UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934(Mark One)

For the fiscal year ended December 31, 20022005

OR

[   ] 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: 000-27163

        KANA

Kana Software, Inc.

(Exact nameName of Registrant as Specified in its Charter)

181 Constitution Drive
     Menlo Park, California   94025     
(Address of Principal Executive Offices including Zip Code)(650) 614-8300

     (650) 614 8300     
(Registrant'sRegistrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Sectionsection 12(g) of the Act:

Common Stock, $0.001 par value per share

(Title of class)

Indicate by check mark if the Registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

Indicate by check mark whether the registrantRegistrant (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  [     ]x

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant'sthe Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  Yes [X]     No [     ]x

Indicate by check mark whether the registrantRegistrant 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

As of June 28, 2002,30, 2005, the last business day of the Registrant'sRegistrant’s most recently completed second fiscal quarter, the aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $70,248,056$49,395,302 based upon the closing sales price of the Registrant’s Common Stock as reported on the Nasdaq StockNASDAQ National Market of $4.00. Shares of Common Stock held by officers, directors, and holders of more than ten percent of the outstanding Common Stock have been excluded from this calculation because such persons may be deemed to be affiliates. The determination of affiliate status is not necessarily a conclusive determination for other purposes.$1.60.

As of March 1, 2003,At May 31, 2006 the Registrant had outstanding 22,981,029approximately 34,517,637 shares of Common Stock.Stock, $0.001 par value per share.

Portions of the Registrant's Proxy Statement to be filed pursuant to Regulation 14A promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, which is anticipated to be filed within 120 days after the end of the Registrant's fiscal year ended December 31, 2002, are incorporated by reference in Part III hereof.

KANA Software, Inc.
TABLE OF CONTENTS
ANNUAL REPORT ON FORM

Form 10-K

For Thethe Fiscal Year Ended December 31, 2002
2005

TABLE OF CONTENTS

PART I

Special Note Regarding Forward Looking Statements

The following discussion of our business and other parts ofIn addition to historical information, this report containcontains forward-looking statements thatwithin the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The forward-looking statements are not historical facts but rather are based on current expectations, estimates and projections about our business and industry, and our beliefs and assumptions. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates"“anticipate,” “believe,” “estimate,” “expects,” “intend,” “plan,” “will” and variations of these words and similar expressions identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, many of which are beyond our control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. These risks and uncertainties include, but are not limited to, those described in "Risk Factors"Item 1A “Risk Factors” and elsewhere in this report. Forward-looking statements that wewere believed to be true at the time we made them may ultimately prove to be incorrect or false. ReadersWe undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements, which reflect our view only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.statements.

ITEM 1. BUSINESSBUSINESS.

Overview

We areKANA Software, Inc. (the “Company” or “KANA”) is a leading provider of enterprise Customer Relationship Management (eCRM) software solutions. These enterpriseworld leader in multi-channel customer support and communications applications are built on a Web-architected platform incorporating our KANA eCRM architecture, which provides users with full access to the applications using a standard Web browser and without requiring them to install additional software on their individual computers.service. Our software helps our customers provide external-facing customer support, and to better service, market to, and understand their customers and partners, while improving results and decreasing costs in contact centers and marketing departments. Our KANA iCARE (Intelligent Customer Acquisition and Retention for the Enterprise) application suite combines our KANA eCRM architecture with customer-focused service, marketing and commerce software applications. These applications enable organizations to improve customerthe quality and partner relationships by allowing themefficiency of interactions with customers and partners across multiple communication points. KANA’s integrated solutions allow companies to interact withdeliver consistent, managed service across all channels, including email, chat, call centers and Web self-service, so customers have the company overfreedom to choose the communication channelsservice they prefer, whether by Web contact, e- mail or telephone. We offer optimized versions of our software for several specific industries including healthcare, financial services, high technology manufacturing,want, how and telecommunications, among others.when they want it. Our customers includetarget market is the Global 2000 with a focus on large enterprises with high volumes of customer interactions, such as banks, telecommunications companies, high-tech manufacturers, healthcare organizations and government agencies.

We are headquartered in healthcare, telecommunications, high technology, financial services, retail, transportation, educationMenlo Park, California, with offices in Japan, Hong Kong, Korea and throughout the public sector, among other industries.United States and Europe.

We were incorporated in July 1996 in California and reincorporated in Delaware in September 1999. We had no significant operations until 1997. References in this annual reportAnnual Report on Form 10-K to "KANA," "we," "our,"“we,” “our” and "us"“us” collectively refer to KANA, Software, Inc., and our predecessor and our subsidiaries and theirits predecessors. Our principal executive offices are located at 181 Constitution Drive, Menlo Park, California 94025 and our telephone number is (650) 614- 8300.614-8300. Our Internet website is located at http://www.kana.com. We make available free of charge on our website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act of 1934, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission (“SEC”). All such filings are also available at the Securities and Exchange Commission Public Reference Room at 100F Street, NE, Washington, DC 20549. Information regarding the Public Reference Room may be obtained by calling the SEC at 1-(800)-SEC-0330. The SEC also maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC which can be found at http://www.sec.gov.

Industry BackgroundOur Strategy

In today's economy, Global 2000 organizations must find a way to increaseDeliver world-class products that focus on improving customer retentionsatisfaction, increasing corporate revenue and loyalty while decreasing operating expenses. The abilityreducing the cost to provide service. Independent studies have shown that a significant percentage of an enterprise’s cost of providing service to its customers resides in resolving individual customer questions and problems, or cases. These cases must be received, routed, tracked and resolved by customer service agents. While many enterprises possess technology capable of routing and tracking cases, the actual resolution of customer issues is largely unautomated, and therefore is the most costly phase. Our product portfolio addresses this largely underserved customer service resolution market. Our knowledge-powered customer service solutions focus on automating the service resolution process across multiple channels. The majority of our license revenues are for applications that are used by our customers’ agents (Assisted Service), or directly by their customers (Web Self-Service), empowering them with knowledge and information to resolve their issues.

Partner with the world’s leading system integrators. Our strategy is to focus our efforts on the sale of software and maintenance and to enter into strategic relationships with leading systems integrators in order to provide our customers with a wide range of implementation, systems integration and consulting services. Our professional services organization augments the systems integrator partners with subject matter expertise on our applications. Our customers can benefit from the integrators’ deep KANA product expertise, as well as their outstanding industry knowledge and proven integration success. In addition, these integrators employ larger sales forces than we do, and we generally coordinate our sales efforts with them.

Deliver industry-specific applications. Some industries, such as banking, telecommunications and healthcare, have exceptionally high qualityvolumes of customer interactions, and experiences,providing consistent and thusaccurate feedback to establish long-term relationshipscustomers of companies in these industries has become increasingly difficult as the products and loyalty, is criticalofferings of such companies have become increasingly complicated. We continue to business survival.expand our portfolio of industry-specific applications to address the unique needs of our customers through a series of industry starter kits.

Until recently, relationships with customers and partners were based on costly phone or mail-based interactions. AsProducts

KANA provides a result, companies invested millions of dollars in expensive phone-based technologies. However, the proliferation of the Internet has fundamentally changed the way businesses communicate with customers and partners, creating a 24-by-7 environment in which customers expect immediate responses via the Web, wireless devices or e-mail. Although these new communication channels have resulted in demand for immediate service, they also provide businesses with an opportunity to dramatically decrease the costcomprehensive suite of customer service by moving more communication to less expensive Web-based channels. By integrating all communication channels and utilizing onlinesoftware. Around the world, KANA’s multi-channel customer support,service solutions are helping Global 2000 organizations and other enterprises can successfully increase customer interactions while decreasing costs in contact centers and marketing departments.

Businesses that fail to manage customer relationships effectively throughout the customer lifecycle face negative consequences, which can include loss of customers, increased difficulty in acquiring new customers and a deterioration of competitive position. In addition, without efficient and reliable management of customer and partner interactions, businesses face higher operating and information technology costs. Further, businesses may lose the opportunity to take advantage of new revenue generating opportunities by failing to capitalize upon the wealth of information conveyed through these interactions. Once a business recognizes the benefits of deploying customer relationship management software to take advantage of the benefits afforded by the Internet, it faces the challenge of finding a suitable eCRM solution. Enterprises increasingly seek eCRM solutions that are optimized for their industry, can be used across multiple departments, integrate with existing business, legacy systems and databases, and can efficiently be scaled as they add new contact channels and increase their volume of customer interactions.

Products

KANA iCARE is a comprehensive eCRM suite made up of modular applications that provides Global 2000 organizations and other enterprises with the ability tocompanies provide more intelligent, effective interactions with customers, leading to loyal and lasting customer relationships while reducing costs in the contact center.

TheKANA’s suite of multi-channel solutions is built on open standards for a high degree of adaptability and flexibility. KANA iCARE suite is a flexible and scalable, Web-architected solution, integrated on a single platform, that supports multiple customer communication channels. KANA iCARE providessolutions provide the critical link between contact centers and marketing departments, allowing organizations to have effective, efficient interactions with customers at all points of contact (including Web contact,web, telephone and e-mail) and throughout the enterprise. KANA iCARE employs robust analyticreporting tools across its entire product family to allow companies to continually analyze and improve their customer and partner relationships. These features enable Global 2000 organizationscompanies and other enterprises to reduce the cost of information access for their employees, customers and partners while creating profitable customer relationships.

Our customers can deploy KANA's iCARE applicationsKANA’s multi-channel solutions as a complete suite or as components that include:separate applications. Our solutions include the following products:

• KANA Contact Center - KANA Contact Center is a multi-channel customer service application for contact centers that provides request management, solution publishing, self-service capabilities, and extranet workflow.

• KANA IQ - Bringing together a self-service application for customers along with an assisted-service solution for contact center agents, KANA IQ is a sophisticated knowledge base that enables customers and agents alike to quickly and accurately locate the information they need.

• KANA Response - KANA Response is a high performancehigh-performance email management system that enables agent-assisted service with fast, high volume,high-volume, intelligent, automated e-mail, Web and instant messaging request management.

• KANA ResponseIQ - KANA ResponseIQ is a tightly-integrated combination of KANA IQ and KANA Response that enables companies to better manage e-mail responses to customer inquiries by accessing a common knowledge base that routes requests through appropriate communications channels. ResponseIQ either automatically responds to customers'customers’ requests with answers to their questions andor, when an automatic answer is unavailable or the customer indicates that the automatic answer is not sufficient, forwards requests to the most qualified agents based on the rules set by the organization.

• KANA ConnectContact Center - KANA Connect automates the preparation and delivery of personalized, event-driven e-mail messages so that the enterprise can repeatedly and proactively engage with customers at lower cost.

• KANA Marketing - KANA MarketingContact Center is a multi-channel marketing automationcustomer service application for contact centers that provides marketing organizations with more tools to build lasting relationships with their customers, including rapid segmentationrequest management, solution publishing, self-service capabilities, and recurring campaign functionality.

In addition, in 2002, we introduced optimized versions of our iCARE suite optimized for several specific industries including the following:

• KANA iCARE Solution for Healthcare Payers - KANA iCARE for Healthcare Payers includes a broad set of eCRM applications designed to meet the specific needs of this industry, including secure messaging and proactive customer notification.

• KANA iCARE Solution for Wireless Telecommunications - KANA iCARE for Wireless Telecommunications includes a broad set of eCRM applications designed to help wireless telecommunications providers reduce customer turnover and provide high-volume customer service at reduced costs.

• KANA iCARE Solution for Consumer Financial Services - KANA iCARE Solution for Consumer Financial Services includes a broad set of eCRM applications designed to help financial services organizations ensure that customer service levels remain high in the new 24-by-7 banking environment.

• KANA iCARE Solution for High Technology Manufacturing - High technology manufacturing companies increasingly need to interact with customers over online communication channels and KANA iCARE Solution for High Technology Manufacturing is focused on meeting the customer services needs particular to this industry, with tools like online self-service, instant messaging and e-mail response.

Our applications are designed to easily integrate with other enterprise software and legacy systems. They can be installed on systems running either Unix or Microsoft Windows NT operating systems, and provides provide

customers with capabilities for personalization, customer profile management, inquiry management, universal business rules, knowledge management, and extranet workflow. They linkcan be linked with customers'customers’ legacy systems allowing customers to design their systems to preserve previous investments and allow rapid deployment of our products.investments. Our eCRMservice orientated architecture uses data modeling to make data located in external systems available in our application without requiring the data to be moved or replicated. KANA'sKANA’s applications run nativelyare built on the J2EE (Java 2a single web-architected platform, which we refer to as KANA’s Enterprise Edition) and COM (Common Object Model) platforms, and some ofApplication Framework. This service-orientated framework provides KANA customers with full access to our applications now runusing a standard web browser and without requiring them to install additional software on the .Net platform.their individual computers.

Alliances and Partnerships

We partnerenter into strategic relationships with leading systems integrators that have developed significant expertise with our Web-architected eCRMweb-architected applications and are able to provide customers with a wide range of consulting, implementation and systems integration services. Our systems integrator partners are involved in nearly allmost customer engagements and, in 2001, we have significantly reduced the size of our professional services team and narrowed the scope of our professional services program in part to ensure that we dodid not compete with these key partners for professional services engagements. We believe that the supportIn addition, many of these systems integrators act as resellers for our products, and we rely on them for assistance in driving our sales efforts. We believe that support for our products by these systems integrators is increasingly important in influencing new customers'customers’ decisions to license our products. In addition,Our systems integrators are increasingly playing an important role as resellers of our products. KANA's systems integration partners include Accenture, Bearing Point, BusinessEdge, CSC, DeloitteBearingPoint, HCL Technologies, and International Business Machines (“IBM”) Business Consulting and IBM Global Services. These integrators have been integral to KANA'sKANA’s success in selling its products to large-organizations such as Advanced Micro Devices, Blue Cross and Blue Shield of Minnesota, mmO2, Dell Computer Corp., eBay, Highmark, O2, Sony Electronics, Inc., Sprint, PCSWachovia, Yahoo! and many others.

Services and Support

Customer Support. Our customer support group uses KANA’s own applications to provide multi-channel global support for our customers and partners, including phone and e-mail support and self-service solutions via our KANA also partners with a number of technology resellers, including Aspect Communications, BEA Systems, BroadVision, Cisco Systems, Hewlett-Packard, MicrosoftCustomer and Sun Microsystems.KANA Partner customer support portals.

Professional Services

Consulting Services.. Our worldwide consulting and education services group provides business and technical expertise to support our alliance partners and customers. In the second half of 2001, we streamlined our internal professional services organization and began working more closely with strategic systems integrator partners for the implementation and integration of our products. Our consulting services group works closely with partnerssystems integrators during implementations to providelend technical experience and functional knowledge of our products, as well as KANA's extensive industry knowledge,product expertise and to assist themthe integrators in providing our customers with high-quality, successful, enterprise-wide implementations.

Technical Support. Our technical support group uses KANA's own eCRM applications to provide multi-channel global support for our customers, including phone and e-mail support and self-service solutions via the KANA Support Web site.

Education Services. Our education services group has preparedprovides a full set of training programs and materials for our customers and partners, including a comprehensive set of courses for end users, business consultants and developers, which are available through instructor-led, Web-basedweb-based and onsite delivery. The group also provides up to dateon-site classes.

Each of our service groups provide up-to-date information to our customers and partners through monthlyquarterly newsletters, Web site FAQ's,as well as real time updates to our customer and regional user groups.partner facing knowledge base.

Sales

Our sales strategy is to focus on Global 2000 companies through a combination of our strategic alliances and our direct sales force. We maintain direct sales personnel across the United States and internationally throughout Europe, Asia-Pacific and Canada. Our direct sales force complements our system integrator and reseller alliances. As of December 31, 2002, 106 of our employees were employed in sales and marketing activities.

Customers

Our customers range from Global 2000 companies to growing companies pursuing an e-business strategy. The following is a list of customers that we believe are representative of our overall customer base:

One customer, IBM, accounted for 11% of our total revenues in 2002.both 2004 and 2005. No customer accounted for 10% or more of our total revenues in 2001 or 2000.2003. A substantial portion of our license and service revenues in any given quarter has been, and we expect will continue to be, generated from a limited number of customers. Our chief operating decision maker reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. Accordingly, we consider ourselves to be in a single industry segment: specifically the licensing and support of its software applications. Revenue classification is based upon customer location. See Note 12 to the Consolidated Financial Statements in Item 8 for geographic information on revenue for the years ended December 31, 2005, 2004, and 2003 and our long-lived assets (Property and Equipment, net, and Other Assets), at December 31, 2005 and 2004.

Research and Development

We believe that strong product development capabilities are essential to our strategy of enhancing our core technology, developing additional applications incorporating that technology and maintaining the competitiveness of our product and service offerings. We have invested significant time and resources in creating a structured process for undertaking all product development. In Januarythe first quarter of 2003, we began implementing an outsourcing strategy, which involves subcontracting a significant portion of our software programming, quality assurance and technical documentation activities to development partnersHCL, Accenture, IBM and BearingPoint with staffing in India and China. AsA substantial amount of outsourcing resources was devoted to developing a result of the first phase of this strategy, in the first quarter of 2003 we transferred the responsibilities of 31 US-based employees to these development partners. We expect to transfer additional positions to these development partners in future quarters of 2003. As of December 31, 2002, 128new version of our employees were engagedsolutions on a J2EE architecture, which was released in research andDecember 2004. We began to significantly reduce the scope of our outsourced development activities.activities in early 2005 to better align our costs with our revenues.

Our success significantly depends in part, on our ability to enhance our existing eCRMcustomer service solutions and to develop new services, functionality and technology that address the increasingly sophisticated and varied needs of our existing and prospective customers. The challenges of developing new products and enhancements require us to commit a substantial investment of resources, and we might not be able to develop or introduce new products on a timely or cost-effective basis, or at all, which could be exploited by our competitorslead existing and lead potential customers to choose alternativea competitor’s products.

Our research and development expenses were $13.2 million, $19.5 million, and $21.4 million in 2005, 2004, and 2003 respectively.

Competition

The market for our products and services is intensely competitive, evolving and subject to rapid technological change. We currently face competition for our products from systemssoftware designed by our customers’ in-house development teams and third-party development efforts.by third parties. We expect that these systemscompeting software applications will continue to be a major source of competition for the foreseeable future. Our primary competitors for eCRMcustomer relationship management software platforms are larger, more established companies such as Oracle which recently acquired Siebel Systems, Inc. and PeopleSoft, Inc., and to a lesser extent, Oracle and SAP.Systems. We also face competition from E.piphany, Inc., Chordiant Software, Inc., Primus Knowledge SolutionsATG, Amdocs, Knova, Talisma, eGain, RightNow, Instranet and Pegasystems Inc. with respect to several specific applications we offer. We may face increased competition upon introduction of new products or upgrades from competitors, or if we expand our product line through acquisition of complementary businesses or otherwise. As we have combined and enhanced our product lines to offer a more comprehensive e-business software solution, we are increasingly competing with large, established providers of customer management and communication solutions as well as other competitors. Our combined product line may not be sufficient to successfully compete with the product offerings available from these companies, which could slow our growth and harm our business.especially knowledge-powered products.

We believe that the principal competitive factors affecting our marketindustry include having a significant base of referenceable customers recommending our products, the breadth and depth of a given solution, product cost, product quality and performance, customer service, product scalability and reliability, product features, ability to implement solutions, and perception of financial position. We believe that our products currently compete favorably with respect to many of these factors, and, in particular, that our Web-basedweb-based architecture provides us with a competitive advantage because it allows for greater product scalability and rapid implementation. However, we may not be able to maintain our

competitive position against current and potential competitors, especially those with greater financial, marketing, service, support, technical and other resources, and who may, for example, be able to add features or functionality to their competing products more quickly or decide to sell their products to their existing customer bases for other products.

Many of our competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger installed base of customers than we have. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of our industry. We may lose potential customers to competitors for various reasons, including the possible introduction by competitors of new software hosting technologies, which could be more scalable, easier to implement and cheaper than the current technologies, and the ability or willingness of competitors to offer lower prices and other incentives that we cannot match. It is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We also expect that competition will increase as a result of industry consolidations. See "Risk Factors-We face substantial competition and may not be able to compete effectively."

Intellectual Property

We rely upon a combination of patent, copyright, trade secret and trademark laws, and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. We currently have threesix issued U.S. patents, four of which expire in 2018 and two of which expire in 2020, and a number of U.S. patent applications pending. Our pending applications, if allowed, in conjunction with our issued patents, willwould cover a significant portion of the technology underlying our products and services. We have also filed international patent applications corresponding to some of our U.S. applications. In addition, we have several trademarks that are registered or pending registration in the U.S. or abroad. Although we rely on patent, copyright, trade secret and trademark law to protect our technology, we believe that factors such as the technological and creative skills of our personnel, new product developments,development, frequent product enhancements and reliable product maintenance are more essential to establishing and maintaining a technology leadership position. As a result, our technology is susceptible to the development efforts of our competitors, who could independently develop technology that is similar or superior to ours.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology or to develop products with the same functionality as our products. Policing unauthorized use of our products is difficult. Also, the laws of other countries in which we market our products may offer little or no effective protection of our proprietary technology. Furthermore, our competitors could independently develop technologies equivalent to ours, and our intellectual property rights may not be broad enough for us to prevent such competitors from selling products incorporating those technologies. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technology could enable third parties to benefit from our technology without paying us for it, which would significantly harm our business. In addition, some of our license agreements require us to place the source code for our products into escrow. These agreements generally provide that some parties will have a limited, non-exclusive right to use this code if there is a bankruptcy proceeding instituted by or against us, we cease to do business and have no successor, or we discontinue providing maintenance and support.

Substantial litigation regarding intellectual property rights exists in our industry. We expect that software in our industry may be increasingly subject to third-party infringement claims as the number of competitors grows and the functionality of products in different industry segments overlaps. Some of our competitors in the market for customer communications software may have filed or may intend to file patent applications covering aspects of their technology that they may claim our technology infringes. Such competitors could make a claim of infringement against us with respect to our products and technology. Third parties may currently have, or may eventually be issued, patents upon which our current or future products or technology infringe. Any of these third parties might make a claim of infringement against us. See "Risk Factors-WeItem 1A “Risk Factors”—“We may become involved in litigation over proprietary rights, which could be costly and time consuming."”

EmployeesBacklog

As of December 31, 2002,2005 and 2004 we had 365$17.9 million and $21.1 million, respectively, in backlog, which relates to firm orders, with $516,000 and $2.2 million, respectively, not expected to be recognized within one year due to the timing of obligations in the underlying agreement. The substantial majority of these firm orders relates to annual support contracts, and was invoiced and recorded as deferred revenue as of December 31, 2005 and 2004.

Employees

As of December 31, 2005, we had 125 full-time employees, compared to 181 full-time employees as of whom 61December 31, 2004. As of May 31, 2006, we had 130 permanent full-time employees. Of the May 31, 2006 employees, 30 were in our services and support group, 10647 were in sales and marketing, 12825 were in research and development, and 7028 were in finance, administrationlegal, Information Technology (“IT”) and administration.

ITEM 1A. RISK FACTORS.

We operate in a dynamic and rapidly changing business environment that involves substantial risks and uncertainty, including but not limited to the specific risks identified below. The risks described below are not the only ones facing our company. Additional risks not presently known to us, or that we currently deem immaterial, may become important factors that impair our business operations. Any of these risks could cause, or contribute to causing, our actual results to differ materially from expectations. Prospective and existing investors are strongly urged to carefully consider the various cautionary statements and risks set forth in this report and our other public filings.

Risks Related to Our Business and Industry

The relatively large size of many of our expected license transactions could contribute to our failure to meet expected sales in any given quarter and could materially harm our operating results.

Our quarterly revenues are especially subject to fluctuation because they depend on the completion of relatively large orders for our products and related services. The average size of our license transactions is generally large relative to our total revenue in any quarter, particularly as we have focused on larger enterprise customers, on licensing our more comprehensive integrated products, and have involved system integrators in our sales process. If sales expected from a specific customer in a particular quarter are not realized in that quarter, we are unlikely to be able to generate revenue from alternate sources in time to compensate for the shortfall. This dependence on large orders makes our net revenue and operating results more likely to vary from quarter to quarter, and more difficult to predict, because the loss of any particular large order is significant. In January 2003,recent periods, we have experienced increases in the length of a typical sales cycle. This trend may add to the uncertainty of our future operating results and reduce our ability to anticipate our future revenues. Moreover, to the extent that significant sales occur earlier than anticipated, revenues for subsequent quarters may be lower than expected. As a result, our operating results could suffer if any large orders are delayed or canceled in any future period. In part as a result of this aspect of our business, our quarterly revenues and operating results may fluctuate in future periods and we may fail to meet the expectations of investors and public market analysts, which could cause the price of our common stock to decline. We expect the concentration of revenues among fewer customers to continue in the future.

We may not be able to forecast our revenues accurately because our products have a long and variable sales cycle and we rely on systems integrator partners for sales.

The long sales cycle for our products may cause license revenue and operating results to vary significantly from period to period. To date, the sales cycle for most of our product sales has taken anywhere from 6 to 18 months. We believe that many existing and potential customers have reassessed and reduced their planned technology and software investments and are deferring purchasing decisions, requiring additional evaluations and levels of internal approval for software investment and lengthening their purchase cycles. Our sales cycle typically requires pre-purchase evaluation by a significant number of individuals in our customers’ organizations. Along with third parties that often jointly market our software with us, we invest significant amounts of time and resources educating and providing information to prospective customers regarding the use and benefits of our products. Many of our customers evaluate our software slowly and deliberately, depending on the specific technical capabilities of the customer, the size of the deployment, the complexity of the customer’s network environment, and the quantity of hardware and the degree of hardware configuration necessary to deploy our products. The continuing stagnancy of information technology spending in our markets has led to a significant increase in the time required for this process.

Furthermore, we increasingly rely on systems integrators to identify, influence and manage large transactions with customers, and we expect this trend to continue as our industry consolidates. Selling our products in conjunction with our systems integrators who incorporate our products into their offerings can involve a particularly long and unpredictable sales cycle, as it typically takes more time for the prospective customer to evaluate proposals from multiple vendors. In addition, when systems integrators propose the use of our products to their customers, it is typically part of a larger project, which can require more levels of customer approvals. We have little or no control over the sales cycle of an integrator-led transaction or our customers’ budgetary constraints and internal decision-making and acceptance processes.

As a result of increasingly long sales cycles, we have faced increased difficulty in predicting our operating results for any given period, and have experienced significant unanticipated fluctuations in our revenues from period to period. Any failure to achieve anticipated revenues for a period could cause our stock price to decline.

Our business relies heavily on customer service solutions, and these solutions may not gain market acceptance.

We have made customer service solutions our main focus and, in recent periods, have allocated a significant portion of our research and development and marketing resources to the development and promotion of such products. If these products are not accepted by potential customers, our business would be materially adversely affected. For our current business model to succeed, we believe that we will need to convince new and existing customers of the merits of purchasing our customer service solutions over traditional customer relationship management, or CRM, solutions and competitors’ customer service solutions. Many of these customers have previously invested substantial resources in adopting and implementing their existing CRM products, whether such products are ours or are those of our competitors. We may be unable to convince customers and potential customers that it is worth them purchasing substantial new software packages to provide them with our specific customer service capabilities. If our strategy of offering customer service solutions fails, we may not be able to sell sufficient quantities of our product offerings to generate significant license revenues, and our business could be harmed.

Our expenses are generally fixed and we will not be able to reduce these expenses quickly if we fail to meet our revenue expectations.

Most of our expenses, such as employee compensation and outsourcing of technical support and certain development functions, are relatively fixed in the short term. Other expenses like leases are fixed and are more long term. Moreover, our forecast is based, in part, upon our expectations regarding future revenue levels. As a result, in any particular quarter our total revenue can be below expectation and we could not proportionately reduce operating expenses for that quarter. Accordingly, such a revenue shortfall would have a disproportionate negative effect on our expected operating results for that quarter.

If we fail to generate sufficient revenues to support our business and require additional financing, failure to obtain such financing would affect our ability to maintain our operations and to grow our business, and the terms of any financing we obtain may impair the rights of our existing stockholders.

In the future, we may be required to seek additional financing to fund our operations or growth, and such financing may not be available to us, or may impair the rights of our existing stockholders. Furthermore, any failure to raise sufficient capital in a timely fashion could prevent us from growing or pursuing our strategies or cause us to limit our operations and cause potential customers to question our financial viability. We had cash and cash equivalents of $6.2 million at December 31, 2005. It is likely that our cash position could decrease over the next few quarters and some customers will be increasingly concerned about our cash situation and our ongoing ability to update and maintain our products. This could significantly harm our sales efforts.

On November 30, 2005, the Company established a new banking relationship with Bridge Bank N.A. (“Bridge”). In addition, on November 30, 2005, the Company entered into a Business Financing Agreement and Intellectual Property Security Agreement with Bridge under which the Company has access to a Loan facility of $7.0 million (“Loan”). This Loan is made up of two parts, (i) a Formula Revolving Line of Credit of up to $5.0 million and (ii) a Non-Formula Revolving Line of Credit of up to $6.0 million, of which $2.0 million is available for a borrowing base for stand-by letters of credits, settlement limits on foreign exchange contracts (FX) or cash management products. The combined total borrowing under the two parts cannot exceed $7.0 million. The Formula Revolving Line of Credit is collateralized by all of our assets and expires November 29, 2006 at which time the entire balance under the line of credit will be due. Interest for the Formula Revolving Line of Credit accrues at Bridge’s Prime Lending Rate plus 2% while interest for the Non-Formula Revolving Line of Credit will accrue at Bridge’s Prime Lending Rate plus 0.50%. On December 29, 2005, the Company entered into a Business Financing Agreement, which provided for additional advances up to $1.5 million based on an advance rate of 80% of eligible receivables. The overall Loan Facility was increased to $7.5 million. As of December 31, 2005, the Company had $7.4 million drawn against the Loan. On March 30, 2006, the Company modified the Business Financing Agreement with Bridge Bank to increase the additional advances for accounts receivable to $2.0 million and the overall Loan Facility to $8.0 million. Factors such as the commercial success of

our existing products and services, the timing and success of any new products and services, the progress of our research and development efforts, our results of operations, the status of competitive products and services, and the timing and success of potential strategic alliances or potential opportunities to acquire or sell technologies or assets may require us to seek additional funding sooner than we expect. In the event that we require additional cash, we may not be able to secure additional financing on terms that are acceptable to us, especially in the current uncertain market climate, and we may not be successful in implementing or negotiating other arrangements to improve our cash position. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders would be reduced and the securities we issue might have rights, preferences, and privileges senior to those of our current stockholders. If adequate funds were not available on acceptable terms, our ability to achieve or sustain positive cash flows, maintain current operations, fund any potential expansion, take advantage of unanticipated opportunities, develop or enhance products or services, or otherwise respond to competitive pressures would be significantly limited.

If we fail to grow our customer base or generate repeat business, our operating results could be harmed.

Our business model generally depends on the sale of our products to new customers as well as on expanded use of our products within our customers’ organizations. If we fail to grow our customer base or generate repeat and expanded business from our current and future customers, our business and operating results will be seriously harmed. In some cases, our customers initially make a limited purchase of our products and services for pilot programs. These customers may not purchase additional licenses to expand their use of our products. If these customers do not successfully develop and deploy initial applications based on our products, they may choose not to purchase deployment licenses or additional development licenses. In addition, as we introduce new versions of our products, new product lines or new product features, our current customers might not require the additional functionality we offer and might not ultimately license these products. Furthermore, because the total amount of maintenance and support fees we receive in any period depends in large part on the size and number of licenses that we have previously sold; any downturn in our software license revenue would negatively affect our future services revenue. Also, if customers elect not to renew their maintenance agreements, our services revenue could decline significantly. If customers are unable to pay for their current products or are unwilling to purchase additional products, our revenues would decline. Additionally, a substantial percentage of our sales come from repeat customers. If a significant existing customer or a group of existing customers decide not to repeat business with us, our revenues would decline and our business would be harmed.

We face substantial competition and may not be able to compete effectively.

The market for our products and services is intensely competitive, evolving, and subject to rapid technological change. From time to time, our competitors reduce the prices of their products and services (substantially in certain cases) in order to obtain new customers. Competitive pressures could make it difficult for us to acquire and retain customers and could require us to reduce the price of our products.

Our customers’ requirements and the technology available to satisfy those requirements are continually changing. Therefore, we must be able to respond to these changes in order to remain competitive. If our international development partners do not adequately perform the software programming, quality assurance and technical documentation activities we outsourced, we may not be able to respond to such changes as quickly or effectively. Changes in our products may also make it more difficult for our sales force to sell effectively. In addition, changes in customers’ demand for the specific products, product features, and services of other companies’ may result in our products becoming uncompetitive. We expect the intensity of competition to increase in the future. Increased competition may result in price reductions, reduced gross margin and loss of market share. We may not be able to compete successfully against current and future competitors, and competitive pressures may seriously harm our business.

Our competitors vary in size and in the scope and breadth of products and services offered. We currently face competition with our products from systems designed in-house and by our competitors. We expect that these systems will continue to be a major source of competition for the foreseeable future. Our primary competitors for eCRM platforms are larger, more established companies such as Oracle, which recently acquired Siebel Systems. The rate that competitors are consolidating is increasing. We also face competition from Chordiant Software, ATG, Amdocs, Knova, Talisma, eGain, RightNow, Instranet, and Pegasystems with respect to specific applications we

offer. We may face increased competition upon introduction of new products or upgrades from competitors, or if we expand our product line through acquisition of complementary businesses or otherwise. As we have combined and enhanced our product lines to offer a more comprehensive software solution, we are increasingly competing with large, established providers of customer management and communication solutions as well as other competitors. Our combined product line may not be sufficient to successfully compete with the product offerings available from these companies, which could slow our growth and harm our business.

Many of our competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger installed base of customers than we have. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of our industry. We may lose potential customers to competitors for various reasons, including the ability or willingness of competitors to offer lower prices and other incentives that we cannot match. It is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We also expect that competition will increase as a result of recent industry consolidations, as well as anticipated future consolidations.

We have a history of losses and may not be able to generate sufficient revenue to achieve and maintain profitability.

Since we began implementing an outsourcingoperations in 1997, our revenues have not been sufficient to support our operations, and we have incurred substantial operating losses in every quarter. As of December 31, 2005, our accumulated deficit was approximately $4.3 billion, which includes approximately $2.7 billion related to goodwill impairment charges. Our stockholders’ deficit at December 31, 2005, was $9.8 million. We continue to commit a substantial investment of resources to sales, product marketing, and developing new products and enhancements, and we will need to increase our revenue to achieve profitability and positive cash flows. Our expectations as to when we can achieve positive cash flows, and as to our future cash balances, are subject to a number of assumptions, including assumptions regarding improvements in general economic conditions and customer purchasing and payment patterns, many of which are beyond our control. Our history of losses has previously caused some of our potential customers to question our viability, which has in turn hampered our ability to sell some of our products. Additionally, our revenue has been affected by the uncertain economic conditions in recent years, both generally and in our market. As a result of these conditions, we have experienced and expect to continue to experience difficulties in attracting new customers, which means that we may continue to experience losses, even if sales of our products and services grow.

We rely on marketing, technology, and distribution relationships for the sale, installation and support of our products that may generally be terminated at any time, and if our current and future relationships are not successful, our growth might be limited.

We rely on marketing and technology relationships with a variety of companies, including systems integrators and consulting firms that, among other things, generate leads for the sale of our products and provide our customers with implementation and ongoing support. If we cannot maintain successful marketing and technology relationships or if we fail to enter into additional such relationships, we could have difficulty expanding the sales of our products and our growth might be limited.

A significant percentage of our revenues depend on leads generated by systems integrators, or “SIs”, and their recommendations of our products. If SIs do not successfully market our products, our operating results will be materially harmed. In addition, many of our direct sales are to customers that will be relying on SIs to implement our products, and if SIs are not familiar with our technology or able to successfully implement our products, our operating results will be materially harmed. We expect to continue increasing our leverage of SIs as indirect sales channels and, if this strategy is successful, our dependence on the efforts of these third parties for revenue growth and customer service will increase. Our reliance on third parties for these functions has reduced our control over such activities and reduced our ability to perform such functions internally. If we come to rely primarily on a single SI that subsequently terminates its relationship with us, becomes insolvent or is acquired by another company with which involves subcontractingwe have no relationship, or decides not to provide implementation services related to our products, we may not be able to internally generate sufficient revenue or increase the revenues generated by our other SI relationships to offset the resulting lost revenues. Furthermore, SIs typically suggest our solution in combination with other products and services, some of which may compete with our solution. SIs are not required to promote any fixed

quantities of our products, are not bound to promote our products exclusively, and may act as indirect sales channels for our competitors. If these companies choose not to promote our products or if they develop, market, or recommend software applications that compete with our products, our business will be harmed.

In addition to relying on SIs to recommend our products, we also rely on SIs and other third-party resellers to install and support our products. If the companies providing these services fail to implement our products successfully for our customers, the customer may be unable to complete implementation on the schedule that it had anticipated and we may have increased customer dissatisfaction or difficulty making future sales as a result. We might not be able to maintain our relationships with SIs and other indirect sales channel partners and enter into additional relationships that will provide timely and cost-effective customer support and service. If we cannot maintain successful relationships with our indirect sales channel partners, we might have difficulty expanding the sales of our products and our growth could be limited. In addition, if such third parties do not provide the support our customers need, we may be required to hire subcontractors to provide these professional services. Increased use of subcontractors would harm our margins because it costs us more to hire subcontractors to perform these services than it would to provide the services ourselves.

Reductions in our workforce may adversely affect our ability to release products and product updates in a timely manner.

We have substantially reduced our headcount over the last two years from a total of 211 as of December 31, 2003 to 181 as of December 31, 2004 to 125 as of December 31, 2005. The majority of this reduction was the result of our decision to shift a significant portion of our software programming, quality assurance, and technical documentation activities to international development partners with staffing in Indiaearly 2003. We reduced the size of our research and China.development department from 88 employees as of December 31, 2003 to 34 employees as of December 31, 2004, and to 30 employees as of December 31, 2005. In addition, we reduced the level of our expenditures on outsourced development in 2005 (the Company announced plans to further reduce headcount in certain locations and concentrate R&D efforts in our Headquarters in Menlo Park, California). The reductions in our research and development headcount and the reductions in our outsourced development capacity may limit our ability to release products within expected timeframes. For example, many of the employees who were terminated in headcount reductions possessed specific knowledge or expertise that may prove to have been important to our operation. As a result of these staff reductions, our ability to respond to unexpected challenges may be impaired and we may be unable to take advantage of new opportunities. Personnel reductions may also subject us to the first phaserisk of litigation, which may adversely impact our ability to conduct our operations and may cause us to incur significant expense. Our termination of two outsourcing arrangements in early 2005 may further reduce our ability to respond to development challenges and to introduce new products in expected timeframes.

We may be unable to hire and retain the skilled personnel necessary to develop and grow our business.

Concern over our long-term financial strength may create concern among existing employees about job security, which could lead to increased turnover and reduce our ability to meet the needs of our current and future customers. Because our stock price declined drastically in recent years, and has not experienced any sustained recovery from the decline, stock-based compensation, including options to purchase our common stock, may have diminished effectiveness as employee hiring and retention devices. If we are unable to retain qualified personnel, we could face disruptions to operations, loss of key information, expertise or know-how and unanticipated additional recruitment and training costs. If employee turnover increases, our ability to provide customer service and execute our strategy would be negatively affected.

For example, our ability to increase revenues in the future depends considerably upon our success in training and retaining effective direct sales personnel and the success of our direct sales force. We might not be successful in these efforts. Our products and services require sophisticated sales efforts. We have experienced significant turnover in our sales force including domestic senior sales management, and may experience further turnover in future periods. It generally takes a new salesperson nine or more months to become productive, and they may not be able to generate new sales. Our business will be harmed if we fail to retain qualified sales personnel, or if newly hired salespeople fail to develop the necessary sales skills or develop these skills more slowly than anticipated.

If we fail to respond to changing customer preferences in our market, demand for our products and our ability to enhance our revenues will suffer.

If we do not continue to improve our products and develop new products that keep pace with competitive product introductions and technological developments, satisfy diverse and rapidly evolving customer requirements, and achieve market acceptance, we might be unable to attract new customers. Our industry is characterized by rapid and substantial developments in the technologies and products that enjoy widespread acceptance among prospective and existing customers. The development of proprietary technology and necessary service enhancements entails significant technical and business risks and requires substantial expenditures and lead-time. In addition, if our international development partners fail to provide the development support we need, our products and product documentation could fall behind those produced by our competitors, causing us to lose customers and sales. We might not be successful in marketing and supporting our products or developing and marketing other product enhancements and new products that respond to technological advances and market changes, on a timely or cost-effective basis. In addition, even if these products are developed and released, they might not achieve market acceptance. We have experienced delays in releasing new products and product enhancements in the past and could experience similar delays in the future. These delays or problems in the installation or implementation of our new releases could cause us to lose customers.

Our failure to manage multiple technologies and technological change could reduce demand for our products.

Rapidly changing technology and operating systems, changes in customer requirements, and evolving industry standards might impede market acceptance of our products. Our products are designed based upon currently prevailing technology to work on a variety of hardware and software platforms used by our customers. However, our software may not operate correctly on evolving versions of hardware and software platforms, programming languages, database environments and other systems that our customers use. If new technologies emerge that are incompatible with our products, or if competing products emerge that are based on new technologies or new industry standards and that perform better or cost less than our products, our key products could become obsolete and our existing and potential customers could seek alternatives to our products. We must constantly modify and improve our products to keep pace with changes made to these platforms and to database systems and other back-office applications and Internet-related applications. Furthermore, software adapters are necessary to integrate our products with other systems and data sources used by our customers. We must develop and update these adapters to reflect changes to these systems and data sources in order to maintain the functionality provided by our products. As a result, uncertainties related to the timing and nature of new product announcements, introductions or modifications by vendors of operating systems, databases, customer relationship management software, web servers and other enterprise and Internet-based applications could delay our product development, increase our product development expense or cause customers to delay evaluation, purchase and deployment of our analytics products. Furthermore, if our international development partners fail to respond adequately when adaptation of our products is required, our ability to respond would be hampered even if such uncertainties were eliminated. If we fail to modify or improve our products in response to evolving industry standards, our products could rapidly become obsolete.

Failure to develop new products or enhancements to existing products on a timely basis would hurt our sales and damage our reputation.

The challenges of developing new products and enhancements require us to commit a substantial investment of resources to development, and we might not be able to develop or introduce new products on a timely or cost-effective basis, or at all, which could be exploited by our competitors and lead potential customers to choose alternative products. To be competitive, we must develop and introduce on a timely basis new products and product enhancements for companies with significant e-business customer interactions needs. Our ability to deliver competitive products may be negatively affected by the diversion of resources to development of our suite of products, and responding to changes in competitive products and in the demands of our customers. If we experience product delays in the future, we may face:

Furthermore, delays in bringing new products or enhancements to market can result, for example, from potential difficulties with managing outsourced research and development, including overseeing such activities occurring in India and China or from loss of institutional knowledge through reductions in force, or the existence of defects in new products or their enhancements.

Failure to license necessary third party software incorporated in our products could cause delays or reductions in our sales.

We license third party software that we incorporate into our products. These licenses may not continue to be available on commercially reasonable terms or at all. Some of this strategy,technology would be difficult to replace. The loss of any of these licenses could result in delays or reductions of our applications until we identify, license and integrate or develop equivalent software. If we are required to enter into license agreements with third parties for replacement technology, we could face higher royalty payments and our products may lose certain attributes or features. In the future, we might need to license other software to enhance our products and meet evolving customer needs. If we are unable to do this, we could experience reduced demand for our products.

Our independent registered public accounting firm has identified material weaknesses in our internal controls that, if not remediated, could affect our ability to prepare timely and accurate financial reports, which could cause investors to lose confidence in our reported financial information and have a negative effect on the trading price of our stock.

In the course of the audit of our consolidated financial statements for the year ended December 31, 2004, our independent registered public accounting firm identified and reported material weaknesses in our internal control over financial reporting. A material weakness is a reportable condition in which our internal controls do not reduce to a low level the risk that undetected misstatements caused by error or fraud may occur in amounts that are material to our audited consolidated financial statements. In addition, our Chief Executive Officer and Chief Financial Officer performed an evaluation of our disclosure controls and procedures and found that they were not effective. First, we had weaknesses in our general accounting processes related to insufficient documentation and analyses to support our consolidated financial statements, failure to properly evaluate estimates of royalties due, and insufficient staffing in the accounting and reporting function, which is exacerbated by changes in management and accounting personnel and insufficient training of our accounting department. Second, there was no independent review of journal entries, and insufficient documentation or support for journal entries and consolidation entries. In a number of cases, these required adjustments to our consolidated financial statements for the year ended December 31, 2004.

Finally, during the first quarter of 20032005, our Audit Committee completed an examination of certain of our internal controls relating to travel and entertainment expenses and determined that we transferredhad made erroneous expense reimbursements to our Chief Executive Officer and certain other executive officers, primarily as a result of inconsistent travel and entertainment policies, inadequate review of expense reimbursement requests and carelessness.

Our management has determined that these deficiencies constitute material weaknesses as of December 31, 2004 that continued to exist during 2005. As a result, we are unable to conclude that our disclosure controls and procedures were effective as of December 31, 2005. (See Item 9A. Controls and Procedures in Part II: Financial Information). We believe that these deficiencies did not have a material impact on our consolidated financial statements included in this report due to the responsibilitiesfact that we performed substantial analysis on and for the December 31, 2005 and prior periods balances, including performing historical account reconciliations, having account balance analysis reviewed by senior management and reconstructing certain account balances. However, these deficiencies increase the risk that a transaction will not be accounted for consistently and in accordance with established policy or accounting principles generally accepted in the United States, and they increase the risk of error.

Management, with the oversight of the Audit Committee of the Board of Directors, has begun to address these control deficiencies and is committed to effective remediation of all these deficiencies as expeditiously as possible. For instance, our new Chief Financial Officer joined the Company in mid October 2004. Some new

processes and controls have already been approved and are being implemented. The Company plans to develop and implement further improvements and additional controls. In addition, management believes that it has remediated the material weakness relating to travel and entertainment expense reimbursement during the first quarter of 2005. The Company’s other weaknesses will not be considered remediated until new internal controls are developed and implemented throughout the Company, are operational for a period of time and are tested, and management concludes that these controls are operating effectively.

Our remediation measures may not be successful in correcting the material weakness reported by our independent registered public accounting firms. In addition, we cannot assure you that additional material weaknesses or significant deficiencies in our internal controls will not be discovered in the future. In addition, controls may become inadequate because of changes in conditions, and the degree of compliance with the policies or procedures may deteriorate. Any failure to remediate the material weaknesses described above or to implement and maintain effective internal controls could harm our operating results, cause us to fail to meet our reporting obligations or result in material misstatements in our financial statements. Deficiencies in our internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock.

We face additional risks and costs as a result of the delayed filing of our Quarterly Reports on Form 10-Q for the quarters ended March 31, US-basedJune 30, and September 30, 2005, and March 31, 2006, and our Annual Report on Form 10-K for the years ended December 31, 2004 and 2005.

As a result of missing an established deadline with the NASDAQ Listing Qualifications Panel for filing our Quarterly Report on Form 10-Q for the quarter ended March 31, 2005, we have experienced additional risks and costs. The March 31, 2005 10-Q was filed on October 11, 2005, past the NASDAQ Listing Qualification Panel’s established deadline of October 7, 2005; thus, the NASDAQ Listing Qualifications Panel delisted the Company’s common stock effective as of the beginning of trading on October 17, 2005. Since our common stock was delisted from The NASDAQ Stock Market, the ability of our stockholders to sell our common stock has been severely limited, causing our stock price to continue to decline.

As a result of our delayed filings, we will be ineligible to register our securities on Form S-3 for sale by us or resale by others until we have timely filed all periodic reports under the Securities Exchange Act of 1934 for one year. Instead, the Company may be required to use Form S-1 to raise capital or complete acquisitions, which would increase transaction costs and adversely affect our ability to raise capital or complete acquisitions of other companies during this period.

Our common stock was recently delisted from The NASDAQ National Market.

Our common stock was delisted from The NASDAQ National Market effective at the opening of business on October 17, 2005 and our common stock is currently trading on the “Pink Sheets.” This delisting will likely reduce the liquidity of our securities, could cause investors not to trade in our securities and result in a lower stock price and could have an adverse effect on the Company. Additionally, we may become subject to the SEC rules that affect “penny stocks,” which are stocks below $5.00 per share that are not quoted on a NASDAQ Market. These SEC rules would make it more difficult for brokers to find buyers for our securities and could lower the net sales prices that our stockholders are able to obtain. If our price of common stock remains low, we may not be able to raise equity capital. While we intend to seek to have our common stock quoted on the Over the Counter (“OTC”) Bulletin Board, there can be no assurances as to when, or whether, they will become quoted on the OTC Bulletin Board.

Our stock price has been highly volatile and has experienced a significant decline, and may continue to be volatile and decline.

The trading price of our common stock has fluctuated widely in the past and we expect that it will continue to do so in the future, as a result of a number of factors, many of which are outside our control, such as:

In addition, stock markets in general, and particularly The NASDAQ National Market and the “Pink Sheets,” have experienced extreme price and volume fluctuations that have affected the market prices of many technology and computer software companies, particularly Internet-related companies. Such fluctuations have often been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations could adversely affect the market price of our common stock. In the past, following periods of volatility in the market price of a particular company’s securities, securities class action litigation has often been brought against that company. Securities class action litigation could result in substantial costs and a diversion of our management’s attention and resources.

Since becoming a publicly traded security listed on The NASDAQ National Market in September 1999, our common stock has reached a sales price high of $1,698.10 per share and a sales price low of $0.65 per share. On October 17, 2005, our common stock was delisted from The NASDAQ National Market due to the failure to file our Quarterly Report on Form 10-Q for the quarter ended March 31, 2005. Since October 17, 2005, our common stock has been traded on the “Pink Sheets.” The last reported sale price of our shares on May 31, 2006 was $1.90 per share.

We have experienced transitions in our management team, our board of directors and our independent registered public accounting firm in the past and may continue to do so in the future.

We have experienced a number of transitions with respect to our board of directors, executive officers, and our independent registered public accounting firm in recent quarters, including the following:

Such past and future transitions may continue to result in disruptions in our operations and require additional costs.

Our pending patents may never be issued and, even if issued, may provide little protection.

Our success and ability to compete depend to a significant degree upon the protection of our software and other proprietary technology rights. We currently have six issued U.S. patents, four of which expire in 2018 and two of which expire in 2020, and multiple U.S. patent applications pending relating to our software. None of our technology is patented outside of the United States. It is possible that:

We rely upon trademarks, copyrights and trade secrets to protect our proprietary rights, which may not be sufficient to protect our intellectual property.

In addition to patents, we rely on a combination of laws, such as copyright, trademark and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. However, despite the precautions that we have taken:

Also, the laws of some other countries in which we market our products may offer little or no effective protection of our proprietary technology. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technology could enable third parties to benefit from our technology without paying us for it, which would significantly harm our business.

We may become involved in litigation over proprietary rights, which could be costly and time consuming.

The software and Internet industries are characterized by the existence of a large number of patents, trademarks, and copyrights and by frequent litigation based on allegations of infringement or other violations of intellectual property rights. As the number of entrants into our market increases, the possibility of an intellectual property claim against us grows. Our technologies may not be able to withstand any third-party claims or rights against their use. Some of our competitors in the market for customer communications software may have filed or may intend to file patent applications covering aspects of their technology that they may claim our technology infringes. Such competitors could make a claim of infringement against us with respect to our products and technology. Third parties may currently have, or may eventually be issued, patents upon which our current or future products or technology infringe. Any of these third parties might make a claim of infringement against us. For example, from time to time, companies have asked us to evaluate the need for a license of patents they hold, and we cannot assure you that patent infringement claims will not be filed against us in the future. Other companies may also have pending patent applications (which are typically confidential for the first eighteen months following filing) that cover technologies we incorporate in our products.

In addition, many of our software license agreements require us to indemnify our customers from any claim or finding of intellectual property infringement. We periodically receive notices from customers regarding patent license inquiries they have received which may or may not implicate our indemnity obligations. Any litigation, brought by others, or us could result in the expenditure of significant financial resources and the diversion of management’s time and efforts. In addition, litigation in which we are accused of infringement might cause product shipment delays, require us to develop alternative technology or require us to enter into royalty or license agreements, which might not be available on acceptable terms, or at all. If a claim of infringement was made against us and we could not develop non-infringing technology or license the infringed or similar technology on a timely and cost-effective basis, our business could be significantly harmed.

We may face liability claims that could result in unexpected costs and damages to our reputation.

Our licenses with customers generally contain provisions designed to limit our exposure to potential product liability claims, such as disclaimers of warranties and limitations on liability for special, consequential, and incidental damages. In addition, our license agreements generally limit the amounts recoverable for damages to the amounts paid by the licensee to us for the product or service giving rise to the damages. However, some domestic and international jurisdictions may not enforce these contractual limitations on liability. We may be subject to claims based on errors in our software or mistakes in performing our services including claims relating to damages to our customers’ internal systems. A product liability claim could divert the attention of management and key personnel, could be expensive to defend, and could result in adverse settlements and judgments.

We may face higher costs and lost sales if our software contains errors.

We face the possibility of higher costs as a result of the complexity of our products and the potential for undetected errors. Due to the mission critical nature of many of our products and services, errors could be particularly problematic. In the past, we have discovered software errors in some of our products after their introduction. We have only a few “beta” customers that test new features and functionality of our software before we make these features and functionalities generally available to our customers. If we are not able to detect and correct errors in our products or releases before commencing commercial shipments, we could face:

Our security could be breached, which could damage our reputation and deter customers from using our services.

We must protect our computer systems and network from physical break-ins, security breaches and other disruptive problems caused by the Internet or other users. Computer break-ins could jeopardize the security of information stored in and transmitted through our computer systems and network, which could adversely affect our ability to retain or attract customers, damage our reputation and subject us to litigation. We have been in the past, and could be in the future, subject to denial of service, vandalism and other attacks on our systems by Internet hackers. Although we intend to continue to implement security technology and establish operational procedures to prevent break-ins, damage and failures, these security measures may fail. Our insurance coverage in certain circumstances may be insufficient to cover losses that may result from such events.

Our international operations expose us to additional risks.

A substantial proportion of our revenues are generated from sales outside North America, exposing us to additional financial and operational risks. Sales outside North America represented 30% of our total revenues for

the year ended December 31, 2005, compared to 35% of our total revenues for the year ended December 31, 2004. We have established offices in the United Kingdom, Japan, the Netherlands, Hong Kong and South Korea. Sales outside North America could increase as a percentage of total revenues as we attempt to expand our international operations. In addition to the additional costs and uncertainties of being subject to international laws and regulations, international operations require significant management attention and financial resources, as well as additional support personnel. To the extent our international operations grow, we will also need to, among other things, expand our international sales channel management and support organizations and develop relationships with international service providers and additional distributors and system integrators. In addition, international operations can lead to greater difficulty with collecting accounts receivable, longer sales cycles and collection periods, greater seasonal fluctuations in business activity and increases in our tax rates. Any growth in our international operations would compound these difficulties. Furthermore, products must be localized, or customized to meet the needs of local users, before they can be sold in particular foreign countries. Developing localized versions of our products for foreign markets is difficult and can take longer than expected.

International laws and regulations may expose us to potential costs and litigation.

Our international operations increase our exposure to international laws and regulations. If we cannot comply with foreign laws and regulations, which are often complex and subject to variation and unexpected changes, we could incur unexpected costs and potential litigation. For example, the governments of foreign countries might attempt to regulate our products and services or levy sales or other taxes relating to our activities. In addition, foreign countries may impose tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers, any of which could make it more difficult for us to conduct our business. The European Union has enacted its own privacy regulations that may result in limits on the collection and use of certain user information, which, if applied to the sale of our products and services, could negatively impact our results of operations.

We may suffer foreign exchange rate losses.

Our international revenues and expenses are denominated in local currency. Therefore, a weakening of other currencies compared to the U.S. dollar could make our products less competitive in foreign markets and could negatively affect our operating results and cash flows. We have not yet experienced, but may in the future experience, significant foreign currency transaction losses, especially because we generally do not engage in currency hedging. To the extent the international component of our revenues grows, our results of operations will become more sensitive to foreign exchange rate fluctuations.

If we acquire companies, products, or technologies, we may face risks associated with those acquisitions.

We acquired Hipbone, Inc. in early 2004, and if we are presented with appropriate opportunities, we may make other investments in complementary companies, products, or technologies. We may not realize the anticipated benefits of any acquisition or investment. For example, since inception, the Company has recorded $2.7 billion of impairment charges for the cost of goodwill obtained from acquisitions. If we acquire another company, we will likely face risks, uncertainties and disruptions associated with the integration process, including, among other things, difficulties in the integration of the operations, technologies and services of the acquired company, the diversion of our management’s attention from other business concerns and the potential loss of key employees of the acquired businesses. If we fail to successfully integrate other companies that we may acquire, our business could be harmed. Also, acquisitions can expose us to liabilities and risks facing the company we acquire, including lawsuits or claims against the company that are unknown at the time of the acquisition. Furthermore, we may have to incur debt or issue equity securities to pay for any additional future acquisitions or investments, the issuance of which could be dilutive to our existing stockholders. In addition, our operating results may suffer because of acquisition-related costs or amortization expenses or charges relating to acquired goodwill and other intangible assets.

The role of acquisitions in our future growth may be limited, which could harm our business and strategy.

Because the recent trading prices of our common stock have been significantly lower than in the past, the role of acquisitions in our growth may be substantially limited. In the past, acquisitions have been an important part of our growth strategy. To gain access to key technologies, new products and broader customer bases, we have acquired companies in exchange for shares of our common stock. If we are unable to acquire companies in exchange for our common stock, we may not have access to new customers, needed technological advances, new products, and/or enhancements to existing products. This would substantially impair our ability to respond to market opportunities.

Compliance with new regulations governing public company corporate governance and reporting will result in additional costs.

Our continuing preparation for and implementation of various corporate governance reforms and enhanced disclosure laws and regulations adopted in recent years requires us to incur significant additional accounting and legal costs. We, like other public companies, are preparing for new accounting disclosures required by laws and regulations adopted in connection with the Sarbanes-Oxley Act of 2002. In particular, we will be preparing to provide, if required, beginning with our Annual Report on Form 10-K for the fiscal year ending December 31, 2007, an Annual Report on our internal control over financial reporting and auditors’ attestation with respect to our report required by Section 404 of the Sarbanes-Oxley Act. Any unanticipated difficulties in preparing for and implementing these and other corporate governance and reporting reforms could result in material delays in compliance or significantly increase our costs. Also, there can be no assurance that we will be able to fully comply with these new laws and regulations. Any failure to timely prepare for and implement the reforms required by these new laws and regulations could significantly harm our business, operating results, and financial condition.

Changes in the accounting treatment of stock options could adversely affect our results of operations.

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised 2004) (‘SFAS 123R”)Share-Based Payment, to require companies to expense employee stock options for financial reporting purposes. This standard became effective for the Company for our quarterly and annual periods beginning on January 1, 2006. Such stock option expensing requires us to value our employee stock option grants pursuant to an option valuation formula and amortize that value against our earnings over the vesting period in effect for those options. Through December 31, 2005, we have accounted for stock-based awards to employees in accordance with Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and have adopted the disclosure-only alternative of Statement of Financial Accounting Standards No. 123,Accounting for Stock-Based Compensation. When we expense employee stock options in the future, this change in accounting treatment could materially and adversely affect our reported results of operations as the stock-based compensation expense would be charged directly against our reported earnings. For pro forma disclosure illustrating the effect such a change on our recent results of operations, see Note 1 to the Consolidated Financial Statements in Item 8. The adoption of SFAS 123R could adversely affect our ability to comply with the financial covenants of our credit facility with our bank.

We have adopted anti-takeover defenses that could delay or prevent an acquisition of the Company.

Our board of directors has the authority to issue up to 5,000,000 shares of preferred stock. Without any further vote or action on the part of the stockholders, the board has the authority to determine the price, rights, preferences, privileges, and restrictions of the preferred stock. This preferred stock, if issued, might have preference over and harm the rights of the holders of common stock. Although the ability to issue this preferred stock provides us with flexibility in connection with possible acquisitions and other corporate purposes, it can also be used to make it more difficult for a third party to acquire a majority of our outstanding voting stock. We currently have no plans to issue preferred stock.

Our certificate of incorporation, bylaws and equity compensation plans include provisions that may deter an unsolicited offer to purchase us. These provisions, coupled with the provisions of the Delaware General Corporation Law, may delay or impede a merger, tender offer, or proxy contest. Furthermore, our board of directors is divided into three classes, only one of which is elected each year. In addition, directors are only removable by the affirmative vote of at least 66 ²/3% of all classes of voting stock. These factors may further delay or prevent a change of control of us.

Risks Related to Our Industry

Future regulation of the Internet may slow our growth, resulting in decreased demand for our products and services and increased costs of doing business.

State, federal and foreign regulators could adopt laws and regulations that impose additional burdens on companies that conduct business online. These laws and regulations could discourage communication by e-mail or other web-based communications, particularly targeted e-mail of the type facilitated by our products, which could reduce demand for our products and services.

The growth and development partners.of the market for online services may prompt calls for more stringent consumer protection laws or laws that may inhibit the use of Internet-based communications or the information contained in these communications. The adoption of any additional laws or regulations may decrease the expansion of the Internet. A decline in the growth of the Internet, particularly as it relates to online communication, could decrease demand for our products and services and increase our costs of doing business, or otherwise harm our business. Any new legislation or regulations, application of laws and regulations from jurisdictions whose laws do not currently apply to our business, or application of existing laws and regulations to the Internet and other online services could increase our costs and harm our growth.

The imposition of sales and other taxes on products sold by our customers over the Internet could have a negative effect on online commerce and the demand for our products and services.

The imposition of new sales or other taxes could limit the growth of Internet commerce generally and, as a result, the demand for our products and services. Federal legislation that limits the imposition of state and local taxes on Internet-related sales will expire on November 1, 2007. Congress may choose to modify this legislation or to allow it to expire, in which case state and local governments would be free to impose taxes on electronically purchased goods. We expectbelieve that most companies that sell products over the Internet do not currently collect sales or other taxes on shipments of their products into states or foreign countries where they are not physically present. However, one or more states or foreign countries may seek to impose sales or other tax collection obligations on out-of-jurisdiction companies that engage in e-commerce within their jurisdiction. A successful assertion by one or more states or foreign countries that companies that engage in e-commerce within their jurisdiction should collect sales or other taxes on the sale of their products over the Internet, even though not physically in the state or country, could indirectly reduce demand for our products.

Privacy concerns relating to the Internet are increasing, which could result in legislation that negatively affects our business in reduced sales of our products.

Businesses using our products capture information regarding their customers when those customers contact them on-line with customer service inquiries. Privacy concerns could cause visitors to resist providing the personal data necessary to allow our customers to use our software products most effectively. More importantly, even the perception of privacy concerns, whether or not valid, may indirectly inhibit market acceptance of our products. In addition, legislative or regulatory requirements may heighten these concerns if businesses must notify Web site users that the data captured after visiting certain Web sites may be used by marketing entities to unilaterally direct product promotion and advertising to that user. If consumer privacy concerns are not adequately resolved, our business could be harmed. Government regulation that limits our customers’ use of this information could reduce the demand for our products. A number of jurisdictions have adopted, or are considering adopting, laws that restrict the use of customer information from Internet applications. The European Union has required that its member states adopt legislation that imposes restrictions on the collection and use of personal data, and that limits the transfer additional positionsof personally identifiable data to countries that do not impose equivalent restrictions. In the United States, the Children’s Online Privacy Protection Act was enacted in October 1998. This legislation directs the Federal Trade Commission to regulate the collection of data from children on commercial websites. In addition, the Federal Trade Commission has investigated the privacy practices of businesses that collect information on the Internet. These and other privacy-related initiatives could reduce demand for some of the Internet applications with which our products operate, and could restrict the use of these development partnersproducts in future quarters of 2003.some e-commerce applications. This could, in turn, reduce demand for these products.

ITEM 1B. UNRESOLVED STAFF COMMENTS.

Not applicable.

ITEM 2. PROPERTIESPROPERTIES.

Our corporate officesheadquarters are located in Menlo Park, California, where we lease approximately 59,00045,000 square feet under two leasesa lease that expireexpires in April 2007. As of December 31, 2002, the annual base rent for these leases totaled approximately $983,000. We also lease approximately 35,000 square feet of space in Manchester, New Hampshire. This lease expires in April 2005, and we have an option to extend the lease for two additional five-year terms. The annual base rent for the New Hampshire lease totals approximately $451,000. We also lease approximately 12,000 square feet of space in Framingham, Massachusetts at an annual base rent of approximately $253,000.  This lease expires in November 2007.

In addition, we lease smaller facilities and offices in several cities throughout the United States and internationally throughout Europe, Australia,in the Netherlands, Japan, Korea, and Korea. The terms of these leases renew semi-annually unless terminated.Hong Kong. We believe thatthe facilities we are now using are adequate and suitable for our office space will be sufficient to meet our needs through at least the next 12 months.business requirements.

We have a total of approximately 79,50039,460 square feet of excess space available for sublease or renegotiation. Locations of theThe excess space includeis located in Menlo Park, California, and Princeton, New Jersey and Marlow in the United Kingdom.Jersey. Remaining lease commitment terms on these leases vary from eightone to ninefive years. We are seeking to sublease or renegotiate the obligations associated with the excess space. We have $10.8 million in accrued restructuring costs as of December 31, 2002, which is our estimate, as of that date, of the exit costs of these excess facilities. However, if we determine that any of these real estate markets continues to deteriorate, additional adjustments to this accrual may be required, which would result in additional restructuring costs in the period in which such determination is made. Likewise, if any of these real estate markets strengthen, and we are able to sublease the properties earlier or at more favorable rates than projected, adjustments to the accrual may be required that would increase income in the period in which such determination is made.

ITEM 3. LEGAL PROCEEDINGS

In April 2001, Office Depot, Inc. filed a complaint against KANA in the Circuit Court for the 15th District of the State of Florida claiming that KANA breached its license agreement with Office Depot. Office Depot is seeking relief in the form of a refund of license fees and maintenance fees paid to KANA, attorneys' fees and costs. We believe we have meritorious defenses to these claims and intend to defend the action vigorously.PROCEEDINGS.

The underwriters for our initial public offering, Goldman Sachs & Co., Lehman Bros, Hambrecht & Quist LLC and Wit Soundview Capital Corp, as well as KANA and certain current and former officers of KANA were named as defendants in federal securities class action lawsuits filed in the United States District Court for the Southern District of New York. The parties have agreed that the claims against the current and former officers of KANA shall be dismissed without prejudice. The cases allege violations of various securities laws by more than 300 issuers of stock, including KANA, and the underwriters of various securities lawsfor such issuers, on behalf of a class of plaintiffs who, in the case of KANA, purchased KANA'sKANA’s stock between September 21, 1999 and December 6, 2000 in connection with our initial public offering. Specifically, the complaints allege that the underwriter defendants engaged in a scheme concerning sales of KANA'sKANA’s and other issuers'issuers’ securities in the initial public offering and in the aftermarket. WeIn July 2003, we decided to join in a settlement negotiated by representatives of a coalition of issuers named as defendants in this action and their insurers. Although we believe that the plaintiffs’ claims have no merit, we have decided to accept the settlement proposal to avoid the cost and distraction of continued litigation. Because the settlement will be funded entirely by KANA’s insurers, we do not believe that the settlement will have any effect on our consolidated financial condition, results of operation or cash flows. The proposed settlement agreement is subject to final approval by the court. Should the court fail to approve the settlement agreement, we believe we have meritorious defenses to these claims and intend to defend the action vigorously.

On April 16, 2002, Davox Corporation (now Concerto Software) filed an action against KANA in the Superior Court, Middlesex, Commonwealth of Massachusetts, asserting breach of contract, breach of implied covenant of good faith and fair dealing, unjust enrichment, misrepresentation, and unfair trade practices, in relation to an OEM Agreement between KANA and Davox under which Davox has paid a total of approximately $1.6 million in fees. Davox seeks actual and punitive damages in an amount to be determined at trial, and award of attorneys' fees. This action is in its early stages and has been re-filed in the Circuit Court of Cook County, Illinois. We believe we have meritorious defenses to these claims and intend to defend the action vigorously.

On February 20, 2003, Tumbleweed Communications Corp. filed suit against our customer Ameritrade, Inc., in the U.S. District Court for the Central District of California, alleging infringement of U.S. Patent No. 6,192,407, and seeking injunctive relief, damages and attorneys fees. KANA has agreed to assume defense of this case on behalf of Ameritrade. We believe we have meritorious defenses to these claims and intend towill defend the action vigorously.

Other third parties have from time to time claimed, and others may claim in the future that we have infringed their past, current or future intellectual property rights. We have in the past been forced to litigate such claims. These claims, whether meritorious or not, could be time-consuming, result in costly litigation, require expensive changes in our methods of doing business or could require us to enter into costly royalty or licensing agreements, if available. As a result, these claims could harm our business.

As of December 31, 2002, approximately $700,000 was accrued as our estimate of costs related to the above legal proceedings. The ultimate outcome of any litigation is uncertain, and either unfavorable or favorable outcomes could have a material negative impact on theour consolidated results fromof operations, consolidated balance sheet and cash flows, due to defense costs, diversion of management resources and other factors.

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

Not applicable.The 2005 Annual Meeting of Stockholders was held on November 17, 2005 at Fenwick & West LLP, located at Silicon Valley Center, 801 California Street, Mountain View, California. Four proposals were voted on at the meeting. The results of each proposal are as follows.

Proposal No. 1 to elect two (2) Class III directors to serve for a three-year term expiring at the 2008 Annual Meeting of Stockholders or until a successor is duly elected and qualified, or until his earlier resignation, death or removal was approved by the stockholders. The nominees received the following votes:

Incumbent Class II directors Jerry Batt, Michael J. Shannahan and William T. Clifford are currently serving for a term expiring at the 2007 Annual Meeting of Stockholders. Incumbent Class I directors Dr. Dixie L. Mills and Stephanie Vinella are currently serving for a term expiring at the 2006 Annual Meeting of Stockholders.

Proposal No. 2 to approve an amendment to the KANA 1999 Stock Incentive Plan to increase the size of automatic stock option grants to our non-employee directors and to update the KANA 1999 Stock Incentive Plan to reflect all prior split adjustments and “evergreen” was approved by the stockholders. This proposal received the following votes:

Proposal No. 3 to to approve an amendment to our Certificate of Incorporation to decrease the number of authorized shares of common stock from 1,000,000,000 to 250,000,000 was approved by the stockholders. This proposal received the following votes:

Proposal No. 4 to ratify the appointment of Deloitte & Touche LLP as our independent registered public accounting firm for the fiscal year ending December 31, 2005 was approved by the stockholders. This proposal received the following votes:

PART II

ITEM 5. MARKET FOR THE REGISTRANT'SREGISTRANT’S COMMON EQUITY, AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

Our common stock is listedcurrently trades on the Nasdaq Stock Market“Pink Sheets” under the symbol "KANA"“KANA.PK”.

Prior to October 17, 2005, our common stock was listed on The followingNASDAQ National Market. Our common stock traded on the “Pink Sheets” as of the beginning of trading on October 17, 2005. The table below sets forth the range of high and low closing sales prices for each period indicated,our common stock as adjustedreported on The NASDAQ National Market and the high and low bid information for our common stock as reported on the “Pink Sheets,” as applicable, for the two-for-one forward stock split effective February 2000, and the one-for-ten reverse stock split effective December 2001:periods indicated:

Holders of Record

There were approximately 1,3901,193 stockholders of record of our common stock as of February 28, 2003. This number does not include stockholders whose shares are held in trust by other entities.May 31, 2006. The actual number of stockholders is greater than this number of record holders, and includes stockholders who are beneficial owners, but whose shares are held in street name by brokers and other nominees. We estimate that theThis number of beneficial ownersholders of record also does not include stockholders whose shares of our common stock as of February 28, 2003 was approximately 55,000.may be held in trust by other entities.

Dividend Policy

We have not paid any cash dividends on our capital stock. We currently intend to retain any earnings to fund the development and growth of our business and, therefore, do not anticipate paying any cash dividends in the foreseeable future. In addition, our existing credit facilities prohibit the payment of cash or stock dividends on our capital stock without the lender'slender’s prior written consent. See Item 7-"Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources."

Recent Unregistered Sales of Equity Securities

The following table provides information about ourIn June 2005, the Company completed a private placement of unregistered salessecurities for the issuance of KANA1,631,541 shares of common stock and warrants to purchase 815,769 shares of common stock for gross proceeds of approximately $2.4 million. In September 2005, the Company completed a private placement of unregistered securities since January 1, 2002:

___________

All sales were made in reliance on Section 4(2)registration deadline of the shares of common stock of the warrants issued to investors from January 27, 2006 to September 30, 2006.

Securities Act and/or Regulation D promulgatedAuthorized for Issuance Under Equity Compensation Plans

Information regarding the securities authorized for issuance under the Securities Act. The securities were sold to a limited numberour equity compensation plans can be found under Item 12 of people with no general solicitation or advertising. The purchasers were sophisticated investors with access to all relevant information necessary to evaluate the investment and who represented to the issuer that the shares were being acquired for investment.Part III of this Annual Report.

ITEM 6. SELECTEED CONSOLIDATEDSELECTED FINANCIAL DATA

The selected consolidated financial data set forth below should be read in conjunction with "Management's“Management’s Discussion and Analysis of Financial Condition and Results of Operations,"” the consolidated financial statements and the related notes included elsewhere in this annual reportAnnual Report on Form 10-K, and in our prior annual and quarterly reports, and other information we have filed with the SEC.Securities and Exchange Commission.

The consolidated statementstatements of operations data for each of the years in the five year period ended December 31, 2005, 2004, 2003, 2002, and 2001, and the consolidated balance sheet data at December 31, 2005, 2004, 2003, 2002, 2001, 2000, 1999 and 19982001 are derived from our audited consolidated financial statements. The diluted net loss per share computation excludes shares of common stock issuable upon exercise or conversion of other securities, including outstanding warrants and options to purchase common stock and common stock subject to repurchase rights, because their effect would be antidilutive. See Note 1 of "Notesthe “Notes to the Consolidated Financial Statements"Statements” included in Item 8 of Part II of this report for a detailed explanation of the determination of the shares used to compute basic and diluted net loss per share. The historicalHistorical results are not necessarily indicative of results to be expected for any future period. See "Management's Discussion and Analysis of Financial Condition and Results of Operations".

                                                                           Year Ended December 31,
                                                            --------------------------------------------------------
                                                              2002        2001        2000        1999       1998
                                                            ---------  ----------  -----------  ---------  ---------
                                                                     (in thousands, except per share amounts)
Consolidated Statement of Operations Data:
Revenues:
 License.................................................. $  41,530  $   37,963  $    75,360  $  10,536  $   2,014
 Service..................................................    37,560      52,632       42,595      2,966        333
                                                            ---------  ----------  -----------  ---------  ---------
 Total revenues...........................................    79,090      90,595      117,955     13,502      2,347
                                                            ---------  ----------  -----------  ---------  ---------
Cost of revenues:
 License..................................................     3,402       2,536        2,856        271         54
 Service..................................................    29,250      51,799       56,082      6,383        666
                                                            ---------  ----------  -----------  ---------  ---------
Total cost of revenues....................................    32,652      54,335       58,938      6,654        720
                                                            ---------  ----------  -----------  ---------  ---------
Gross profit..............................................    46,438      36,260       59,017      6,848      1,627
                                                            ---------  ----------  -----------  ---------  ---------
Operating expenses:
 Sales and marketing......................................    37,423      69,635       88,186     21,199      5,504
 Research and development.................................    25,933      35,558       42,724     12,854      5,669
 General and administrative...............................    13,053      21,215       18,945      5,018      1,826
 Amortization of stock-based compensation.................    16,620      15,880       14,715     80,476      1,456
 Amortization of goodwill and
  identifiable intangibles................................     4,800     127,660      873,022         --         --
 Merger and transition related costs......................        --      13,443        6,564      5,635         --
 Restructuring costs......................................    (5,086)     89,047           --         --
 In process research and development......................        --          --        6,900         --         --
 Goodwill impairment......................................    55,000     603,446    2,084,841         --         --
                                                            ---------  ----------  -----------  ---------  ---------
 Total operating expenses.................................   147,743     975,884    3,135,897    125,182     14,455
                                                            ---------  ----------  -----------  ---------  ---------
Operating loss............................................  (101,305)   (939,624)  (3,076,880)  (118,334)   (12,828)
Impairment of investment..................................        --      (1,000)          --         --         --
Other income (expense), net...............................       913       1,521        4,834       (744)       227
                                                            ---------  ----------  -----------  ---------  ---------
Loss from continuing operations...........................  (100,392) $ (939,103) $(3,072,046) $(119,078) $ (12,601)
Discontinued operation:
 Income (loss) from operations of discontinued operation..        --        (125)       1,173        335         --
 Loss on disposal, including provision of $1.1 million
  for operating losses during phase-out period............       381      (3,667)          --         --         --
Cumulative effect of accounting change related
  to the elimination of negative goodwill.................     3,901          --           --         --         --
                                                            ---------  ----------  -----------  ---------  ---------
         Net loss......................................... $ (96,110)   (942,895)  (3,070,873)  (118,743)   (12,601)
                                                            =========  ==========  ===========  =========  =========
Basic and diluted net loss per share:
  Loss from continuing operations ........................ $   (4.48) $   (68.33) $   (395.83) $  (46.21) $  (20.13)
  Income (loss) from discontinued operation...............      0.02       (0.28)        0.15       0.13         --
  Gain on elimination of negative goodwill................      0.17          --           --         --         --
                                                            ---------  ----------  -----------  ---------  ---------
  Net loss ............................................... $   (4.29) $   (68.61) $   (395.68) $  (46.08) $  (20.13)
                                                            =========  ==========  ===========  =========  =========
Shares used in computing basic and
  diluted net loss per share amounts......................    22,403      13,743        7,761      2,577        626
                                                            =========  ==========  ===========  =========  =========


                                                                                  December 31,
                                                            --------------------------------------------------------
                                                              2002        2001        2000        1999       1998
                                                            ---------  ----------  -----------  ---------  ---------
                                                                                  (in thousands)
Consolidated Balance Sheet Data:
Cash, cash equivalents and
  short-term investments.................................. $  32,498  $   40,130  $    76,499  $  53,217  $  14,035
Working capital...........................................    (4,533)    (13,697)      52,753     38,591     11,833
Total assets..............................................    80,550     160,672      980,124     70,229     16,876
Total long-term debt......................................        --         108          148        412        726
Total stockholders' equity................................ $  21,952  $   66,839  $   899,452  $  48,500  $  12,951

		Year Ended December 31,
		2005				2004				2003				2002				2001
		(in thousands, except per share amounts)
Consolidated Statements of Operations Data:
Revenues:
License fees		$	8,094			$	14,169			$	26,228			$	41,530			$	37,963
Services			35,034				34,731				34,778				37,560				52,632
Total revenues			43,128				48,900				61,006				79,090				90,595
Costs and Expenses:
Cost of license fees			2,995				2,449				3,125				3,402				2,536
Cost of services			8,744				9,488				9,702				29,250				51,799
Amortization of goodwill			—				—				—				—				122,860
Amortization of acquired intangible assets			133				119				1,453				4,800				4,800
Sales and marketing			17,673				25,099				29,189				37,423				69,635
Research and development			13,230				19,497				21,437				25,933				35,558
General and administrative			11,379				8,137				9,073				13,053				21,215
Stock-based compensation (1)			38				1,231				5,870				16,620				15,880
Merger and transition related costs			—				—				—				—				13,443
Impairment of internal-use software			6,326				1,062				—				—				—
Restructuring costs			468				3,400				1,704				(5,086	)			89,047
Goodwill impairment			—				—				—				55,000				603,446
Total costs and expenses			60,986				70,482				81,553				180,395				1,030,219
Loss from operations			(17,858	)			(21,582	)			(20,547	)			(101,305	)			(939,624	)
Impairment of investment			—				—				(500	)			—				(1,000	)
Interest and other income (expense), net			88				128				186				913				1,521
Loss from continuing operations before income taxes			(17,770	)			(21,454	)			(20,861	)			(100,392	)			(939,103	)
Income tax expense			(196	)			(314	)			(318	)			—				—
Loss from continuing operations			(17,966	)			(21,768	)			(21,179	)			(100,392	)			(939,103	)
Discontinued operation:
Loss from operations of discontinued operation			—				—				—				—				(125	)
Gain (loss) on disposal, including provision of $1.1 million for operating losses during phase-out period			—				—				—				381				(3,667	)
Cumulative effect of accounting change related to the elimination of negative goodwill			—				—				—				3,901				—
Net loss		$	(17,966	)		$	(21,768	)		$	(21,179	)		$	(96,110	)		$	(942,895	)
Basic and diluted net loss per share:
Loss from continuing operations		$	(0.58	)		$	(0.75	)		$	(0.88	)		$	(4.48	)		$	(68.33	)
Income (loss) from discontinued operation			—				—				—				0.02				(0.28	)
Gain on elimination of negative goodwill			—				—				—				0.17				—
Net loss		$	(0.58	)		$	(0.75	)		$	(0.88	)		$	(4.29	)		$	(68.61	)
Shares used in computing basic and diluted net loss per share			30,814				28,950				24,031				22,403				13,743
		December 31,
		2005				2004				2003				2002				2001
		(in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents		$	6,216			$	13,772			$	16,282			$	19,112			$	25,476
Marketable securities			—				6,361				16,674				13,386				14,654
Working capital (deficit)			(18,439	)			(9,657	)			4,168				(4,533	)			(13,697	)
Total assets			35,706				50,361				69,878				80,550				160,672
Total long-term debt			—				—				—				—				108
Total stockholders’ equity (deficit)		$	(9,794	)		$	3,164			$	21,532			$	21,952			$	66,839

ITEM 7. MANAGEMENT'SMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS

The following discussion of our financial condition and results of operations and other parts ofIn addition to historical information, this report contain forward lookingcontains forward-looking statements thatwithin the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The forward-looking statements are not historical facts but rather are based on current expectations, estimates and projections about our business and industry, and our beliefs and assumptions. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates"“anticipate,” “believe,” “estimate,” “expects,” “intend,” “plan,” “will” and variations of these words and similar expressions identify forward lookingforward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, many of which are beyond our control, are difficult to predict and could cause actual results to differ materially fromfrom” those expressed or forecasted in the forward lookingforward-looking statements. These risks and uncertainties include, but are not limited to, those described in "Risk Factors"Item 1A “Risk Factors” and elsewhere in this report. Forward lookingForward-looking statements that wewere believed to be true at the time we made them may ultimately prove to be incorrect or false. ReadersWe undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on forward looking statements, which reflect our view only as of the date of this report. Except as required by law, we undertake no obligation to update any forward looking statement, whether assuch forward-looking statements.

Overview

KANA is a result of new information, future events or otherwise.

OVERVIEW

We are a leading provider of enterprise Customer Relationship Management (eCRM) software solutions. These enterpriseworld leader in multi-channel customer support and communications applications are built on a Web-architected platform incorporating our KANA eCRM architecture, which provides users with full access to the applications using a standard Web browser and without requiring them to install additional software on their individual computers.service. Our software helps our customers provide external-facing customer support, and to better service, market to, and understand their customers and partners, while improving results and decreasing costs in contact centers and marketing departments. We offer optimized versions of our software for several specific industries including healthcare, financial services, high technology manufacturing, and telecommunications, among others. Our KANA iCARE (Intelligent Customer Acquisition and Retention for the Enterprise) application suite combines our KANA eCRM architecture with customer- focused service, marketing and commerce software applications. These applications enable organizations to improve the quality and efficiency of interactions with customers and partners across multiple communication points. KANA’s integrated solutions allow companies to deliver consistent, managed service across all channels, including email, chat, call centers and Web self-service, so customers have the freedom to choose the service they want, how and when they want it. As a result, our target market is comprised of large enterprises with high volumes of customer interactions, such as banks, telecommunications companies, high-tech manufacturers, healthcare organizations, and partner relationships by allowing them to interact withgovernment agencies.

Our revenue is primarily derived from the company over the communication channels they prefer, whether by Web contact, e-mail or telephone.

On June 29, 2001, we completed a merger with Broadbase. This transaction was accounted for using the purchase method of accounting. The purchase price approximated $101.4 million.

In December 2001, our our stockholders approved a one-for-ten reverse stock split of the common stock for stockholders of record on December 13, 2001. All share and per share amounts have been retroactively restated to reflect the effect of this stock split.

In 1999, we initiated our KANA Online business. Our KANA Online business provided a hosted environmentsale of our software and related maintenance and support of the software. To a lesser extent, we derive revenues from consulting and training. Our products are generally installed by our customers using a systems integrator, such as IBM, Accenture, BearingPoint or HCL Technologies. To a large degree, we rely on our relationship with IBM to customers. Our servers for this business were maintainedrecommend and install our software. This provides leverage in the selling phase, and also allows us to realize higher gross margins by a third-party service provider.selling primarily software licenses and support, which typically have higher margins than consulting and implementation services. In the secondpast, KANA supplied specialists (subject matter experts) to work with IBM and other systems integrators. While KANA continues this practice, KANA has recently seen an increase in providing consulting and implementation services directly. These services may be provided to our existing customers who would like KANA to review their implementations or to new customers who are not quite large enough to gain the interest of a large system integrator to provide services to the KANA customer. However, in the case of most of the initial installations of our premise based applications that are generally installed by our customers using a system integrator, these services generally increase the cost of the project substantially, subjecting their purchase to more levels of required approval and scrutiny of projected cost savings in their customer service and marketing departments. Consequently, we face difficulty predicting the quarter in which sales to expected customers will occur, if at all, which contributes to the uncertainty of our future operating results. To the extent that significant sales occur earlier or later than anticipated, revenues for subsequent quarters may be lower or higher, respectively, than expected.

In the first quarter of 2001,2005, we adoptedreduced our cost structure through the reduction of outsourced product development, a planreduction in amortization related to discontinue the KANA Online business.discontinuance of certain internal-use software, reduced headcount, and other cost reduction programs. In late 2005, we made a decision to back shore virtually all product development, i.e. we are in the secondprocess of bringing core technology development to the United States. We will also be back shoring our Technical Support. We anticipate that these adjustments and others will reduce our total cost of licenses, cost of services, sales, marketing, research and development, and general and administrative expenses into the first quarter of 2002, all2006. After that time, we will strive to match our spending with the anticipated revenue but, given the unpredictability of our license revenue, we are unable to predict when KANA Online operations ceased. We have accounted for our KANA Online business as a discontinued operation.will be profitable, if at all.

Since 1997 we have incurred substantial costs to develop our products and to recruit, train and compensate personnel for our engineering, sales, marketing, client services, and administration departments. As a result, we have incurred substantial losses since inception. For the twelve months endedOn December 31, 2002, we incurred a net loss2005, the Company had ending cash, cash equivalents, and short term investments of $96.1 million. Included$6.2 million and borrowings outstanding under our line of credit of $7.4 million expiring in the net loss is $55.0 million related to the impairment of goodwill in 2002.November 2006. As of December 31, 2002, we2005, the Company had an accumulated deficit of $4.2$4.3 billion which includes approximately $2.7 billion relatedand a negative working capital of $18.4 million. Losses from operations were $17.9 million and $21.6 million for 2005 and 2004, respectively. Net cash used for operating activities was $16.3 million and $13.1 million in 2005 and 2004, respectively. These conditions, among others, raise substantial doubt about the Company’s ability to goodwill impairment charges. We expect to decrease our operating losses in 2003continue as a going concern. The condensed consolidated financial statements do not reflect any adjustments that might be required as a result of our restructuring activities in 2001, as well as ongoing personnelthis uncertainty.

We continue to take steps to lower the expenses related to cost of revenues, sales and facility cost reductions throughout 2002. We expect our cashmarketing, research and cash equivalentsdevelopment, and short-term investmentsgeneral and administrative areas of the Company. KANA successfully closed two private sales of KANA common stock, approximately $2.4 million on handJune 30, 2005 and approximately $4.0 million on September 29, 2005. Management believes that based on its current plans, its existing funds will be sufficient to meet ourthe Company’s working capital and capital expenditure needsrequirements through December 31, 2006. However, if we experience lower than anticipated demand for the next 12 months.our products, we will need to further reduce costs, issue equity securities or borrow money to meet our cash requirements. Any such equity issuances could be dilutive to our stockholders, and any financing transactions may be on unfavorable terms.

As of December 31, 2002,2005, we had 365125 full-time employees, which isrepresents a decrease from 409181 employees at December 31, 2001. The2004 and a decrease during 2002 was based primarily upon attrition. We restructured our organization throughout 2001, with net workforce reductionsfrom 211 employees at December 31, 2003. As of approximately 772 employees, in order to streamline operations, eliminate redundant positions after the merger with Broadbase, reduce costsMay 31, 2006, we had 130 permanent full-time employees.

Critical Accounting Policies and bring our staffing and structure in line with industry standards and current economic conditions. These reductions have been significant, particularly in light of the addition of approximately 896 employees upon our merger with Broadbase in June of 2001.

CRITICAL ACCOUNTING POLICIES AND ESTIMATESEstimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.America (“GAAP”). The preparation of these consolidated financial statements requires us to make estimates and judgmentsassumptions about future events that affect ourthe amounts reported assets, liabilities, revenuesin the financial statements and expenses, and our related disclosure of contingent assets and liabilities. We continually evaluate our estimates, including those related to revenue recognition, collectibility of receivables, goodwill and intangible assets, contract loss reserve, income taxes, and restructuring.accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. This forms the basis of judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. ActualIn some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results maycould differ materially from these estimates under different assumptions or conditions.our estimates.

We believe the following discussion addresses the Company’s most critical accounting policies, andwhich are those that are most important to the related judgmentsportrayal of the Company’s financial condition and estimates significantly affect the preparation of our consolidated financial statements:

Revenue Recognition. In addition to determining our results of operations and require management’s most difficult, subjective and complex judgments. In addition, please refer to Note 1 of the Notes to the Consolidated Financial Statements for a given period, our revenue recognition determines the timing of certain expenses, such as commissions and royalties. Revenue recognition rules for software companies are complex, and various judgments affect the applicationfurther description of our revenue policy. accounting policies.

Revenue Recognition.

The amount and timingCompany recognizes revenues in accordance with the American Institute of our revenue is difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantlyCertified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2,Software Revenue Recognition, as amended.

Revenue from quarter to quarter and could result in future operating losses.

License revenuesoftware license agreements is recognized when there isthe basic criteria of software revenue recognition have been met (i.e. persuasive evidence of an arrangement,agreement exists, delivery to the customer has occurred, provided the arrangement does not require significant customization of the software,product has occurred, the fee is fixed or determinable, and collectibilitycollection is reasonably assured.

In software arrangements that include rights to multiple software products and/or services, we allocate the total arrangement fee among each of the deliverables usingprobable). The Company uses the residual method under whichdescribed in AICPA SOP 98-9,Modification of SOP 97-2 With Respect to Certain Transactions (“SOP 98-9”) to recognize revenue is allocatedwhen a license agreement includes one or more elements to undelivered elements based onbe delivered at a future date and vendor-specific objective evidence of the fair value of suchall undelivered elements withexists. Under the residual amountsmethod, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as license revenue. If evidence of the fair value of one or more undelivered elements does not exist, all revenue being allocatedis deferred and recognized when delivery of those elements occurs or when fair value can be established.

When licenses are sold together with consulting services, license fees are recognized upon delivery, provided that (1) the basic criteria of software revenue recognition have been met, (2) payment of the license fees is not dependent upon the performance of the consulting services, and (3) the consulting services do not provide significant customization of the software products and are not essential to the delivered elements. Elements includedfunctionality of the software that was delivered. The Company does not provide significant customization of its software products.

Revenue arrangements with extended payment terms are generally considered not to be fixed or determinable and, the Company generally does not recognize revenue on these arrangements until the customer payments become due and all other revenue recognition criteria have been met.

Probability of collection is based upon assessment of the customer’s financial condition through review of their current financial statements or publicly-available credit reports. For sales to existing customers, prior payment history is also considered in multiple element arrangements primarily consistassessing probability of software products, maintenance (which includescollection. The Company is required to exercise significant judgment in deciding whether collectibility is reasonably assured, and such judgments may materially affect the timing of our revenues and our results of operations.

Services revenues include revenues for consulting services, customer support and training. Consulting services revenues and the related cost of services are generally recognized on a time and materials basis. KANA’s consulting arrangements do not include significant customization of the software. Customer support agreements provide technical support and the right to unspecified upgrades), or consulting services. future upgrades on an if-and-when available basis. Customer support revenues are recognized ratably over the term of the support period (generally one year). Training services revenues are recognized as the related training services are delivered. The unrecognized portion of amounts billed in advance of delivery for services is recorded as deferred revenues.

Vendor-specific objective evidence for software productsconsulting and consultingtraining services isare based on the price charged when an element is sold separately or, in the case of an element not yet sold separately, the price established by authorized management, if it is probable that the price, once established, will not change before market introduction. Vendor-specific objective evidence for maintenance services is generally based uponon the price charged when an element is sold separately or the stated contractual renewal rates. Evaluating whether sufficient and appropriate vendor-specific objective evidence exists to use in allocating revenue to undelivered elements, and the interpretation of such evidence to determine the fair value of undelivered elements is subject to judgment and estimates that affect when and to what extent we may recognize revenues from a given contractual arrangement.

Probability of collection is based upon assessment of the customer's financial condition through review of their current financial statements or credit reports. For sales to existing customers, prior payment history is also considered in assessing probability of collection. We are required to exercise significant judgment in deciding whether collectibility is reasonably assured, and such judgments may materially affect the timing of our revenues and our results of operations.

Revenues from customer support services are recognized ratably over the term of the contract, typically one year. Consulting revenues are primarily related to implementation services performed on a time-and-materials basis or, in certain situations, on a fixed-fee basis, under separate service arrangements. Implementation services are performed under fixed-fee arrangements and are generally recognized on a percentage-of-completion basis. When acceptance is not assured or an ability to reliably estimate costs is not possible, we use the completed contract method, whereby revenues are deferred until all contractual obligations are met, and acceptance, if required in the contract, is received. Revenues from consulting and training services are recognized as services are performed.

Collectibility of Receivables. In order to recognize revenue from a transaction, collectibility must be determined by management to be reasonably assured. If collectibility is not determined to be reasonably assured, amounts billed to customers are recorded as deferred revenue. For sales to existing customers, prior payment history is a factor in assessing probability of collection.

We make judgments as to our ability to collect outstanding receivables and provide allowances for receivables that may not be collectible. A considerable amount of judgment is required to assess the ultimate realization of receivables. In assessing collectibility, we consider the age of the receivable, our historical collection experience, current economic trends, and the current credit-worthiness of each customer. In the future, additional provisions for doubtful accounts may be needed and the future results of operations could be materially affected.

Reserve for Loss Contract. We were party to a contract with a customer that provided for fixed fee payments in exchange for services upon meeting certain milestone criteria. In order to assess whether a loss reserve was necessary, we estimated the total expected costs of providing services necessary to complete the contract and compared these costs to the fees expected to be received under the contract. Based on analysis we performed in the fourth quarter of 2000, we expected the costs to complete the project to exceed the associated fees, and accordingly we recorded a loss reserve of $1.4 million in the quarter ended December 31, 2000. As a result of our restructuring in the third quarter of 2001, substantially all of the remaining professional services required under the contract were being provided by a third party, and we recorded an additional loss reserve of $6.1 million in the quarter ended September 30, 2001, based upon an analysis of costs to complete these services. In the second quarter of 2002, we began discussions with the customer regarding the timing and scope of the project deliverables, which led to an amendment to the original contract in August 2002. Based on the amendment and associated negotiations with a third-party integrator that had been providing implementation services to the customer, we recorded a charge of approximately $15.6 million to cost of services revenue in the second quarter of 2002 and in accordance with the terms of the amendment were relieved from providing any further implementation services under the contract. The amendment required us to transfer $6.9 million to an escrow account (which included $5.8 million previously reported as restricted cash) to compensate any third party integrator for the continued implementation of the customer's system. The charge also included $8.5 million of fees which we had paid the third party integrator prior to the amendment and approximately $200,000 of related expenditures. Contract

During the second quarter of 2002, we received a scheduled payment of $4.0 million associated with the original agreement which isthat we reported as deferred revenue.revenue, which was associated with an agreement to settle a loss contract. The $4.0 million will beis recognized in future periods as revenue as we fulfill our maintenancesupport and training obligations. As of December 31, 2005, we had recognized $3.8 million of the $4.0 million as revenue, and $175,000 remained in deferred revenue that relates to support to be recognized ratably through the first quarter of 2006. $880,000 of the $4.0 million was related to training and was recognized in the third quarter of 2005 when the training credits expired.

Accounting for Internal-Use Software. Software

Internal-use software costs, including fees paid to third parties to implement the software, are capitalized beginning when we have determined various factors are present, including among others, that technology exists to achieve the performance requirements, we have made a decision as to whether we will purchase the software or develop it internally, and we have authorized funding for the project. Capitalization of software costs ceases when the software implementation is substantially complete and is ready for its intended use, and the capitalized costs are amortized over the software'ssoftware’s estimated useful life (generally five years) using the straight-line method. As of December 31, 2002,2005, we had $15.1 million$561,000 of capitalized costs offor internal use software, net of which $14.4 million has been subject to depreciation based upon deployment dates of the related projects. The remainder was attributable to software that we deployed in January 2003, at which time we began depreciating the associated capitalized costs.$411,000 accumulated amortization.

When events or circumstances indicate the carrying value of internal use software might not be recoverable, we assess the recoverability of these assets by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating cash flows. The amount of impairment, if any, is recognized to the extent that the carrying value exceeds the projected discounted future operating cash flows and is recognized as a write down of the asset. In addition, if it is no longer probable that computer software being developed will be placed in service, the asset will be adjusted to the lower of its carrying value or fair value, if any, less direct selling costs. Any such adjustment would result in an expense in the period recorded, which could have a material adverse effect on our consolidated statement of operations. Based on our assessment as ofIn the fourth quarter ended December 31, 2002,2004, the Company’s Information Technology department reviewed its operations and technology requirements, and decided to discontinue its use of certain internal use software, which resulted in a non-cash impairment charge of $1.1 million. Additionally, during the quarter ended March 31, 2005 we determined that no such impairmentdecided to discontinue the use of certain other internal-use software, existed.which resulted in an additional $6.3 million impairment expense.

Restructuring.

Restructuring

During 2001, we recorded significant reservesliabilities in connection with our restructuring program. These reserves included estimates pertaining to contractual obligations related to excess leased facilities in Menlo Park, California, Princeton, New Jersey and Marlow in the United Kingdom. Remaining lease commitments terminate over various dates beginning in April 2007 through January 2011. We are seeking to sublease or renegotiate the obligations associated with the excess space. We had $7.6 million in accrued restructuring costs as of December 31, 2005, which was our estimate, as of that date, of the exit costs of these excess facilities. We have worked with external real estate advisorsbrokers in each of the markets where the properties are located to help us estimate the amount of the accrual. This process involves significant judgments regarding these markets. If thewe determine that any of these real estate market continues to worsen,markets has deteriorated further, additional adjustments to the reservethis accrual may be required, which would result in additional restructuring expenses in the period in which such determination is made. Likewise, if theany of these real estate market strengthens,markets strengthen, and we are able to sublease the properties earlier or at more favorable rates than projected, or if we are otherwise able to negotiate early termination of obligations on favorable terms, adjustments to the reserveaccrual may be required that would increase income in the period in which such determination is made. As of December 31, 2005, our estimate of accrued restructuring cost included an assumption that we would receive $2.0 million in sublease payments that are not yet subject to any contractual arrangement and for which, in most cases, a potential sublessee has not been identified. We have assumed that the majority of these sublease payments will begin in 2007 and continue through the end of the related leases.

In NovemberDecember 2005, the Company consolidated its research and development operations into one location in Menlo Park, California to optimize the Company’s research and development processes and decrease overall operating expenses. As a result, the Company terminated the employment of 2002,15 employees based in New Hampshire. As a result of this consolidation, the Company incurred a restructuring charge of $282,000 related to employee termination costs. Additionally, we entered into an amendmentrecorded a $186,000 restructuring charge during 2005 related to a facility lease. In connection with this lease amendment, ourchange in evaluation of the real estate market conditions relating to this and other excess leased facilities, and discussions with our other landlords, we reduced our associated restructuring reserve by approximately $9.1 million. This reduction was primarily comprised of a $4.0 million payment made in connection with the amendment, as well as approximately $5.1 million in restructuring cost savings resulting from this amendment that were reflected as a reduction in the restructuring reserveUnited Kingdom, a change in the sublease estimates in the United States and the consolidation of our operating results for the quarter ended December 31, 2002.research and development operations in Menlo Park, California.

Goodwill and Intangible Assets. Consideration paid in connection with acquisitions is required to be allocated to the acquired assets, including identifiable intangible assets, and liabilities acquired. Acquired assets and liabilities are recorded based on our estimate of fair value, which requires significant judgment with respect to future cash flows and discount rates. For intangible assets other than goodwill, we are required to estimate the useful life of the asset and recognize its cost as an expense over the useful life. We use the straight-line method to expense long-lived assets, which results in an equal amount of expense in each period. Amortization of goodwill ceased as of January 1, 2002 upon our adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ("SFAS 142"). Instead, we are now required to test goodwill for impairment under certain circumstances and write down goodwill when it is impaired. We have determined that the consolidated results of KANA comprise one reporting unit for the purpose of impairment testing throughout 2002.

We regularly evaluate acquired businesses forall potential indicators of impairment of goodwill and intangible assets.assets, but at a minimum, test goodwill and intangible assets for impairment on an annual basis. Our judgments regarding the existence of impairment indicators are based on market conditions and operational performance of our acquired businesses and identification of reporting units.performance. Future events could cause us to conclude that impairment indicators exist and that goodwill and other intangible assets associated with our acquired businesses are impaired.

Under the transition provisions of SFAS No. 142, there was no goodwill impairment at January 1, 2002 based upon our analysis completed at that time. However, during the quarter ended June 30, 2002, circumstances developed that indicated the goodwill was likely impaired and we performed an impairment analysis as of June 30, 2002. This analysis resulted in a $55.0 million impairment expense to reduce goodwill. The circumstances that led to the impairment included the lower-than-previously-expected revenues and net loss for the second quarter of 2002 and the revision of estimates of our revenues and net loss for subsequent quarters, based upon financial results for the second quarter of 2002 and the reduction of estimated revenue and cash flows in future quarters. We used relevant market data, including KANA's market capitalization during the period following the announcement of preliminary results for the second quarter of 2002, to calculate an estimated fair value and the resulting goodwill impairment. The estimated fair value was compared to the corresponding carrying value of goodwill at June 30, 2002, which resulted in a revaluation of goodwill as of June 30, 2002. The remaining amount of goodwill as of December 31, 2002 was $7.42005 is $8.6 million. We continue to assess whether any potential indicators of impairment of goodwill have occurred and have determined that no such indicators have arisen since June 30, 2005, the date of our annual goodwill impairment test. Any further impairment loss could have a material adverse impact on our financial condition and results of operations.

Income Taxes. Taxes

We estimate our income taxes in each of the jurisdictions in which we operate as part of the process of preparing our consolidated financial statements. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue,net operating loss carryforwards, and stock-based compensation, for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We then assess the likelihood that our net deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not more likely than not, we establish a valuation allowance. We concluded that a full valuation allowance was required for all periods presented. While we have considered future taxable income in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the valuation allowancedeferred tax asset would be made, increasing our income in the period in which such determination was made.

Pursuant to the Internal Revenue Code, the amounts of and benefits from net operating loss carryforwards may be impaired or limited in certain circumstances. Events which cause limitations in the amount of net operating losses that we may utilize include, but are not limited to, a cumulative change of more than 50% ownership of the company, as defined, over a three year period. The portion of the net operating loss and tax credit carryforwards subject to potential expiration has not been included in deferred tax assets.

Contingencies and Litigation. Litigation

We are subject to lawsuits and other claims and proceedings. We assess the likelihood of any adverse judgments or outcomes to these matters as well as ranges of probable losses. A determination of the amount of loss contingency required, if any, for these matters are made after careful analysis of each individual matter. The required loss contingencies may change in the future as the facts and circumstances of each matter changes.

QUARTERLY RESULTS OF OPERATIONSStock Based Compensation

Through December 31, 2005, we have accounted for our stock-based compensation arrangements with employees using the intrinsic-value method in accordance with Accounting Principles Board (“APB”) Opinion No. 25,Accounting for Stock Issued to Employees. Deferred stock-based compensation is recorded on the date of grant when the deemed fair value of the underlying common stock exceeds the exercise price for stock options or the purchase price for the shares of common stock. However, we have adopted the disclosure requirements of SFAS No. 148,Accounting for Stock-Based Compensation, Transition and Disclosure, and disclose in our consolidated financial statement footnotes what the net loss and net loss per share would have been adjusted to if we accounted for options using the fair-value method under SFAS No. 123,Accounting for Stock-Based Compensation.

The preparation of the financial statement footnotes requires us to estimate the fair value of stock options granted to employees. While fair value may be readily determinable for awards of stock, market quotes are not available for long-term, nontransferable stock options because these instruments are not traded. We currently use the Black-Scholes valuation model to estimate the fair value of employee stock options. However, the Black-Scholes valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions, including but not limited to stock price volatility. Because our stock options have characteristics significantly different from those of traded options and changes to the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, existing models do not provide a reliable single measure of the fair value of our employee stock options. We are currently evaluating our option valuation methodologies and assumptions in light of evolving accounting standards related to employee stock options. See Recent Accounting Pronouncements below.

Effect of Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004) (“SFAS 123R”),Share Based Payment, which replaces SFAS No. 123,Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25,Accounting for Stock Issued to Employees (“APB 25”). SFAS 123R requires compensation costs relating to share-based payment transactions be recognized in financial statements. The pro forma disclosure previously permitted under SFAS 123 will no longer be an acceptable alternative to recognition of expenses in the financial statements. SFAS 123R became effective for the Company on January 1, 2006. Through December 31, 2005, the Company has reported compensation costs related to share-based payments under APB 25, as allowed by SFAS 123, and provides disclosure in the notes to financial statements as required by SFAS 123. We are currently evaluating the requirements of SFAS 123R and we expect that the adoption of SFAS 123R will have a material impact on our consolidated results of operations and net loss per share. However, the impact of adoption of SFAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. It is likely that we will adopt the modified prospective application method and the Black Scholes valuation model to determine the fair value of our stock as provided by the provisions of SFAS 123R.

In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107. In accordance with this Bulletin, effective January 1, 2006 we will no longer present stock-based compensation separately on our statements of operations. Instead we will present stock-based compensation in the same lines as cash compensation paid to the same individuals.

In November 2005, the FASB issued FASB Staff Position (FSP) Nos. FAS 115-1 and FAS 124-1,The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. FSP Nos. FAS 115-1 and FAS 124-1 amend SFAS No. 115,Accounting for Certain Investments in Debt and Equity Securities,SFAS No. 124,Accounting for Certain Investments Held by Not-for-Profit Organizations,as well as APB Opinion No. 18,The Equity Method of Accounting for Investments in Common Stock. This guidance nullifies certain requirements of EITF 03-1,The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. FSP Nos. FAS 115-1 and FAS 124-1 include guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. FSP Nos. FAS 115-1 and FAS 124-1 also require an other-than-temporary impaired debt securities to be written down to its impaired value, which becomes the new cost basis. FSP Nos. FAS 115-1 and FAS 124-1 are effective for fiscal years beginning after December 15, 2005. We do not believe that adoption of FSP Nos. FAS 115-1 and FAS 124-1 on January 1, 2006 will have a material effect on our financial position, cash flows or results of operations.

Results of Operations

The following table sets forth selected data for the periods presented. Percentages are expressed as a percentage of total revenues.

Comparison of the Years Ended December 31, 2005 and 2004

Revenues

Total revenues decreased by 12% to $43.1 million for the year ended December 31, 2005 from $48.9 million for the year ended December 31, 2004, primarily as a result of fewer license transactions in 2005 than in 2004. We believe the decrease in 2005 was due to many factors including competitive pressures, greater-than-anticipated delays in completing expected license transactions through systems integrators, and a slow recovery in the information technology spending environment.

License revenues include licensing fees only, and exclude associated maintenance and consulting revenue. The majority of our licenses to customers are perpetual and associated revenues are recognized upon shipment provided that all revenue recognition criteria are met as discussed in “Revenue Recognition” under “Critical Accounting Policies” above. License revenues decreased by 43% to $8.1 million for 2005 from $14.2 million for 2004. This decrease in license revenue was primarily due to a decrease in the average selling price of license transactions due to competitive pricing pressures, as well as a decrease in the number of license transactions closed during the year. We expect our average selling price to continue to fluctuate in future quarters given the relatively low number of new transactions that comprise the majority of our license revenue recognized per quarter. The market for our products is unpredictable and intensely competitive, and the economic environment over the last few years has had an effect on corporate purchasing, which has adversely affected sales of our products.

Our service revenues consist of support revenues and professional services fees. Support revenues relate to providing customer support, product maintenance and updates to our customers (including when-and-if-available upgrades). Professional services revenues relate to providing consulting, training and, to a lesser extent, implementation services to our customers. Service revenues remained flat at $35.0 million for the year ended December 31, 2005 compared to $34.7 million for 2004. The consistency in service revenue amount was in line with expectations since the relatively small percentage of support renewal cancellations is typically more than offset by new maintenance contracts associated with new license transactions. Support revenues are the largest component of service revenues, and in 2005, were relatively consistent with our 2004 support revenues, at $29.8 million in 2005 versus $31.0 million in 2004. The drop in sales of new licenses in 2005 affected service revenues less than license revenues because the majority of our maintenance revenues relate to ongoing maintenance contracts with existing customers. We expect that service revenues in 2006 will be fairly consistent with those from 2005 in absolute dollars.

Revenues from international sales were $13.1 million, or 30% of total revenues, in the year ended December 31, 2005 and $17.2 million, or 35% of total revenues, in the year ended December 31, 2004. Our international revenues were derived from sales in Europe and Asia Pacific.

Costs and Expenses

Total cost of revenues decreased by 2% to $11.9 million for the year ended December 31, 2005 from $12.0 million for the year ended December 31, 2004.

License Fees. Cost of license fees consists of third party software royalties, costs of product packaging, documentation, and production and delivery costs for shipments to customers. Cost of license fees as a percentage of license revenue for 2005 was 37% compared to 17% in 2004. The increase was due to royalty costs associated with a relatively higher proportion of non-revenue-related shipments, such as upgrades and updates during 2005, as well as a decrease in license fees.

Services. Cost of services consists primarily of salaries and related expenses for our customer support, consulting, and training services organization, and allocation of facility costs and system costs incurred in providing customer support. Cost of services decreased to 25% of service revenues, or $8.7 million, for 2005 compared to 27% of service revenues, or $9.5 million, for 2004. Both totals exclude amortization of stock-based compensation of $2,000 and $346,000 for periods ended December 31, 2005 and 2004, respectively. The consistency in service margins in 2005 compared to 2004 was due to consistency in our strategy and professional service staffing levels throughout 2005 and 2004.

Amortization of Acquired Intangible Assets.The amortization of acquired intangible assets recorded in 2005 and 2004 related to $400,000 of intangible assets recorded in connection with the acquisition of Hipbone, Inc. in February 2004. Amortization totaled $133,000 and $119,000 for the years ended December 31, 2005 and 2004, respectively.

Sales and Marketing. Sales and marketing expenses consist primarily of compensation and related costs for sales and marketing personnel and promotional expenditures, including public relations, advertising, trade shows and marketing materials. Sales and marketing expenses decreased by 30% to $17.7 million for the year ended December 31, 2005 from $25.1 million for the year ended December 31, 2004. This decrease was partly attributable to reductions in sales and marketing personnel during 2005, from 70 positions at December 31, 2004 to 41 positions at December 31, 2005 and a reduction in information technology support.

Research and Development. Research and development expenses consist primarily of compensation and related costs for research and development employees and contractors and enhancement of existing products and quality assurance activities. Research and development expenses decreased by 32% to $13.2 million for the year ended December 31, 2005 from $19.5 million for the year ended December 31, 2004. This decrease was partly attributable to a reduction in research and development personnel during 2005 by 12%, from 34 at December 31, 2004 to 30 at December 31, 2005 and a reduction in information technology support. The decrease can also be attributed to lower outsourcing expenses paid to our development partners with staffing in India and China.

General and Administrative. General and administrative expenses consist primarily of compensation and related costs for finance, legal, human resources, corporate governance, and bad debt expense. Information technology and facilities costs are allocated among all operating departments. General and administrative expenses increased by 40% to $11.4 million for the year ended December 31, 2005 from $8.1 million for the year ended December 31, 2004. This increase was primarily attributable to an increase in professional services and other general and administrative expenses for the year ended December 31, 2005, partially offset by a reduction of general and administrative personnel during 2005 by 16%, from 25 at December 31, 2004 to 21 at December 31, 2005.

Stock-Based Compensation. We amortize employee-related deferred stock-based compensation on an accelerated basis by charges to operations over the vesting period of the options, consistent with the method described in FASB Interpretations No. 28. Amortization of stock-based compensation was $38,000 and $1.2 million for the years ended December 31, 2005 and 2004, respectively. In 2005 and 2004, there were no options granted with an exercise price below the fair value of the option shares on the grant date.

As of December 31, 2005, no unearned deferred stock-based compensation remained to be amortized. The amortization of stock-based compensation for 2005 and 2004, by operating expense, is detailed as follows (in thousands):

Impairment of Internal Use Software. In the fourth quarter ended December 31, 2004, the Company’s IT department reviewed its operations and technology requirements, and decided to discontinue its use of certain internal use software. As a result, a material charge for impairment was required under SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets. The capitalized cost of this internal-use software included capitalized fees paid to third parties to implement the software. The total non-cash impairment charge related to this software was $1.1 million in the fourth quarter of 2004.

In the first quarter ended March 31, 2005, the Company reviewed all continuing operating expenses across the entire Company, including our technology requirements. One result of this review was a decision to discontinue the use of certain internal use software. The total non-cash impairment charge related to this software was $6.3 million in the first quarter of 2005.

Restructuring Costs.During the preparation of the Company’s consolidated financial statements for the three months ended March 31, 2005, the Company discovered that errors had been made in the fourth quarter 2004 revaluation of the restructuring accrual calculation for unoccupied leased facilities. The Company increased the first quarter 2005 restructuring accrual by $938,000 to adjust for these errors. The Company believes that these errors are not material to the financial statements for 2004 or 2005.

In the second quarter of 2005, the assumptions as to when certain U.S. facilities would be subleased were revised, which increased the reserve by $1.0 million. This increase was offset by an additional $1.6 million in sublease income from the actual sublet of the Marlow U.K. facility.

In the third quarter of 2005, the Company made adjustments to the restructuring accrual of $189,000 to correct for certain calculation errors made in the fourth quarter of 2004. The Company believes that these errors are not material to the Company’s financial statements for 2004 or 2005.

In the fourth quarter of 2005, the Company recorded a restructuring charge of $271,000 for the termination of certain employees net of adjustments to restructured facilities.

During the year ended December 31, 2004, the Company recorded $3.4 million in restructuring costs related to a change in evaluation of real estate market conditions in the United Kingdom, and changes in sublease estimates based on offers from potential subtenants in the United States.

The following table summarizes our restructuring activity for the years ended December 31, 2005 and 2004 (in thousands):

The remainder of the restructuring payments will be paid relatively evenly from 2006 through 2011.

Goodwill Impairment.During June 2005, we performed our annual test for goodwill impairment as required by SFAS No. 142. Based on our evaluation, we concluded that goodwill was not impaired as the fair value of the Company exceeded its carrying value, including goodwill. There have been no events or circumstances from June 30, 2005 to December 31, 2005 that have affected our June 30, 2005 conclusion regarding the recoverability of goodwill. The remaining amount of goodwill at December 31, 2005 is $8.6 million. Any further impairment loss could have a material adverse impact on our financial condition and results of operations.

Interest and Other Income (Expense), net

Interest and other income (expense), net consists primarily of interest income, interest expense and changes in fair value of warrant liabilities. Interest income consists primarily of interest earned on cash and cash equivalents and marketable securities and was approximately $265,000 and $294,000 for the years ended December 31, 2005 and 2004, respectively. The decrease in interest income related to lower cash and cash equivalents and marketable securities balances in 2005 than in 2004. Interest expense relates primarily to our line of credit and was approximately $513,000 and $180,000 for the years ended December 31, 2005 and 2004, respectively. Interest and other income (expense), net also consists of changes in the fair value of warrant liabilities of approximately $331,000 and zero for the years ended December 31, 2005 and 2004, respectively.

Provision for Income Taxes

We have incurred operating losses on a consolidated basis for all periods from inception through December 31, 2005. Accordingly, we have recorded a valuation allowance for the full amount of our gross deferred tax assets, as the future realization of the tax benefit is not currently more likely than not. In 2005 and 2004, certain of our foreign subsidiaries were profitable, based upon application of our intercompany transfer pricing agreements, which resulted in us reporting income tax expense totaling approximately $196,000 and $314,000 for the years ended December 31, 2005 and 2004, respectively, in those foreign jurisdictions.

As of December 31, 2005 the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $444.6 million and $345.6 million, respectively. The federal and state net operating loss carryforwards, if not offset against future taxable income, will expire by 2025. The Company also had foreign net operating loss carryforwards of approximately $20.0 million. The foreign losses expire at various dates and some can be carried forward indefinitely. Pursuant to the Internal Revenue Code, the amounts of and benefits from net operating loss carryforwards may be impaired or limited in certain circumstances. Events which cause limitations in the amount of net operating losses that the Company may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50%, as defined, over a three year period. As such, the portion of the net operating loss and tax credit carryforwards subject to potential expiration has not been included in deferred tax assets. In addition, it is possible additional limitations may exist.

Comparison of the Years Ended December 31, 2004 and 2003

Revenues

Total revenues decreased by 20% to $48.9 million for the year ended December 31, 2004 from $61.0 million for the year ended December 31, 2003, primarily as a result of fewer license transactions in 2004 than in 2003. We believe the decrease in 2004 was due to many factors including competitive pressures, greater-than-anticipated delays in completing expected license transactions through systems integrators, and a slow recovery in the information technology spending environment.

License revenues include licensing fees only, and exclude associated maintenance and consulting revenue. The majority of our licenses to customers are perpetual and associated revenues are recognized upon shipment provided that all revenue recognition criteria are met. License revenues decreased by 46% to $14.2 million for the year ended December 31, 2004 from $26.2 million for 2003. This decrease in license revenue was primarily due to a decrease in the average selling price of license transactions due to competitive pricing pressures, as well as a decrease in the number of license transactions closed during the year.

Our service revenues consist of support revenues and professional services fees. Support revenues relate to providing customer support, product maintenance and updates to our customers (including when-and-if-available upgrades). Professional services revenues relate to providing consulting, training and, to a lesser extent, implementation services to our customers. Service revenues remained flat at $34.7 million for the year ended December 31, 2004 compared to $34.8 million for 2003. The consistency in service revenue amount was in line with expectations since the relatively small percentage of support renewal cancellations is typically more than offset by new maintenance contracts associated with new license transactions. In addition, we maintained a relatively

constant professional services headcount in 2004 compared with 2003. Support revenues are the largest component of service revenues, and, in 2004, were relatively consistent with our 2003 support revenues, at $31.0 million in 2004 versus $30.6 million in 2003. The drop in sales of new licenses in 2004 affected service revenues less than license revenues because the majority of our maintenance revenues relate to ongoing maintenance contracts with existing customers.

Revenues from international sales were $17.2 million, or 35% of total revenues, in the year ended December 31, 2004 and $17.2 million, or 28% of total revenues, in the year ended December 31, 2003. Our international revenues were derived from sales in Europe, Canada and Asia Pacific.

    Costs and Expenses

Total cost of revenues decreased by 16% to $12.0 million for the year ended December 31, 2004 from $14.3 million for the year ended December 31, 2003.

License Fees. Cost of license fees consists of third party software royalties, costs of product packaging, documentation, and production and delivery costs for shipments to customers. Cost of license fees as a percentage of license revenue for 2004 was 17% compared to 12% in 2003. The increase was due to royalty costs associated with a relatively higher proportion of non-revenue-related shipments, such as upgrades and updates during 2004.

Services. Cost of services revenue consists primarily of salaries and related expenses for our customer support, consulting, and training services organization, and allocation of facility costs and system costs incurred in providing customer support. Cost of services revenue decreased to 27% of services revenue, or $9.5 million, for 2004 compared to 28%, or $9.7 million, for the prior year. Both totals exclude amortization of stock-based compensation of $346,000 and $430,000 for periods ending December 31, 2004 and 2003, respectively. The consistency in service margins in 2004 compared to 2003 was due to consistency in our strategy and professional service staffing levels throughout 2004 and 2003.

Amortization of Acquired Intangible Assets.The amortization of acquired intangible assets recorded in 2004 and 2003 related to $14.8 million of intangible assets recorded in connection with the purchase of Silknet Software, Inc. in April 2000 and Hipbone, Inc. in February 2004. The amortization of the assets related to Silknet concluded in April 2003. Amortization totaled $119,000 and $1.5 million for the years ended December 31, 2004 and 2003, respectively.

Sales and Marketing. Sales and marketing expenses consist primarily of compensation and related costs for sales and marketing personnel and promotional expenditures, including public relations, advertising, trade shows and marketing materials. Sales and marketing expenses decreased by 14% to $25.1 million for the year ended December 31, 2004 from $29.2 million for the year ended December 31, 2003. This decrease was partly attributable to reductions in sales and marketing personnel during 2004, from 77 positions as of December 31, 2003 to 70 positions as of December 31, 2004 and a reduction in information technology support. In addition, commission expense in 2004 was $600,000 lower than in 2003 due to decreases in license revenues in 2004 as discussed above.

Research and Development. Research and development expenses consist primarily of compensation and related costs for research and development employees and contractors and enhancement of existing products and quality assurance activities. Research and development expenses decreased by 9% to $19.5 million for the year ended December 31, 2004 from $21.4 million for the year ended December 31, 2003. This decrease was partly attributable to a reduction in research and development personnel during 2004 by 15%, from 40 as of December 31, 2003 to 34 at December 31, 2004 and a reduction in information technology support. The decrease can also be attributed to lower outsourcing expenses paid to our development partners with staffing in India and China.

General and Administrative. General and administrative expenses consist primarily of compensation and related costs for finance, legal, human resources, corporate governance, and bad debt expense. Information technology and facilities costs are allocated among all operating departments. General and administrative expenses decreased by 11% to $8.1 million for the year ended December 31, 2004 from $9.1 million for the year ended December 31, 2003. This decrease was primarily attributable to a reduction in information technology support, professional services, bad debt expense and other general and administrative expenses for the year ended December 31, 2004.

Stock-Based Compensation. We amortize employee-related deferred stock-based compensation on an accelerated basis by charges to operations over the vesting period of the options, consistent with the method described in FASB Interpretations No. 28. The amortization of deferred stock-based compensation related to fully vested warrants to third parties are amortized on a straight-line basis. Amortization of stock-based compensation was $1.2 million and $5.9 million for the years ended December 31, 2004 and 2003, respectively. In 2004 and 2003, there were no options granted with an exercise price below the fair value of the option shares on the grant date.

As of December 31, 2004, a total of approximately $58,000 of unearned deferred stock-based compensation remained to be amortized. The amortization of stock-based compensation for 2004 and 2003, by operating expense, is detailed as follows (in thousands):

Impairment of Internal Use Software. In the fourth quarter ended December 31, 2004, the Company’s IT department reviewed its operations and technology requirements, and decided to discontinue its use of certain internal use software. As a result, a material charge for impairment was required under SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets.The capitalized cost of this internal-use software included capitalized fees paid to third parties to implement the software. The total non-cash impairment charge related to this software was $1.1 million in the fourth quarter.

Restructuring Costs. During the year ended December 31, 2004, the Company recorded $3.4 million in restructuring costs related to a change in evaluation of real estate market conditions in the United Kingdom, and changes in sublease estimates based on offers from potential subtenants in the United States. For the year ended December 31, 2003, the Company recorded approximately $1.7 million in restructuring related to a change in real estate market conditions relating to excess leased facilities, and discussions with our respective landlords.

The following table summarizes our restructuring activity for the years ended December 31, 2004 and 2003 (in thousands):

The remainder of the restructuring payments will be paid relatively evenly from 2005 through 2011.

Goodwill Impairment.During June 2004 we performed our annual test for goodwill impairment as required by SFAS No. 142. Based on our evaluation, we concluded that goodwill was not impaired as the fair value of the Company exceeded its carrying value, including goodwill. There have been no events or circumstances from June 30, 2004 to December 31, 2004 that have affected our June 30, 2004 conclusion regarding the recoverability of goodwill. The remaining amount of goodwill at December 31, 2004 was $8.6 million. Any further impairment loss could have a material adverse impact on our financial condition and results of operations.

    Interest and Other Income (Expense), net

Interest and other income (expense), net consists of interest income, interest expense and other income (expense). Interest income consisted primarily of interest earned on cash and short-term investments and was approximately $294,000 and $315,000 for the years ended December 31, 2004 and 2003. The decrease in other income (expense), net related to lower amounts of interest income earned due to lower average cash balances in 2004 than in 2003. Interest expense consisted primarily of interest expense related to our line of credit and was approximately $180,000 and $174,000 for the years ended December 31, 2004 and 2003.

    Provision for Income Taxes

We incurred operating losses on a consolidated basis for all periods from inception through December 31, 2004. Accordingly, we recorded a valuation allowance for the full amount of our gross deferred tax assets, as the future realization of the tax benefit is not currently more likely than not. In 2004 and 2003, certain of our foreign subsidiaries were profitable, based upon application of our intercompany transfer pricing agreements, which resulted in us reporting income tax expense totaling approximately $314,000 and $318,000, respectively, in those foreign jurisdictions.

As of December 31, 2004, the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $425.0 million and $358.1 million, respectively. The Company also had foreign net operating loss carryforwards of approximately $20.0 million. The federal net operating loss carryforwards, if not offset against future taxable income, will expire from 2011 through 2024. Pursuant to the Internal Revenue Code, the amounts and benefits from net operating loss carryforwards may be impaired or limited in certain circumstances. Events which cause limitations in the amount of net operating losses that we may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50%, as defined, over a three year period. As such, the portion of the net operating loss and tax credit carryforwards subject to potential expiration has not been included in deferred tax assets. In addition, it is possible additional limitations may exist.

Quarterly Results of Operations

The following tables set forth a summary of our unaudited quarterly operating results for each of the eight quarters in the period ended December 31, 2002.2005. The information has been derived from our unaudited consolidated financial statements that, in management'smanagement’s opinion, have been prepared on a basis consistent with the audited consolidated financial statements contained elsewhere in this annual reportAnnual Report and include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of this information when read in conjunction with our audited consolidated financial statements and notes thereto. The operating results for any quarter are not necessarily indicative of results to be expected for any future period.

                                                                     Quarter Ended
                                    --------------------------------------------------------------------------------------
                                    Mar. 31,   June 30,   Sept. 30,   Dec 31,   Mar. 31,   June 30,   Sept. 30,   Dec 31,
                                      2001       2001       2001       2001       2002       2002       2002       2002
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
                                                              (in thousands, except per share amounts)
Consolidated Statement
 of Operations Data:
Revenues:
 License.......................... $  11,857  $   9,587  $   2,891  $  13,628  $  15,129  $   8,309  $   8,784  $   9,308
 Service..........................    11,614     14,046     15,286     11,686     10,014      8,881      9,243      9,422
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
  Total revenues..................    23,471     23,633     18,177     25,314     25,143     17,190     18,027     18,730
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
Cost of revenues:
 License..........................       633        653        503        747        965      1,056        548        833
 Service..........................    16,403      8,882     21,003      5,511      3,907     19,891      2,762      2,690
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
Total cost of revenues............    17,036      9,535     21,506      6,258      4,872     20,947      3,310      3,523
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
Gross profit (loss)...............     6,435     14,098     (3,329)    19,056     20,271     (3,757)    14,717     15,207
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
Operating expenses:
 Sales and marketing..............    26,534     13,789     19,205     10,107     10,305     10,395      8,732      7,991
 Research and development.........    12,949      6,273     10,236      6,100      6,638      6,512      6,389      6,394
 General and administrative.......     6,068      2,523      9,500      3,124      3,220      3,383      3,458      2,992
 Amortization of stock-
  based compensation..............     4,112      2,250      4,177      5,341      9,887      3,041      1,951      1,741
 Amortization of goodwill and
  identifiable intangibles........    86,852     13,730     13,551     13,527      1,200      1,200      1,200      1,200
 Merger and transition
  related costs...................        --      6,676      4,841      1,926         --         --         --         --
 Restructuring costs..............    19,930     34,327     32,081      2,709         --         --         --     (5,086)
 Goodwill impairment..............   603,446         --         --         --         --     55,000         --         --
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
  Total operating expenses........   759,891     79,568     93,591     42,834     31,250     79,531     21,730     15,232
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
Operating loss....................  (753,456)   (65,470)   (96,920)   (23,778)   (10,979)   (83,288)    (7,013)       (25)
Impairment of investment..........        --         --         --     (1,000)        --         --         --         --
Other income (expense), net.......       302       (252)       858        613        298        297        175        143
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
Loss from continuing operations...  (753,154)   (65,722)   (96,062)   (24,165)   (10,681)   (82,991)    (6,838)       118
Discontinued operation:
 Income (loss) from operations
   of discontinued operation......       258       (383)        --         --         --         --         --         --
 Loss on disposal, including
   provision of $1.1 million
   for operating losses during
   phase-out period...............        --     (3,667)        --         --         --        381         --         --
Cumulative effect of accounting
 change related to the elimination
 of negative goodwill.............        --         --         --         --      3,901         --         --         --
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
         Net loss................. $(752,896) $ (69,772) $ (96,062) $ (24,165) $  (6,780) $ (82,610) $  (6,838) $     118
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
Basic and diluted net
  loss per share..................     (8.23)     (0.76)     (0.53)     (1.76)     (0.32)     (3.63)     (0.30)      0.01
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
Shares used in computing
  basic and diluted net
  loss per share..................    91,518     91,534    180,376     13,743     21,071     22,762     22,851     22,403
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------

As a Percentage of Total Revenues:
Revenues:
 License..........................      50.5 %     40.6 %     15.9 %     53.8 %     60.2 %     48.3 %     48.7 %     49.7 %
 Service..........................      49.5       59.4       84.1       46.2       39.8       51.7       51.3       50.3
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
  Total revenues..................     100.0      100.0      100.0      100.0      100.0      100.0      100.0      100.0
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
Cost of revenues:
 License..........................       2.7        2.8        2.8        3.0        3.8        6.1        3.0        4.4
 Service..........................      69.9       37.6      115.5       21.8       15.5      115.7       15.3       14.4
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
  Total cost of
   revenues.......................      72.6       40.3      118.3       24.7       19.4      121.9       18.4       18.8
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
Gross profit (loss)...............      27.4       59.7      (18.3)      75.3       80.6      (21.9)      81.6       81.2
                                    ---------  ---------  ---------  ---------  ---------  ---------  ---------  ---------
Selected operating
 expenses:
 Sales and marketing..............     113.1       58.3      105.7       39.9       41.0       60.5       48.4       42.7
 Research and
  development.....................      55.2       26.5       56.3       24.1       26.4       37.9       35.4       34.1
 General and
  administrative..................      25.9 %     10.7 %     52.3 %     12.3 %     12.8 %     19.7 %     19.2 %     16.0 %

		Quarter Ended
		Mar. 31, 2004				June 30, 2004				Sept. 30, 2004				Dec. 31, 2004				Mar. 31, 2005				June 30, 2005				Sept. 30, 2005				Dec. 31, 2005
Consolidated Statements of Operations Data:
Revenues:
License fees		$	4,583			$	1,049			$	3,827			$	4,710			$	1,541			$	2,364			$	1,600			$	2,589
Services			8,672				8,563				8,583				8,913				8,530				8,318				9,353				8,833
Total revenues			13,255				9,612				12,410				13,623				10,071				10,682				10,953				11,422
Costs and Expenses:
Cost of license fees			786				219				170				1,274				814				835				597				749
Cost of services			2,557				2,324				2,239				2,368				2,619				1,754				2,219				2,152
Amortization of acquired intangible assets			19				33				33				34				33				33				34				33
Sales and marketing			6,453				5,897				6,523				6,226				5,340				4,286				4,309				3,738
Research and development			4,984				5,078				4,844				4,591				4,308				3,348				2,908				2,666
General and administrative			2,016				2,181				1,588				2,352				3,362				2,754				2,245				3,018
Stock-based compensation			543				361				308				19				27				9				2				—
Impairment of internal-use software			—				—				—				1,062				6,326				—				—				—
Restructuring costs			—				—				—				3,400				938				(552	)			(189	)			271
Total costs and expenses			17,358				16,093				15,705				21,326				23,767				12,467				12,125				12,628
Loss from operations			(4,103	)			(6,481	)			(3,295	)			(7,703	)			(13,696	)			(1,785	)			(1,172	)			(1,205	)
Interest and other income (expense), net			83				75				(4	)			(26	)			(42	)			(45	)			(74	)			249
Loss before income taxes			(4,020	)			(6,406	)			(3,299	)			(7,729	)			(13,738	)			(1,830	)			(1,246	)			(957	)
Income tax expense			(66	)			(66	)			(78	)			(104	)			(62	)			(54	)			(18	)			(62	)
Net loss		$	(4,086	)		$	(6,472	)		$	(3,377	)		$	(7,833	)		$	(13,800	)		$	(1,884	)		$	(1,264	)		$	(1,018	)
Basic and diluted net loss per share		$	(0.14	)		$	(0.22	)		$	(0.12	)		$	(0.27	)		$	(0.47	)		$	(0.06	)		$	(0.04	)		$	(0.03	)
Shares used in computing basic and diluted net loss per share			28,640				28,939				29,031				29,180				29,254				29,278				30,929				33,785
As a Percentage of Total Revenues:
Revenues:
License fees			35	%			11	%			31	%			35	%			15	%			22	%			15	%			23	%
Services			65				89				69				65				85				78				85				77
Total revenues			100				100				100				100				100				100				100				100
Costs and Expenses:
Cost of license fees			6				2				1				9				8				8				6				7
Cost of services			19				24				18				18				26				17				20				19
Amortization of acquired intangible assets			0				0				0				0				0				0				0				0
Sales and marketing			49				61				53				46				53				40				39				33
Research and development			38				53				39				34				43				31				27				23
General and administrative			15				23				13				17				34				26				21				26
Stock-based compensation			4				4				3				0				0				0				0				0
Impairment of internal-use software			0				0				0				8				63				0				0				0
Restructuring costs			0				0				0				25				9				(5	)			(2	)			2
Total costs and expenses			131	%			167	%			127	%			157	%			236	%			117	%			111	%			111	%

The amount and timing of our operating expenses generally will vary from quarter to quarter depending on our level of actual and anticipated business activities. Our revenues and operating results are difficult to forecast and will fluctuate, and we believe that period-to-period comparisons of our operating results will not necessarily be meaningful. As a result, you should not rely upon them as an indication of future performance.

Results of Operations

The following table sets forth selected data for the periods presented. Percentages are expressed as a percentage

LIQUIDITY AND CAPITAL RESOURCES

As of total revenues.

                                           Year Ended December 31, -----------------------------------------------
                                       20022005, we had $6.2 million in cash and cash equivalents and marketable securities, compared to $20.1 million as of December 31, 2004. As of December 31, 2005, we had negative working capital of $18.4 million. $14.5 million of our current liabilities consists of current deferred revenue (primarily reflecting payments for future maintenance services under our software licenses).
History and recent trends. We have had negative cash flows from operations in each year since inception. To date, we have funded our operations primarily through issuances of common stock and, to a lesser extent, cash acquired in acquisitions. Cash used in operations increased from $12.7 million in 2003, to $13.1 million in 2004 to $16.3 million in 2005. The increase of cash used in operations primarily relates to a 12% decrease in revenues during the same period offset partially by a reduction in payments of operating expenses. Our cost reductions have been realized through our restructuring plan commencing in 2001, 2000
                                 --------------   -------------   --------------
Revenues:
 License....................... $ 41,530    53 % $ 37,963   42 % $ 75,360    64 %
 Service.......................   37,560    47     52,632   58     42,595    36
                                 -------- -----   -------- ----   -------- -----
   Total revenues..............   79,090   100     90,595  100    117,955   100

Costas well as various cost controls and operational efficiencies realized since 2001. In 2005, 2004, and 2003, we had net workforce reductions of revenues:
 License.......................    3,402     4      2,536    3      2,856     2
 Service.......................   29,250    37     51,799   57     56,082    48
                                 -------- -----   -------- ----   -------- -----
   Total costapproximately 56, 30, and 154 employees, respectively.
Primary driver of revenues......   32,652    41     54,335   60     58,938    50
                                 -------- -----   -------- ----   -------- -----
Gross profit...................   46,438    59     36,260   40     59,017    50

cash flow. Our ability to generate cash in the future depends upon our success in generating sufficient sales, especially new license sales. We expect our maintenance renewals in 2006 will be fairly consistent with 2005. Since our new license transactions are relatively small in volume and are difficult to predict, we may not be able to generate new license transactions as anticipated in any particular future period. From time to time, changes in working capital will affect our cash flows. However, we do not expect this to materially impact our future cash flows over time, since we expect relative stability, or slight growth, in our assets and liabilities.
Operating expenses:
 Sales and marketing...........   37,423    47     69,635   77     88,186    75
 Research and development......   25,933    33     35,558   39     42,724    36
 General and administrative....   13,053    17 %   21,215   23 %   18,945    16 %

COMPARISON OF THE YEARS ENDED DECEMBER 31, 2002 AND 2001

Revenues

Total revenues decreased by 13% to $79.1cash flow. Our use of $16.3 million of cash for operating activities for the year ended December 31, 2002 from $90.62005, included $18.0 million for the year ended December 31, 2001 primarily asnet loss, a result of decreased service revenues.

License revenues increased by 9% to $41.5 million for the year ended December 31, 2002 from $38.0 million for 2001. This increase in license revenue was primarily due to an increase in the average selling price of licenses, particularly in Europe, as well as sales of products formerly offered by Broadbase, which were not included in our revenues prior to the June 2001 merger (license revenues recorded by Broadbase through June 2001 totaled $16.1 million). The increase in the average selling price of licenses in recent periods reflects the growth in our sales to larger organizations that often license our applications for more users and that need more functionality. We believe this growth has resulted, in significant part, from our increased use of indirect channels to market and sell our products, which allow us to market our products more effectively to Global 2000 organizations. In addition, we believe the introduction of our KANA iCARE suite in 2001, with its deployment and integration advantages, has facilitated sales of licenses for multiple applications to our customers resulting in larger transaction sizes than those involving a stand-alone application. We expect that license transactions closed in any particular quarter will continue to constitute a significant percentage of our license revenues in that quarter. One customer accounted for 11% of our total revenues in 2002.

License revenues represented 53% of total revenues in 2002 and 42% in 2001. Our license revenue increased as a percentage of total revenue mostly due to the$331,000 reduction in our professional services personnel resulting from our shift during the fourth quarter of 2001 to encourage our customers to increase their use of third party integrators to provide implementation services, rather than purchase those services from us. We expect license revenues to increase moderately in absolute dollars in 2003 from 2002, primarily due to our expectations of increasing total contract value with existing and new customers. However, the market for our products is unpredictable and intensely competitive, and sales of our products are impacted by the current economic environment and the corresponding effect it has on corporate purchasing habits.

Our service revenues consist of support revenues (primarily from customer support, product maintenance and updates) and professional services revenues (primarily from consulting and implementation services). Service revenues decreased by 29% to $37.6 million for the year ended December 31, 2002 from $52.6 million for 2001. Service revenues decreased primarily due to our customers' increased use of third party integrators for implementation services as discussed above. Service revenues represented 47% of total revenues for the year ended December 31, 2002 and 58% of total revenues for 2001. We expect that service revenues in 2003 will be fairly consistent with 2002 in absolute dollars as we continue to focus on license sales and using third-party integrators for implementation services.

Revenues from international sales were $25.5 million in the year ended December 31, 2002 and $13.8 million in the year ended December 31, 2001. The increase in international sales in 2002 is primarily as a result of sales through our integration partner in the UK. Our international revenues were derived from sales in Europe, Canada, Asia Pacific and Latin America.

Cost of Revenues

Total cost of revenues decreased by 40% to $32.7 million for the year ended December 31, 2002 from $54.3 million for the year ended December 31, 2001.

Cost of license revenues consist primarily of third party software royalties, costs of product packaging, documentation, and production and delivery costs for shipments to customers. Cost of license revenues as a percentage of license revenue for 2002 was 8% compared to 7% in 2001. The slight increase was due to greater sales of certain licenses in 2002, which have higher associated royalty rates. We expect that our cost of license revenue as a percentage of sales in 2003 will be approximately the same as in 2002.

Cost of service revenues consists primarily of salaries and related expenses for our customer support, implementation and training services organization and allocation of facility costs and system costs incurred in providing customer support. Cost of service revenues decreased to 78% of service revenues for 2002 compared to 98% for the prior year. Cost of service revenues in 2002 included approximately $15.6 million, or 42% of service revenues, related to a loss contract with a customer. See "Reserve for Loss Contract" under "Critical Accounting Policies" above. The improvement in service margins was primarily due to the change in service revenues mix following our shift to have customers increase their use of third party integrators to provide implementation services, rather than purchase those services from us. As a result, support revenues comprised a larger percentage of service revenues, which have yielded better margins than training and consulting revenues due to higher utilization of customer support personnel than training and consulting personnel. Maintenance revenues comprised $30.8 million, or 39% of total revenues in 2002, compared to $27.9 million, or 31% in 2001. We anticipate that our cost of service revenues will significantly decrease in absolute dollars, and as a percentage of service revenue, in 2003 compared to 2002 as a result of the finalization of the restructuring of a contract with a customer discussed above.

Operating Expenses

Sales and Marketing. Sales and marketing expenses consist primarily of compensation and related costs for sales and marketing personnel and promotional expenditures, including public relations, advertising, trade shows and marketing materials. Sales and marketing expenses decreased by 46% to $37.4 million for the year ended December 31, 2002 from $69.6 million for the year ended December 31, 2001. This decrease was primarily attributable to reductions in sales and marketing personnel since the second half of 2001, which reduced sales and marketing-related positions from 289 positions as of June 30, 2001 to 106 positions at December 31, 2002, and related decreases in benefits, travel, and facility costs. As a percentage of total revenues, sales and marketing expenses were 47% for the year ended December 31, 2002 and 77% for the year ended December 31, 2001. We anticipate that sales and marketing expenses in 2003 will be fairly consistent with 2002 in absolute dollars, and will fluctuate as a percentage of revenues depending on the timing and amount of revenues.

Research and Development. Research and development expenses consist primarily of compensation and related costs for research and development employees and contractors and enhancement of existing products and quality assurance activities. Research and development expenses decreased by 27% to $25.9 million for the year ended December 31, 2002 from $35.6 million for the year ended December 31, 2001. This decrease was attributable primarily to the reduction of personnel since the second half of 2001, which reduced research and development-related positions from 227 as of June 30, 2001 to 128 at December 31, 2002. As a percentage of total revenues, research and development expenses were 33% for the year ended December 31, 2002 and 39% for the year ended December 31, 2001. We anticipate that research and development expenses will be slightly lower in absolute dollars in 2003 than in 2002 due to cost reductions implemented in 2002 impacting the full year in 2003 (as discussed in the "Business" section of this report under "Overview-Research and Development"), and will fluctuate as a percentage of revenues depending on the timing and amount of revenues.

General and Administrative. General and administrative expenses consist primarily of compensation and related costs for finance, legal, human resources, corporate governance, various taxes, and bad debt expense. Information technology and facilities costs are allocated among all operating departments. General and administrative expenses decreased by 38% to $13.1 million for the year ended December 31, 2002 from $21.2 million for the year ended December 31, 2001. This decrease was attributable to the reduction in bad debts charged to general and administrative expenses, from $4.2 million in 2001 to approximately $57,000 in 2002. This decrease was also attributable to the reduction of personnel since the second half of 2001, which reduced finance, legal and human resources-related positions from 52 as of June 30, 2001 to 24 at December 31, 2002. As a percentage of total revenues, general and administrative expenses were 17% for the year ended December 31, 2002 and 23% for the year ended December 31, 2001. We anticipate that general and administrative costs will be slightly lower in absolute dollars in 2003 compared to 2002, and will fluctuate as a percentage of revenues depending on the timing and amount of revenues.

Amortization of Stock-Based Compensation. In connection with our stock option grants to employees, we recorded unearned stock-based compensation charges. These charges represent the total difference between the exercise prices of stock options and the deemed fair value of the underlying common stock for accounting purposes on the date these stock options were granted. The majority of these charges relate to grants made prior to our initial public offering as well as options assumed in connection with our merger with Broadbase in 2001. In 2002, options granted with an exercise price below the fair value of the option shares on the date of grant resulted in a charge of $138,000,warrant liability and cancellations of grants with previous associated charges resulted in a reversal of $1.8 million. In 2001, options granted with an exercise price below the fair value of the option shares on the date of grant resulted in a charge of $2.6 million, and cancellations of grants with previous associated charges resulted in a reversal of $3.0 million. In connection with the merger with Broadbase, we recorded unearned stock-based compensation totaling approximately $15.5 million during the year ended December 31, 2001. These amounts are included as a component of stockholders' equity and are being amortized on an accelerated basis by charges to operations over the vesting period of the options, consistent with the method described in FASB Interpretation No. 28.

In September 2000, we issued to Accenture 40,000 shares of common stock and a warrant to purchase up to 72,500 shares of our common stock at an exercise price of $371.25 per share pursuant to a stock and warrant purchase agreement in connection with our global strategic alliance. The shares of the common stock issued were fully vested, and we recorded a deferred stock-based compensation charge of approximately $14.8 million to be amortized over the four-year term of the agreement. As of December 31, 2002, 33,997 shares of common stock subject to the warrant were fully vested and 28,503 had been forfeited, with the remaining 10,000 warrants subject to vesting upon the achievement of certain performance goals. The vested portion of the warrant was valued using the Black-Scholes model resulting in charges totaling $2.0 million of which $1.0 million was immediately expensed$437,000 change in the fourth quarter of 2000 and $1.0 million is being amortized over the term of the agreement. We will incur a stock-based compensation charge for the unvested portion of the warrant when and if annual performance goals are achieved. As of December 31, 2002, unvested shares of common stock under the warrant had a fair value of approximately $20,000 based upon the fair market value of our common stock at such date.

In June 2001, we entered into an agreement to issue to a customer a fully vested and exercisable warrant to purchase up to 25,000 shares of common stock at an exercise price of $40 per share pursuant to a warrant purchase agreement. The warrant was valued using the Black-Scholes model, resulting in a deferred stock-based compensation charge of $330,000, which was fully amortized as a reduction of revenue in 2001.

In September 2001, we issued to a customer a warrant to purchase up to 5,000 shares of common stock at an exercise price of $7.50 per share pursuant to a warrant purchase agreement. The warrant will become fully vested in September 2006 and has a provision for accelerationdoubtful accounts partially offset by non-cash charges of vesting by 1,250 shares annually over four years if certain marketing criteria are met by the customer. As of December 31, 2002, no such marketing criteria has been met. The warrant was valued using the Black-Scholes model, resulting$2.3 million in a deferred stock-based compensation charge of approximately $29,000, which is being amortized over the four-year term of the agreement.

In September 2001, we issued to Accenture a fully-vested warrant to purchase up to 150,000 shares of common stock at an exercise price of $3.33 per share pursuant to a warrant purchase agreementdepreciation, $38,000 in connection with our global strategic alliance. The warrant was valued using the Black-Scholes model resulting in a charge of approximately $946,000 which is being amortized over the four-year term of the agreement. Accenture exercised this additional warrant in March 2002.

In November 2001, we issued to two investment funds warrants to purchase up to 386,118 shares of our common stock at an exercise price of $10.00 per share in connection with a proposed financing which was to have been completed in February 2002 upon attaining stockholder approval. These warrants were initially exercisable for an aggregate of 193,059 shares. The exercisable warrants were valued using the Black-Scholes model resulting in a charge of approximately $1.0 million to deferred stock-based compensation. On February 1, 2002, our stockholders voted against the proposed financing, which resulted in us terminating the share purchase agreement and caused the warrants to become exercisable with respect to all 386,118 shares. The warrants are exercisable until February 2004. Using the Black-Scholes model, the warrants issued in November 2001 that were initially exercisable were re-valued as of February 1, 2002, and the warrants that became exercisable on February 1, 2002 were valued as of such date, resulting in a charge totaling approximately $4.7 million which was reflected as amortization of stock-based compensation, in the first quarter of 2002.

As of December 31, 2002, a total of approximately $8.6 million of unearned deferred stock-based compensation remained to be amortized. We anticipate stock-based compensation expense to approximate from $6.0 million to $7.0 million in 2003, $1.0 to $2.0 million in 2004, and the remainder in 2005. The amortization of stock-based compensation for 2002 and 2001, by operating expense, is detailed as follows (in thousands):

                                  Year Ended December 31,
                                  -----------------------
                                     2002         2001
                                  -----------  ----------
Cost of service................. $       883  $    1,417
Sales and marketing.............       4,697       7,230
Research and development........       4,384       4,226
General and administrative......       6,656       3,007
                                  -----------  ----------
 Total.......................... $    16,620  $   15,880
                                  ===========  ==========

Amortization of Goodwill. Amortization of goodwill ceased as of January 1, 2002 upon our adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ("SFAS 142"). Under SFAS 142, goodwill is no longer amortized.

The following table presents comparative information showing the effects that the non-amortization of goodwill provisions of SFAS 142 would have had on the net loss and basic and diluted net loss per share for the periods shown (in thousands, except per share amounts):

                                                Year Ended December 31,
                                         -------------------------------------
                                            2002         2001         2000
                                         -----------  -----------  -----------
Reported net loss...................... $   (96,110) $  (942,895) $(3,070,873)
Goodwill amortization..................          --      118,060      866,328
                                         -----------  -----------  -----------
Adjusted net loss...................... $   (96,110) $  (824,835) $(2,204,545)
                                         ===========  ===========  ===========

Basic and diluted net loss per share... $     (4.29) $    (68.61) $   (395.68)
Goodwill amortization..................          --         8.59       111.63
                                         -----------  -----------  -----------
Adjusted basic and diluted
  net loss per share................... $     (4.29) $    (60.02) $   (284.05)
                                         ===========  ===========  ===========
Shares used in computing adjusted basic
  and diluted net loss per share.......      22,403       13,743        7,761
                                         ===========  ===========  ===========

Amortization of Identifiable Intangibles.We recorded $4.8 million$133,000 in amortization of identifiable intangiblesacquired intangible assets, $468,000 of restructuring costs, and a $6.3 million in both 2002impairment of internal-use software. Other working capital changes totaled a negative $6.9 million, resulting primarily from a $1.5 million increase in accounts receivable, $3.1 million reduction in accrued restructuring, and 2001. This amortization relates to $14.4$2.9 million reduction in deferred revenue, partially offset by $547,000 decrease in prepaid expenses and other assets, and $129,000 increase in accounts payable and accrued liabilities. Our operating activities used $13.1 million and $12.7 million of purchased technology recorded as an intangible asset in connection with the merger with Silknet in April 2000. We expect amortization of these identifiable intangibles to conclude in April 2003. The remaining unamortized portion of identifiable intangibles is $1.5 million at December 31, 2002.

Mergercash and Related Cost.There were no merger-related costs incurred in 2002. In connection with the merger with Broadbase, we recorded $13.4 million of merger-related expenses in 2001. The merger costs included personnel costs of $5.6 million, and $7.8 million relating to duplicate facility and insurance costs, redundant assets, and professional fees associated with the merger. As of December 31, 2002, no accrued merger-related costs remained on the consolidated balance sheet.

Restructuring Costs. For the year ended December 31, 2002, we recorded approximately $5.1 million in restructuring cost savings related to an amendment to a facility lease, our evaluation of real estate market conditions relating to this and other excess leased facilities, and discussions with our other landlords. For the year ended December 31, 2001, we incurred restructuring charges of approximately $89.0 million primarily related to reductions in our workforce and costs associated with certain excess leased facilities and asset impairments. The restructuring charges included $26.4 million for assets disposed of or removed from operations. Assets disposed of or removed from operations consisted primarily of computer equipment and related software, office equipment, furniture and fixtures and leasehold improvements.

The restructuring charge in 2001 also included $24.4 million for severance, benefits and related costs associated with reductions in our workforce. As of December 31, 2001, we had 409 full-time employees. We restructured our organization throughout 2001, with net workforce reductions of approximately 772 employees, or 65% from December 31, 2000, in order to streamline operations, eliminate redundant positions after the merger with Broadbase, reduce costs and bring our staffing and cost structure in line with industry standards and current economic conditions.

The restructuring charge in 2001 also included $38.2 million resulting from our decision to exit and reduce some of our facilities. The estimated facility costs were based on our contractual obligations, net of estimated sublease income, based on current comparable rates for leases in the respective markets.

The following table summarizes our restructuring expenses, payments, and liabilities at andcash equivalents for the years ended December 31, 20022004 and 2001 (in thousands):

                                                                    Fixed Asset
                                          Severance    Facilities    Disposals     Totals
                                          ----------  ------------  ------------  --------
Restructuring reserve at 12/31/2000..... $       --  $         --  $         --  $     --
                                          ----------  ------------  ------------  --------
Restructuring charge....................     24,426        38,168        26,453    89,047
Non-cash charges........................     (1,858)           --       (26,453)  (28,311)
Payments made...........................    (21,655)      (10,750)           --   (32,405)
                                          ----------  ------------  ------------  --------
Restructuring reserve at 12/31/2001.....        913        27,418            --    28,331
                                          ----------  ------------  ------------  --------
Non-cash reduction of restructuring.....         --        (5,086)           --    (5,086)
Payments made...........................       (695)      (12,415)           --   (13,110)
Sublease payments received..............         --           814            --       814
                                          ----------  ------------  ------------  --------
Restructuring reserve at 12/31/2002..... $      218  $     10,731  $         --  $ 10,949
                                          ==========  ============  ============  ========