonable terms, or at all. In addition, beginning in June 2007, the holders of our preferred stock can force us to redeem the shares of our preferred stock, and if we were required to redeem all of the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $7.7 million.

Accounting for Stock-based Compensation

Compensation — Transition and Disclosure,” we disclosed our net income or loss and net income or loss per share as if we had applied the fair value based method in measuring compensation expense for our stock-based compensation programs. Under SFAS 123, we elected to calculate our compensation expense by applying the Black-Scholes valuation model, applying the graded vesting expense attribution method and recognizing forfeited awards in the period that they occurred.

Effective April 1, 2006, we adopted the fair value recognition provisions of SFAS 123R using the modified prospective transition method. Under that transition method, compensation expense that we recognized for the quarter ended April 1, 2006 included: (a) compensation expense for all share-based payments granted prior to but not yet vested as of April 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation expense for all share-based payments granted or modified on or after April 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123). Compensation expense is recognized only for those awards that are expected to vest, whereas prior to the adoption of SFAS 123R, we recognized forfeitures as they occurred. In addition, we elected the straight-line attribution method as our accounting policy for recognizing stock-based compensation expense for all awards that are granted on or after April 1, 2006. For awards subject to graded vesting that were granted prior to the adoption of SFAS 123R, we use an accelerated expense attribution method. Results in prior periods have not been restated.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

Our exposure to market risk has not changed materially from our exposure at March 31, 2006.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures.

Subject to the limitations described below, our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in Internal Control Over Financial Reporting.

There was no change in our internal control over financial reporting during the quarter ended June 30, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

We are in the process of reviewing and analyzing our system of internal controls as we prepare for our first management report on internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002, which we currently expect to adopt in the fiscal year ending March 31, 2008. In this process we have identified areas of our internal controls requiring improvement, and are in the process of designing and documenting enhanced processes and controls to address these matters.

Limitations on the Effectiveness of Disclosure Controls and Procedures.

Our management, including our Chief Executive Officer and our Chief Financial Officer, does not expect that our disclosure controls and procedures will necessarily prevent all error and all fraud. A control system, no matter how well conceived and operated, can only provide reasonable, not absolute, assurance that the objectives of the control system are met. Any control system will reflect inevitable limitations, such as resource constraints, a cost-benefit analysis based on the level of benefit of additional controls relative to their costs, assumptions about the likelihood of future events and human error. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and may not be detected. Accordingly, our disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that the objectives of our disclosure control system are met and, as set forth above, our Chief Executive Officer and our Chief Financial Officer have concluded, based on their evaluation as of June 30, 2006, that our disclosure controls and procedures were effective to provide reasonable assurance that the objectives of our disclosure controls and procedures were met.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We are subject from time to time to legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, we do not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position, results of operations or cash flows.

ITEM 1A. RISK FACTORS

We operate in a rapidly changing economic and technological environment that presents numerous risks. Many of these risks are beyond our control and are driven by factors that we cannot predict. The following discussion, as well as our discussion above of critical accounting policies and estimates, highlights some of these risks. You should carefully consider the risks and uncertainties described below and the other information in this report before deciding whether to invest in shares of our common stock. If any of the following risks actually occur, our business, financial condition or operating results could be materially adversely affected. This could cause the trading price of our common stock to decline, and you may lose part or all of your investment.

Items That Affect Our Future Operations

We have had a history of losses, have only recently achieved profitability, and we may not be able to generate sufficient revenues to sustain profitability.

We commenced our operations in April 1995 and incurred net losses for every fiscal year until attaining profitability in fiscal 2005. We achieved profitability in the fourth quarter of fiscal 2004 and had annual profitability through the third quarter of fiscal 2005 and 2006. As of June 30, 2006, we had an accumulated deficit of $76.7 million. We may incur losses again as we continue to develop our business. Our ability to sustain profitability is based on a number of assumptions, including some outside of our control, including the state of the overall economy and the demand for our products, and if these assumptions do not prove to be accurate then we may not be able to generate sufficient revenues to sustain profitability. Furthermore, even if we do sustain profitability and positive operating cash flow, we may not be able to increase profitability or positive operating cash flow on a quarterly or annual basis. If our profitability does not meet the expectations of investors, the price of our common stock may decline.

We have a limited amount of capital resources and we may not be able to sustain or grow our business if we cannot sustain profitability or raise additional funds on a timely basis.

We believe we have adequate cash to sustain operations through the next twelve months, and we are managing the business to achieve positive cash flow utilizing existing assets. However, even if we sustain profitability, we may not be able to generate sufficient profits to grow our business. As a result, we may need to raise additional funds through public or private financings or other sources to fund our operations. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, these equity securities might have rights, preferences or privileges senior to our common stock and preferred stock. In addition, the necessity of raising additional funds could force us to incur debt on terms that could restrict our ability to make capital expenditures and incur additional indebtedness.

The terms of our credit facilities contain covenants that limit our flexibility and prevent us from taking certain actions.

The terms governing our credit facilities with Silicon Valley Bank include a number of significant restrictive covenants. These covenants could adversely affect us by limiting our ability to plan for or react to market conditions, meet our capital needs and execute our business strategy. These covenants will, among other things, limit our ability to:

•

incur additional debt;

•

make certain investments;

•

create liens; or

•

sell certain assets.

These covenants may significantly limit our operating and financial flexibility and limit our ability to respond to changes in our business or competitive activities. Our failure to comply with these covenants could result in an event of default, which, if not cured or waived, could result in our being required to repay these borrowings before their scheduled due date. In addition, Silicon Valley Bank could foreclose on our assets.

Our quarterly operating results may fluctuate significantly and may not be predictive of future financial results.

Our quarterly operating results may fluctuate in the future, and may vary from investors’ expectations, depending on a number of factors, including:

•

Variances in demand for our products and services and the relative mix of such demand;

•

Timing of the introduction of new products or services and enhancements of existing products or services;

•

Our ability to complete fixed-price service contracts without committing additional unplanned resources;

•

Unanticipated changes in the capacity of our services organization;

•

Delays or deferrals of customer implementations of our software products;

•

Delays or deferrals of client drug development processes;

•

The tendency of some of our customers to wait until the end of a fiscal quarter or fiscal year in the hope of obtaining more favorable terms;

•

Changes in industry conditions affecting our customers, including industry consolidation; and

•

Our ability to realize operating efficiencies through restructuring or other actions.

As a result, quarterly comparisons may not indicate reliable trends of future performance.

We manage our expense levels in part based upon our expectations concerning future revenue, and these expense levels are relatively fixed in the short term. If we have lower revenue than expected, we may not be able to reduce our spending in the short term in response. Any shortfall in revenue would have a direct impact on our results of operations.

In the past we have taken actions intended to reduce our expenses on an annualized basis. Our cost reduction measures have left us with less excess capacity to deliver our products and services. If there is a significant increase in demand from what we estimate, it will take us longer to address this demand, which would limit our ability to grow our business and sustain profitability.

We may be required to defer recognition of software license revenue for a significant period of time after entering into an agreement, which could negatively impact our results of operations.

We may have to delay recognizing license revenue for a significant period of time for a variety of types of transactions, including:

•

Transactions that include both currently deliverable software products and software products that are under development or contain other currently undeliverable elements;

•

Transactions where the customer demands services that include significant modifications, customizations or complex interfaces that could delay product delivery or acceptance;

•

Transactions that involve non-standard acceptance criteria or identified product-related performance issues; and

•

Transactions that include contingency-based payment terms or fees.

These factors and other specific accounting requirements for software revenue recognition require that we have very precise terms in our license agreements to allow us to recognize revenue when we initially deliver software or perform services. Although we have a standard form of license agreement that we believe meets the criteria for current revenue recognition on delivered elements, we negotiate and revise these terms and conditions in some transactions. Therefore, it is possible that from time to time we may license our software or provide service with terms and conditions that do not permit revenue recognition at the time of delivery or even as work on the project is completed. In the three months ended June 30, 2006 and 2005, software license revenue accounted for 51% and 39% of our total revenues, respectively. The majority of our large PKS software transactions include services pertaining to modification and customization of the core PKS software product, which may result in delayed revenue recognition for a significant period of time.

An increase in service revenue as a percentage of total revenues, or a decrease in software license revenue as a percentage of total revenues, may decrease our overall margins.

We realize lower margins on services than on license revenues. In addition, we may contract with certain third parties to supplement the services we provide to customers, which generally yields lower gross margins than our deployment organization or internal scientific staff. As a result, if service revenue increases as a percentage of total revenue or if we increase our use of third parties to provide such services, our gross margins would be lower and our operating results may be adversely affected.

Because our sales and implementation cycles are long and unpredictable, our revenues are difficult to predict and may not meet our expectations or those of our investors.

The lengths of our sales and implementation cycles are difficult to predict and depend on a number of factors, including the type of product or services being provided, the nature and size of the potential customer and the extent of the commitment being made by the potential customer. Our sales cycle is unpredictable and may take six months or more. Our implementation cycle is also difficult to predict and can be longer than one year. Each of these can result in delayed revenues, increased selling expenses and difficulty in matching revenues with expenses, which may contribute to fluctuations in our results of operations. A key element of our strategy is to market our product and service offerings to large organizations. These organizations can have particularly lengthy decision-making processes and may require evaluation periods, which could extend the sales and implementation cycle. Moreover, we often must provide a significant level of education to our prospective customers regarding the use and benefit of our product and service offerings, which may cause additional delays during the evaluation and acceptance process. We therefore have difficulty forecasting the timing and recognition of revenues from sales of our product and service offerings.

Our revenue is concentrated in a few customers, and if we lose any of these customers our revenue may decrease substantially.

We receive a substantial majority of our revenue from a limited number of customers. For the three months ended June 30, 2006 and 2005, sales to our top two customers accounted for 24% and 44% of total revenue, respectively, and sales to our top five customers in the same periods accounted for 40% and 59% of total revenue, respectively. For fiscal 2006, 2005 and 2004 sales to our top two customers accounted for 42, 45% and 28% of total revenue, respectively, and sales to our top five customers in the same periods accounted for 52, 62% and 50% of total revenue, respectively. We expect that a significant portion of our revenue will continue to depend on sales to a small number of customers. If we do not generate as much revenue from these major customers as we expect to, or if revenue from such customers is delayed, or if we lose any of them as customers, our total revenue may be significantly reduced.

We may need to change our pricing models to compete successfully.

The markets in which we compete can put pressure on us to reduce our prices. If our competitors offer deep discounts on certain products in an effort to recapture or gain market share, we may then need to lower prices or offer other favorable terms in order to compete successfully. Any such changes would be likely to reduce margins and could adversely affect operating results. We have periodically changed our pricing model and any broadly based changes to our prices and pricing policies could cause service and license revenues to decline or be delayed as our sales force implements and our customers adjust to the new pricing policies. If we do not adapt our pricing models to reflect changes in customer use of our products, our revenues could decrease.

If we are unable to generate additional sales from existing customers and/or generate sales to new customers, we may not be able to realize sufficient revenues to sustain or increase our profitability.

Our success depends on our ability to develop our existing customer relationships and establish relationships with additional pharmaceutical and biotechnology companies. If we lose any significant relationships with existing customers or fail to establish additional relationships, we may not be able to execute our business plan and our business will suffer. Developing customer relationships with pharmaceutical companies can be difficult for a number of reasons. These companies are often very large organizations with complex decision-making processes that are difficult to affect. In addition, because our products and services relate to the core technologies of these companies, these organizations are generally cautious about working with outside companies. Some potential customers may also resist working with us until our products and services have achieved more widespread market acceptance. Our existing customers could also reassess their commitment to us, not renew existing agreements or choose not to expand the scope of their relationship with us.

Our revenues and results of operations would be adversely affected if a customer cancels a contract for services or software deployment with us.

Many of our services agreements can be canceled upon prior notice by our customers. Additionally, due to the nature of our services and deployment engagements, customers sometimes delay projects because of timing of the clinical trials and the need for data and information that prevent us from proceeding with our projects. These delays and contract cancellations cannot be predicted with accuracy and we cannot assure you that we will be able to replace any delayed or canceled contracts with the customer or other customers. If we are unable to replace those contracts, our revenues and results of operations would be adversely affected.

We may lose existing customers or be unable to attract new customers if we do not develop new products and services or if our offerings do not keep pace with technological changes.

The successful growth of our business depends on our ability to develop new products and services and incorporate new capabilities, including the expansion of our product and services offerings to address a broader set of customer needs related to clinical development of drugs and thereby expand the number of our prospective users, on a timely basis. If we cannot adapt to changing technologies, emerging and evolving industry standards, new scientific developments and increasingly sophisticated customer needs, we may not achieve revenue growth and our products and services may become obsolete, and our business could suffer. We have suffered product delays in the past, resulting in lost product revenues. In addition, early releases of software often contain errors or defects. We cannot assure you that, despite our extensive testing, errors will not be found in our products before or after commercial release, which could result in product redevelopment costs and loss of, or delay in, market acceptance. Furthermore, a failure by us to introduce new products or services on schedule could harm our business prospects. Any delay or problems in the installation or implementation of new products or services may cause customers to forego purchases from us. We may need to accelerate product introductions and shorten product life cycles, which will require high levels of expenditures of research and development that could adversely affect our operating results. A failure by us to introduce new services on a timely and cost-effective basis to meet evolving customer requirements, or to integrate new services with existing services, could harm our business prospects.

If the security or confidentiality of our customers’ data is compromised or breached, we could be liable for damages and our reputation could be harmed.

As part of implementing our products and services, we inherently gain access to certain highly confidential proprietary customer information. It is critical that our facilities and infrastructure remain secure and are perceived by the marketplace to be secure. Despite our implementation of a number of security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. We do not have insurance to cover us for losses incurred in many of these events. If we fail to meet our customers’ security expectations, we could be liable for damages and our reputation could suffer.

If we are unable to complete a project due to scientific limitations or otherwise meet our customers’ expectations, our reputation may be adversely affected and we may not be able to generate new business.

Because our projects may contain scientific risks, which are difficult to foresee, we cannot guarantee that we will always be able to complete them. Any failure to meet our customers’ expectations could harm our reputation and ability to generate new business. On a few occasions, we have encountered scientific limitations and been unable to complete a project. In each of these cases, we have been able to successfully renegotiate the terms of the project with the particular customer. We

cannot assure you that we will be able to renegotiate our customer agreements if such circumstances occur in the future. Moreover, even if we complete a project, we may not meet our customers’ expectations regarding the quality of our products and services or the timeliness of our services.

Our future success depends on our ability to continue to retain and attract qualified employees.

We believe that our future success depends upon our ability to continue to train, retain, effectively manage and attract highly skilled technical, scientific, managerial, sales and marketing personnel. We currently have limited personnel and other resources to staff and complete consulting and software deployment projects. In addition, as we grow our business, we expect an increase in the number of complex projects and large deployments of our products and services, which require a significant amount of personnel for extended periods of time. In particular, there is a limited supply of modeling and simulation personnel worldwide, and competition for these personnel from numerous companies and academic institutions may limit our ability to hire these persons on commercially reasonable terms. From time to time, we experience difficulties in locating enough highly qualified candidates in desired geographic locations, or with required scientific or industry-specific expertise. Staffing projects and deploying our products and services will become more difficult as our operations and customers become more geographically diverse. If we are not able to adequately staff and complete our projects, we may lose customers and our reputation may be harmed. Any difficulties we may have in completing customer projects may impair our ability to grow our business.

If we lose key members of our management, scientific or development staff, or our scientific advisors, our reputation may be harmed and we may lose business.

We are highly dependent on the principal members of our management, scientific and development staff. Our reputation is also based in part on our association with key scientific advisors. The loss of any of these personnel might adversely impact our reputation in the market and harm our business. Failure to attract and retain key management, scientific and technical personnel could prevent us from achieving our strategy and developing our products and services. In addition, our management team has experienced significant personnel changes over the past years and may continue to experience changes in the future. If our management team continues to experience attrition, high turnover, or does not work effectively together, it could harm our business. Additionally, we do not currently hold key-man life insurance policies on our CEO, CFO or other key contributors. The demise of any of these individuals could adversely impact our business.

Our business depends on our intellectual property rights, and if we are unable to adequately protect them, our competitive position will suffer.

Our intellectual property is important to our competitive position. We protect our proprietary information and technology through a combination of patent, trademark, trade secret and copyright law, confidentiality agreements and technical measures. We have filed nine patent applications, of which two patents have issued. We cannot assure you that the steps we have taken will prevent misappropriation of our proprietary information and technology, nor can we guarantee that we will be successful in obtaining any patents or that the rights granted under such patents will provide a competitive advantage. Misappropriation of our intellectual property could harm our competitive position. We may also need to engage in litigation in the future to enforce or protect our intellectual property rights or to defend against claims of invalidity, and we may incur substantial costs as a result. In addition, the laws of some foreign countries provide less protection of intellectual property rights than the laws of the United States and Europe. As a result, we may have an increasingly difficult time adequately protecting our intellectual property rights as our sales in foreign countries grow.

If we become subject to infringement claims by third parties, we could incur unanticipated expense and be prevented from providing our products and services.

We cannot assure you that infringement claims by third parties will not be asserted against us or, if asserted, will be unsuccessful. These claims, whether or not meritorious, could be expensive and divert management resources from operating our company. Furthermore, a party making a claim against us could secure a judgment awarding substantial damages, as well as injunctive or other equitable relief that could block our ability to provide products or services, unless we obtain a license to such technology. In addition, we cannot assure you that licenses for any intellectual property of third parties that might be required for our products or services will be available on commercially reasonable terms, or at all.

International sales of our product account for a significant portion of our revenue, which exposes us to risks inherent in international operations.

We market and sell our products and services in the United States and internationally. International sales of our products and services as a percentage of our total revenues for the three months ended June 30, 2006 and fiscal 2006, 2005, and 2004 were approximately 35%, 24%, 22% and 29%, respectively. We have a total of 12 employees based outside the United States who deploy our software, perform consulting services and perform research in Europe and Australia. We cannot be certain that we have fully complied with all rules and regulations in every applicable jurisdiction outside of the United States with respect to our current and previous operations outside of the United States. The failure to comply with such rules and regulations could result in penalties, monetary or otherwise, against us. Our existing marketing efforts into international markets may require significant management attention and financial resources. We cannot be certain that our existing international operations will produce desired levels of revenue. We currently have limited experience in developing localized versions of our products and services and marketing and distributing our products internationally. Our international operations also expose us to the following general risks associated with international operations:

•

Disruptions to commercial activities or damage to our facilities as a result of political unrest, war, terrorism, labor strikes and work stoppages;

•

Difficulties and costs of staffing and managing foreign operations;

•

The impact of recessions or inflation in economies outside the United States;

•

Greater difficulty in accounts receivable collection and longer collection periods;

•

Reduced protection for intellectual property rights in some countries;

•

Potential adverse tax consequences, including higher tax rates generally in Europe;

•

Tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries;

•

Unexpected changes in regulatory requirements of foreign countries, especially those with respect to software, pharmaceutical and biotechnology companies; and

•

Fluctuations in the value of currencies.

To the extent that such disruptions and costs interfere with our commercial activities, our results of operations could be harmed.

Changes in government regulation could decrease the need for the products and services we provide.

Governmental agencies throughout the world, but particularly in the United States, highly regulate the drug development and approval process. A large part of our software and services business involves helping pharmaceutical and biotechnology companies through the regulatory drug approval process. Any relaxation in regulatory approval standards could eliminate or substantially reduce the need for our services, and, as a result, our business, results of operations and financial condition could be materially adversely affected. Potential regulatory changes under consideration in the United States and elsewhere include mandatory substitution of generic drugs for patented drugs, relaxation in the scope of regulatory requirements or the introduction of simplified drug approval procedures. These and other changes in regulation could have an impact on the business opportunities available to us.

While we believe we currently have adequate internal control over financial reporting, we are required to evaluate our internal control under Section 404 of the Sarbanes-Oxley Act of 2002 and any adverse results from such evaluation could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with our Annual Report on Form 10-K for the fiscal year ending March 31, 2008, we will be required to furnish a report by our management on our internal control over financial reporting. Such report will contain, among other matters, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. In such a case, we would assess our internal control as ineffective. Such report must also contain a statement that our independent registered public accounting firm have issued an attestation report on management’s assessment of such internal control. PCAOB Auditing Standard No. 2 provides the professional standards and related performance guidance for independent registered public accounting firms to attest to, and report on, management’s assessment of the effectiveness of internal control over financial reporting under Section 404.

While we currently believe our internal control over financial reporting is effective, we are in the process of preparing system and process documentation and the evaluation needed to comply with Section 404, which is both costly and challenging. During this process, if our management identifies one or more material weaknesses in our internal control over financial reporting, and those weaknesses are not appropriately remediated prior to March 31, 2008, we will be unable to assert such internal control is effective. If we are unable to assert that our internal control over financial reporting is effective as of March 31, 2008 (or if our independent registered public accounting firm is unable to attest that our management’s report is fairly stated or they are unable to express an opinion on our management’s evaluation or on the effectiveness of the internal control), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price, and our business and operating results could be harmed.

Risks Related To Our Industry

Our market may not develop as quickly as expected, and companies may enter our market, thereby increasing the amount of competition and impairing our business prospects.

Because some of our products and services are new and still evolving, there is significant uncertainty and risk as to the demand for, and market acceptance of, these products and services. As a result, we are not able to predict the size and growth rate of our market with any certainty. In addition, other companies, including potential strategic partners, may enter our market. Our existing customers may also elect to terminate our services and internally develop products and services similar to ours. If our market fails to develop, grows more slowly than expected, or becomes saturated with competitors, our business prospects will be impaired.

Government regulation of the pharmaceutical industry may restrict our operations or the operations of our customers and, therefore, adversely affect our business.

The pharmaceutical industry is regulated by a number of federal, state, local and international governmental entities. Although our products and services are not directly regulated by the United States Food and Drug Administration or comparable international agencies, the use of some of our analytical software products by our customers may be regulated. We currently provide assistance to our customers in achieving compliance with these regulations. The regulatory agencies could enact new regulations or amend existing regulations with regard to these or other products that could restrict the use of our products or the business of our customers, which could harm our business.

Consolidation in the pharmaceutical industry could cause disruptions of our customer relationships, interfere with our ability to enter into new customer relationships and have a negative impact on our revenues.

In recent years, the worldwide pharmaceutical industry has undergone substantial consolidation. If any of our customers consolidate with another business, they may delay or cancel projects, lay off personnel or reduce spending, any of which could cause our revenues to decrease. In addition, our ability to complete sales or implementation cycles may be impaired as these organizations undergo internal restructuring.

Reductions in the IT and/or research and development budgets of our customers may affect our sales.

Our customers include researchers at pharmaceutical and biotechnology companies, academic institutions and government and private laboratories. Fluctuations in the IT and research and development budgets of these researchers and their organizations could have a significant effect on the demand for our products. Research and development and IT budgets fluctuate due to changes in available resources, spending priorities, internal budgetary policies and the availability of grants from government agencies. Our business could be harmed by any significant decrease in research and development or IT expenditures by pharmaceutical and biotechnology companies, academic institutions or government and private laboratories.

Recent or continued withdrawals of drugs from the public market could affect pharmaceutical spending, reduce the demand for our products and have a negative impact on our revenues.

Recently, the pharmaceutical industry has experienced, and may continue to experience, forced withdrawal of certain drugs from the public market due to safety risks. Recent or future drug withdrawals could affect our ability to market and sell our products and services to companies faced with withdrawals. For example, withdrawals of drugs from the public market

by our customers or potential customers may result in the reduction of current levels of spending on software solutions and strategic consulting services by these companies to minimize the impact of a potential decline in revenues. In addition, we may provide products or services to customers with drugs in the same class as the drugs withdrawn from the market. If the demand for drugs within the class of drugs faced with recent withdrawals decreases, we may experience a decrease in demand for our products or services in that class of drugs. A decrease in demand for our products, or a decrease in IT or research and development spending by pharmaceutical companies, could prevent us from increasing or sustaining our software and strategic consulting revenues and adversely affect our revenues and results of operations.

Risks Related to Our Stock

Our common stock only trades on the Over-the-Counter Bulletin Board system, and has experienced reduced trading volumes and stock price since it began to be traded there.

On November 8, 2002 our stock was removed from trading on the NASDAQ National Market, the predecessor to the Nasdaq Global Market, as a result of failure to meet the continuing listing requirements, and our common stock is now quoted on the Over-the-Counter Bulletin Board system. Our common stock does not experience large trading volumes. In addition, our delisting from the NASDAQ National Market has caused the loss of our exemption from the provisions of Section 2115 of the California Corporations Code that imposes particular aspects of California corporate law on certain non-California corporations operating within California. As a result, (i) our Board of Directors is no longer classified and our stockholders elect all of our directors at each annual meeting, (ii) our stockholders are entitled to cumulative voting, and (iii) we are subject to more stringent stockholder approval requirements and more stockholder-favorable dissenters’ rights in connection with certain strategic transactions. Some of these changes may impact any possible transaction involving a change of control of Pharsight, which could negatively impact your investment. Other consequences include no analyst coverage, a lower share price as a result of lower trading volumes, and the loss of certain state securities law exemptions available to us while our securities were traded on the NASDAQ National Market, which may impact our ability to provide for future issuances of our securities, among other consequences.

Should we decide to relist our common stock on the NASDAQ Global Market, the criteria for relistment may be difficult for us to achieve.

The market price of our common stock has been lower than the required minimum bid price for relistment on NASDAQ, and the reduced trading volumes that we currently experience may prevent our stock from reaching the required minimum bid price for NASDAQ relistment. Additionally, our current stockholder’s deficit balance and our history of net losses may make it difficult for us to relist on NASDAQ at any point in the near future, if at all. We may be required to restructure our capital or debt structure, including our redeemable convertible preferred stock, in order to relist on NASDAQ. There is no guarantee that we would be able to effect such restructuring under terms as favorable as our current equity and debt, if at all.

The public market for our common stock may be volatile.

The market price of our common stock has been, and we expect it to continue to be, highly volatile and to fluctuate significantly in response to various factors, including:

•

Actual or anticipated variations in our quarterly operating results or those of our competitors;

•

Announcements of technological innovations or new services or products by us or our competitors;

•

Timeliness of our introductions of new products;

•

Changes in financial estimates by securities analysts;

•

Changes in management; and

•

Changes in the conditions and trends in the pharmaceutical market.

For instance, during fiscal 2006 the price of our common stock closed as low as $1.20 and as high as $2.32 per share. We have experienced very low trading volume in our stock, and thus small purchases and sales can have a significant effect on our stock price. In addition, the stock markets have experienced extreme price and volume fluctuations, particularly in the past year, that have affected the market prices of equity securities of many technology companies. These fluctuations have often been unrelated or disproportionate to operating performance. These broad market factors may materially affect the trading price of our common stock. General economic, political and market conditions, such as recessions and interest rate fluctuations, may also have an adverse effect on the market price of our common stock.

Insiders continue to hold a majority of our stock, which may negatively affect your investment.

Entities affiliated with two of our directors beneficially own or control a majority of the outstanding common stock, calculated on an as-if-converted basis, as of June 30, 2006. If these parties choose to act or vote together, they will have the power to control all matters requiring the approval of our stockholders, including the election of directors and the approval of significant corporate transactions. This ability may have the effect of delaying or otherwise influencing a possible change in control transaction, which may or may not be favored by our other stockholders. In addition, without the consent of these parties, we would likely be prevented from entering into transactions that could result in our stockholders receiving a premium for their stock.

Our preferred stockholders may continue to elect to receive their dividend payments in the form of shares instead of cash, which may negatively impact our profitability.

Our preferred stockholders have elected in the past, and may continue to elect, to receive their quarterly dividend payments in the form of Series B Preferred shares instead of cash. We record the value of these dividend payments in the form of shares at fair market value as of the dividend payment date on our statement of operations. The fair market value is defined as the amount at which the capital stock would change hands between a willing buyer and a willing seller, each having reasonable knowledge of all relevant facts, neither being under any compulsion to act, with equity to both. Because there is no market for such Series B Preferred shares, we perform a valuation of the fair market value of these shares. This valuation is impacted by numerous factors, including but not limited to our operations, financial conditions, future prospects and projected operations and performance of the company, as well as historical market prices and trading volume for our publicly traded securities. As such, the valuation of these dividend payments may fluctuate widely, may be greater or lesser than the stated value of the Series B Preferred shares, and may impact our ability to sustain or increase our profitability. We are unable to project with any accuracy the impact of fair market value of the Series B Preferred shares on our statement of operations.

We face risks related to changes in accounting standards for stock option plans.

Beginning in the first fiscal quarter of 2006, we adopted SFAS 123), which requires us to recognize compensation expense in our statement of operations for the fair value of stock options granted to our employees over the related vesting periods of the stock options. The requirement to expense stock options granted to employees reduces the attractiveness of equity compensation awards because the expense associated with these grants results in compensation charges. In addition, the expenses recorded may not accurately reflect the value of our stock options, because option pricing models commonly used under SFAS 123R were not developed for use in valuing employee stock options and are based on highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Alternative compensation arrangements that can replace stock option programs may also negatively impact profitability. Stock options remain an important employee recruitment and retention tool, and we may not be able to attract and retain key personnel if we reduce the scope of our employee stock option programs. Our employees are critical to our ability to develop and design systems that advance our productivity and technology goals, increase our sales goals and provide support to customers. Accordingly, as a result of the requirements of SFAS 123R, our profitability can be expected to be reduced compared to periods prior to adoption of the new standard.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

We have filed, or incorporated into this Quarterly Report on Form 10-Q by reference, the exhibits listed on the accompanying Exhibit Index immediately following the signature page of this Quarterly Report on Form 10-Q.

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.

Date: August 11, 2006


PHARSIGHT CORPORATION

By:		/S/ William Frederick
		William Frederick Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)

INDEX TO EXHIBITS


Exhibit Number		Description Of Document
10.1		Offer letter dated April 5, 2006 between Pharsight Corporation and William Frederick.

10.2		Fifth Amendment to Loan and Security Agreement effective as of June 12, 2006 between Pharsight Corporation and Silicon Valley Bank (which is incorporated herein by reference to Exhibit 99.1 to the Registrant’s Current Report on Form 8-K filed on June 15, 2006).

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.

32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

EX-10.1 2 dex101.htm OFFER LETTER DATED APRIL 5, 2006 BETWEEN PHARSIGHT CORP. AND WILLIAM FREDERICK Offer Letter dated April 5, 2006 between Pharsight Corp. and William Frederick

Exhibit 10.1

April 5, 2006

William W. Frederick

Dear William:

On behalf of Pharsight Corporation (“Pharsight” or the “Company”), I am pleased to offer you the position of Senior Vice President and Chief Financial Officer, reporting directly to me, with a start date of April 10, 2006 or as otherwise mutually agreed.

We are confident that you will make an outstanding addition to our team. There are many professional and technical challenges and the Company is still small enough and growing rapidly enough to provide ample opportunity for professional development and an increasing role in the leadership of the Company. Pharsight also offers you the opportunity to participate in the company’s growth, on both a financial and intellectual basis.

Base Salary and Bonus Potential

Your base salary will be $250,000 annually, and will be paid semi-monthly. In Fiscal Year 2007 (FY2007), which begins April 1, 2006, and for subsequent years, you will be eligible for an annual performance bonus, pursuant to the terms and conditions of the Company’s Management Incentive Bonus Program, targeted at thirty-five (35%) percent of your base salary, with total compensation targeted at $337,500. This bonus is tied to company corporate performance goals as well as specific goals to be determined based upon your individual responsibilities, and will be pro-rated from your date of hire for FY2007 to reflect the date on which you joined the Company. The Company’s Compensation Committee will determine at its sole discretion whether you have earned an annual bonus, and the amount of any earned annual bonus, provided that you are employed by Pharsight and in good standing at the time of annual payment.

The Company may modify your compensation from time to time as it deems necessary.

Employee Benefits

You will be eligible for Pharsight’s employee benefits programs, including health, dental, life and disability insurance and 401(k) plan.

Stock Options

In addition, I will recommend to the Board that you be granted an option to purchase two hundred and fifty thousand (250,000) shares of Pharsight common stock with an exercise price equal to the fair market value of such shares in accordance with the terms of the Company’s 2000 Equity Incentive Plan. Such options will vest over a four (4) year period as follows: 25% will vest on the first anniversary date of grant and the remainder will vest in equal monthly installments thereafter until fully vested

Offer Letter for William W. Frederick

April 5, 2006

Page 2

(“Vesting Schedule”). However, upon a Change of Control (as defined in the Company’s 2000 Equity Incentive Plan), the Vesting Schedule will accelerate by one (1) year (“Accelerated Vesting”). Accelerated Vesting will immediately vest upon a Change of Control, the number of options equal to the amount, which would have vested one year from the occurrence of such event. Accelerated Vesting described herein will supplement, but not supersede section 12(c) of the Company’s 2000 Equity Incentive Plan as amended and restated.

Confidential Information and Inventions Assignment Agreement; Company Policies and Procedures

As a condition of your employment with Pharsight, you will be required to sign the Company’s Confidential Information and Inventions Assignment Agreement, two originals of which are enclosed. Please sign both originals and return one to me with your acceptance of this offer.

In order to comply with Federal labor law requirements (IRCA), you will be required to provide the Company documentary evidence of your identity and eligibility for employment in the United States. Such documentation must be provided to us within three (3) business days of your date of hire, or our employment relationship with you may be terminated.

In addition, you will continue to be required to abide by the Company’s policies and procedures, as may be in effect from time to time and as reflected in the Company’s Employee Handbook.

At-Will Employment Relationship

Your employment continues to be terminable at-will, and either you or the Company may terminate your employment relationship at any time, with or without Cause (defined below) or advance notice.

Severance Benefits

In the event that your employment is involuntarily terminated by the Company without Cause, as your sole severance benefits, the Company will continue to pay your base salary and health care benefits in effect on the termination date for twelve (12) months (the “Severance Payments”). As a condition of your receipt of the Severance Payments, you must first enter into a separation agreement with the Company that includes your general release of all known and unknown claims, in a form provided by the Company. The Severance Payments will be paid on the Company’s normal payroll schedule and will be subject to standard deductions and withholdings.

For the purposes of this letter, “Cause” for your termination shall mean: (a) your conviction of any felony or of any crime involving dishonesty; (b) your participation in any fraud or act of dishonesty against the Company; (c) failure to perform your assigned duties or responsibilities as an employee (other than a failure resulting from a “disability” as that term is defined in Section 22(e)(3) of the Internal Revenue Code of 1986, as amended (the “Code”) after written notice thereof from the Company setting forth your failure to perform such duties or responsibilities; (d) your intentional damage to, or willful misappropriation of, any property of the Company; (e) your material breach of any written agreement with the Company (including this Agreement or your Confidential Information and Inventions Assignment Agreement); or (f) conduct, that in the good faith and reasonable determination of the Board demonstrates gross unfitness to serve.

Offer Letter for William W. Frederick

April 5, 2006

Page 3

In addition, if, within six (6) months of a Change in Control (defined below), you resign from your employment with the Company and such resignation qualifies as a Resignation for Good Reason (defined below), you shall be entitled to receive the Severance Benefits, provided that you must first enter into a separation agreement with the Company that includes your general release of all known and unknown claims, in a form provided by the Company.

For the purposes of this letter, the occurrence of either of the following events shall constitute a “Change in Control”: (a) the sale or lease of all or substantially all of the assets of the Company; or (b) an acquisition of the Company by another corporation or entity by consolidation, merger or other reorganization in each case in which the holders of the Company’s outstanding voting stock immediately prior to such transaction own, immediately after such transaction, securities representing less than fifty percent (50%) of the voting power of the corporation or other entity purchasing such assets or surviving such transaction.

For purposes of this letter, a “Resignation for Good Reason” shall mean a resignation by you due to any of the following events which occur after and as a direct result of a Change in Control: (1) a material reduction in compensation, unless such a reduction is applied, by resolution of the Board of Directors, to all members of the Company’s officers; (2) a material adverse change in your title due to a demotion; (3) a material adverse reduction in your role and responsibilities; or (4) a requirement for you to relocate as a part of your position.

You will not be eligible for any severance benefits in the event of a termination with Cause or any resignation that does not qualify as a Resignation for Good Reason.

I am providing two originals of this letter. Please sign and return one to indicate your acceptance. This offer is valid through April 5, 2006. We are excited about the prospect of having you on the Pharsight team.

Sincerely,

PHARSIGHT CORPORATION

/s/ Shawn O’Connor

Shawn O’Connor

President and Chief Executive Officer

April 5, 2006

Offer Letter for William W. Frederick

April 5, 2006

Page 4

I accept employment with Pharsight Corporation subject to the terms and conditions hereof. I understand that the terms set forth in this letter supersede all oral discussions I may have had with anyone in the Company.

ACCEPTED:

/s/ William W. Frederick

William W. Frederick

April 5, 2006

Date

EX-31.1 3 dex311.htm CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO RULE 13A-14(A) Certification of Chief Executive Officer pursuant to Rule 13a-14(a)

Exhibit 31.1

CERTIFICATIONS

I, Shawn M. O’Connor, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Pharsight Corporation;

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

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

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

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

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

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

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

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

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

Date: August 11, 2006

/S/ SHAWN M. O’CONNOR

Shawn M. O’Connor

President, Chief Executive Officer, Director and Chairman

EX-31.2 4 dex312.htm CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO RULE 13A-14(A) Certification of Chief Financial Officer pursuant to Rule 13a-14(a)

Exhibit 31.2

CERTIFICATIONS

I, William Frederick, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Pharsight Corporation;

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

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

Date: August 11, 2006

/S/ William Frederick

William Frederick

Senior Vice President, Chief Financial Officer and

Corporate Secretary

EX-32.1 5 dex321.htm CERTIFICATION OF CEO AND CFO PURSUANT TO 18 U.S.C. SECTION 1350 Certification of CEO and CFO pursuant to 18 U.S.C. Section 1350

Exhibit 32.1

CERTIFICATION

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350, as adopted), Shawn M. O’Connor, Chief Executive Officer of Pharsight Corporation (the “Company”), and William Frederick, Chief Financial Officer of the Company, each hereby certify that, to the best of his knowledge:

1. The Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2006, and to which this Certification is attached as Exhibit 32.1 (the “Quarterly Report”) fully complies with the requirements of section 13(a) or section 15(d) of the Securities Exchange Act of 1934, and

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

IN WITNESS WHEREOF, the undersigned have set their hands hereto as of the 11th day of August 2006.

/s/ SHAWN M. O’CONNOR, CHIEF EXECUTIVE OFFICER

/s/ WILLIAM FREDERICK, CHIEF FINANCIAL OFFICER

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