Rainmaker Systems 10Q 2006 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

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

FOR THE QUARTERLY PERIOD ENDED: March 31, 2006

COMMISSION FILE NUMBER 000-28009

RAINMAKER SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Delaware

33-0442860

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification Number)

900 East Hamilton Ave.

Campbell, California 95008

(address of principal executive offices) (zip code)

Registrant’s telephone number, including area code: (408) 626-3800

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

(1) Yes x No ¨

(2) Yes x No ¨

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

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 April 28, 2006, the registrant had 13,372,836 shares of Common Stock outstanding.

RAINMAKER SYSTEMS, INC.

FORM 10-Q

AS OF MARCH 31, 2006

TABLE OF CONTENTS


		Page
PART I.	FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Financial Statements (Unaudited):	3
	Condensed Consolidated Balance Sheets at March 31, 2006 and December 31, 2005	3
	Condensed Consolidated Statements of Operations for the three months ended March 31, 2006 and 2005	4
	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2006 and 2005	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Qualitative and Quantitative Disclosures About Market Risk	24
Item 4.	Controls and Procedures	24

PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	25
Item 1A.	Risk Factors	25
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	32
Item 3.	Default Upon Senior Securities	32
Item 4.	Submission of Matters to a Vote of Security Holders	32
Item 5.	Other Information	32
Item 6.	Exhibits	32

	Signatures	33

PART I. - FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

RAINMAKER SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

(Unaudited)


	March 31, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	15,373		$	9,746
Restricted cash		480			586
Accounts receivable, less allowance for doubtful accounts of $410 and $422 at March 31, 2006 and December 31, 2005, respectively		12,065			10,374
Prepaid expenses and other current assets		1,321			1,212

Total current assets		29,239			21,918

Property and equipment, net		4,607			4,410
Intangible assets, net		3,417			3,652
Goodwill		3,921			3,921
Other noncurrent assets		256			257

Total assets	$	41,440		$	34,158

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	20,903		$	17,741
Accrued compensation and benefits		1,503			1,427
Other accrued liabilities		1,795			1,732
Deferred revenue		1,183			882
Obligations under financing arrangements		201			301
Current portion of capital lease obligations		40			99
Current portion of notes payable		1,500			3,500

Total current liabilities		27,125			25,682

Deferred tax liability		445			440
Notes payable, less current portion		1,542			1,917

Stockholders’ equity:
Preferred stock, $0.001 par value; 20,000,000 shares authorized, none issued and outstanding		—			—
Common stock, $0.001 par value; 80,000,000 shares authorized, 13,332,772 and 11,306,937 outstanding at March 31, 2006 and December 31, 2005, respectively		13			11
Additional paid-in capital		74,476			69,089
Accumulated deficit		(62,161	)		(62,981	)

Total stockholders’ equity		12,328			6,119

Total liabilities and stockholders’ equity	$	41,440		$	34,158

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

RAINMAKER SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)


	Three Months Ended March 31,
	2006		2005
Net revenue	$	11,070	$	6,420

Operating expenses:
Costs of services		5,498		3,892
Sales and marketing		732		744
Technology		1,221		901
General and administrative		2,070		2,608
Depreciation and amortization		696		778

Total operating expenses		10,217		8,923

Operating income (loss)		853		(2,503	)
Interest and other (expense) income, net		21		(3	)

Income (loss) before income taxes		874		(2,506	)
Provision for income taxes		54		—

Net income (loss)	$	820	$	(2,506	)

Basic income (loss) per share	$	0.07	$	(0.27	)

Diluted income (loss) per share	$	0.06	$	(0.27	)

Weighted average common share
Basic		12,496		9,269

Diluted		13,068		9,269

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

RAINMAKER SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)


	Three Months Ended March 31,
	2006			2005
Operating activities:
Net income (loss)	$	820		$	(2,506	)
Adjustment to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization of property and equipment		461			616
Amortization of intangible assets		235			162
Stock-based compensation expense		14			—
Provision for allowances for doubtful accounts		89			330
Loss on disposal of fixed assets		—			26
Changes in operating assets and liabilities, net of assets acquired and liabilities assumed:
Accounts receivable		(1,780	)		(602	)
Prepaid expenses and other assets		(8	)		24
Accounts payable		3,162			2,169
Accrued compensation and benefits		76			1,000
Other accrued liabilities		(31	)		914
Deferred revenue		301			(246	)

Net cash provided by operating activities		3,339			1,887

Investing activities:
Purchases of property and equipment		(658	)		(786	)
Restricted cash, net		106			(700	)
Acquisition of businesses, net of cash acquired		—			(4,221	)

Net cash used in investing activities		(552	)		(5,707	)

Financing activities:
Proceeds from issuance of common stock from option exercises		63			8
Net proceeds from issuance of common stock and warrants from private placement		5,312			—
Proceeds from notes payable		—			3,000
Principal payment of notes payable		(2,376	)		(83	)
Principal payment of financing arrangements		(100	)		(127	)
Principal payment of capital lease obligations		(59	)		(80	)

Net cash provided by financing activities		2,840			2,718

Net increase (decrease) in cash and cash equivalents		5,627			(1,102	)

Cash and cash equivalents at beginning of period		9,746			10,104

Cash and cash equivalents at end of period	$	15,373		$	9,002

Supplement disclosures of cash flow information:
Cash paid for interest	$	79		$	20

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

RAINMAKER SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

— UNAUDITED —

1. BASIS OF PRESENTATION

The accompanying condensed consolidated financial statements include the accounts of Rainmaker Systems, Inc. and its wholly-owned subsidiaries (“Rainmaker”, “we”, “our” or “the Company”). All intercompany balances and transactions have been eliminated in consolidation. The condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. The interim financial statements are unaudited but reflect all normal recurring adjustments, which are, in the opinion of management, necessary for the fair presentation of the results of these periods.

The results of our operations for the three months ended March 31, 2006 are not necessarily indicative of results to be expected for the year ending December 31, 2006, or any other period. These condensed consolidated financial statements should be read in conjunction with Rainmaker’s financial statements and notes thereto included in Rainmaker’s Annual Report on Form 10-K for the year ended December 31, 2005. Balance sheet information as of December 31, 2005 has been derived from the audited financial statements for the year then ended.

Certain amounts reported in the accompanying financial statements for 2005 have been reclassified to conform to the 2006 presentation. Such reclassifications had no effect on previously reported results of operations, total assets or accumulated deficit.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Business

Rainmaker Systems, Inc. is a provider of business-to-business sales and marketing services, leveraging integrated telesales, marketing, web technologies, and data analytics to achieve higher revenue for clients. Our core activities include lead qualification and nurturing management, lead generation for product sales, subscription and service contract sales, and contract renewals and warranty extension sales. Our services are available individually or as an integrated solution.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of Rainmaker Systems, Inc. and its wholly-owned subsidiaries (“we”, “our” or “the Company”). All inter-company balances and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Our estimates are based on historical experience, input from sources outside of the company, and other relevant facts and circumstances. Actual results could differ from those estimates. Accounting policies that include particularly significant estimates are revenue recognition and presentation policies, valuation of accounts receivable, and the assessment of recoverability and measuring impairment of goodwill, intangible assets and fixed assets.

Cash and Cash Equivalents

We consider all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash equivalents generally consist of money market funds and certificates of deposit. The fair market value of cash equivalents represents the quoted market prices at the balance sheet dates and approximates their carrying value.

Allowance for Doubtful Accounts

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our clients’ customers to make required payments of amounts due to us. The allowance is comprised of specifically identified account balances for which collection is currently deemed doubtful. In addition to specifically identified accounts, estimates of amounts that may not be collectible from those accounts whose collection is not yet deemed doubtful but which may become doubtful in the future are made based on historical bad debt write-off experience. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. At March 31, 2006 and December 31, 2005, our allowance for potentially uncollectible accounts was $410,000 and $422,000, respectively.

Property and Equipment

Property and equipment are stated at cost. Depreciation of property and equipment is recorded using the straight-line method over the assets’ estimated useful lives. Computer equipment and capitalized software are depreciated over two to five years and furniture and fixtures are depreciated over five years. Amortization of leasehold improvements is recorded using the straight-line method over the shorter of the lease term or the estimated useful lives of the assets. Amortization of fixed assets under capital leases is included in depreciation expense.

Costs of internal use software are accounted for in accordance with Statement of Position 98-1 (“SOP 98-1”), “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” and Emerging Issue Task Force Issue No. 00-02 (“EITF 00-02”), “Accounting for Website Development Costs.” SOP 98-1 and EITF 00-02 require that we expense computer software and website development costs as they are incurred during the preliminary project stage. Once the capitalization criteria of SOP 98-1 and EITF 00-02 have been met, external direct costs of materials and services consumed in developing or obtaining internal-use software, including website development, the payroll and payroll-related costs for employees who are directly associated with and who devote time to the internal use computer software and associated interest costs are capitalized. Capitalized costs are amortized using the straight-line method over the shorter of the term of related client agreement, if such development relates to a specific outsource client, or the software’s estimated useful life, ranging from two to five years. Capitalized internal use software and website development costs are included in property and equipment in the accompanying balance sheets.

Goodwill and Other Intangible Assets

Goodwill represents the excess of the acquisition purchase price over the estimated fair value of net tangible and intangible assets acquired. Goodwill and intangible assets acquired in a business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually. Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values, and are reviewed for impairment in accordance with Financial Accounting Standards Board (FASB) Statement No. 144,Accounting for Impairment or Disposal of Long-Lived Assets. During the quarter end ending March 31, 2006, we performed the annual impairment test for the goodwill generated by the Sunset Direct acquisition in the first quarter of 2005 (see Note 4.). The results of that test indicate that the market value of the Sunset Goodwill is greater than the carrying value, and accordingly, no impairment charge was recorded.

Impairment of Long-Lived Assets

In accordance with Statement No. 144, long-lived assets, such as property, equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.

Goodwill is tested at least annually for impairment, and more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. This determination is made at the reporting unit level and consists of two steps. The Company has identified its

reporting units as Service Sales and lead Generation. First, the Company determines the fair value of a reporting unit and compares it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with FASB Statement No. 141,Business Combinations. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill.

Revenue Recognition and Presentation

Substantially all of our revenues are generated from the sale of service contracts and maintenance renewals, and performance of lead generation services. We recognize revenue from the sale of our client’s service contracts and maintenance renewals under the provisions of Staff Accounting Bulletin (“SAB”) 104 “Revenue Recognition” and on the “net basis” in accordance with EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”. Revenue from the sale of service contracts and maintenance renewals is recognized when a purchase order from the client’s customer is received; the service contract or maintenance agreement is delivered; the fee is fixed or determinable; the collection of the receivable is reasonably assured; and no significant post-delivery obligations remain unfulfilled. Revenue from lead generation services we perform is recognized as the services are accepted and is generally earned ratably over the service contract period. Some of our lead generation service revenue is earned when we achieve certain attainment levels and is recognized upon customer acceptance of the service. Revenue from service sales activities is recognized once these services have been delivered. Revenue from product sales is recognized at the time of shipment of the product directly to the client’s customer and has been historically an insignificant percentage of our net revenue. We generally do not enter into multiple-element revenue arrangements with our clients or customers.

Our revenue recognition policy involves significant judgments and estimates about collectibility. We assess the probability of collection based on a number of factors, including past transaction history and/or the creditworthiness of our clients’ customers, which is based on current published credit ratings, current events and circumstances regarding the business of our client’s customer and other factors that we believe are relevant. If we determine that collection is not reasonably assured, we defer revenue recognition until such time as collection becomes reasonably assured, which is generally upon receipt of cash payment.

Costs of Services

Costs of services consist of costs associated with promoting and selling our clients’ products and services including compensation costs of sales personnel, sales commissions and bonuses, costs of designing, producing and delivering marketing services, and salaries and other personnel expenses related to fee-based activities. Costs of services also include the cost of allocated facility and telephone usage for our telesales representatives as well as other direct costs associated with the delivery of our services. Most of the costs are personnel related and are relatively fixed. Bonuses and sales commissions will typically change in proportion to revenue or profitability.

Advertising

We expense advertising costs as incurred. These costs were not material and are included in sales and marketing expense.

Income Taxes

We account for income taxes using the liability method in accordance with Financial Accounting Standards Board Statement No. 109, “Accounting for Income Taxes” (“SFAS 109”). SFAS 109 requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements, but have not been reflected in our taxable income. A valuation allowance is established to reduce deferred tax assets to their estimated realizable value. Therefore, we provide a valuation allowance to the extent that we do not believe it is more probable than not that we will generate sufficient taxable income in future periods to realize the benefit of our deferred tax assets. At March 31, 2006, we had gross deferred tax assets of approximately $20 million. Our deferred tax asset is subject to a 100% valuation allowance and therefore is not recorded on our balance sheet as an asset.

Stock-Based Compensation

exchanges its equity instruments for goods or services, primarily focusing on accounting for transactions where an entity obtains employee services in share-based payment transactions.

The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The Company’s Consolidated Financial Statements as of and for the three months ended March 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Consolidated Statement of Operations. Prior to the adoption of SFAS 123(R), the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123,Accounting for Stock-Based Compensation (SFAS 123). Under the intrinsic value method, no stock-based compensation expense had been recognized in the Company’s Consolidated Statements of Operations, other than option grants to employees and directors below the fair market value of the underlying stock at the date of grant. See Note 6 for further discussion of the adoption of this standard and its effects on the financial statements presented herein.

Concentrations of Credit Risk and Credit Evaluations

Our financial instruments that expose us to concentrations of credit risk consist primarily of cash and cash equivalents and trade accounts receivable.

We place our cash and cash equivalents in a variety of financial institutions and limit the amount of credit exposure through diversification and by investing the funds in money market accounts and certificates of deposit which are insured by the FDIC.

We sell our clients’ products and services primarily to business end users and, in most transactions, assume full credit risk on the sale. Credit is extended based on an evaluation of the financial condition of our client’s customer, and collateral is generally not required. Credit losses have traditionally been immaterial, and such losses have been within management’s expectations.

We enter into contracts with our clients to market and sell our clients’ products and services. As a result, we primarily earn revenue from sales to the client’s customer, not the client itself. We have generated a significant portion of our net revenue from sales to customers of a limited number of clients. During the three months ended March 31, 2006, two customers accounted for more than 10% of our revenue and collectively represented 48% of our net revenue with the largest representing 38% of our net revenue. In the quarter ended March 31, 2005, these same two customers each accounted for more than 10% of our revenue and collectively represented 57% of our net revenue.

No individual client’s end-user customer accounted for 10% or more of our revenues in any period presented.

We have outsourced services agreements with our clients that expire at various dates ranging through April 2009. Many of our client agreements contain automatic renewal clauses. These clients may, however, terminate their contracts for cause in accordance with the provisions of each contract. In most cases, a client must provide us with advance written notice of its intention to terminate. Any loss of a single significant client may have a material adverse effect on the Company’s consolidated financial position, cash flows and results of operations.

Fair Value of Financial Instruments

The amounts reported as cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate fair value due to their short-term maturities. The fair value for our investments in marketable equity securities is estimated based on quoted market prices. The carrying value of those securities, as of each period presented, approximates their fair value.

The fair value of short-term and long-term capital lease and debt obligations is estimated based on current interest rates available to us for debt instruments with similar terms, degrees of risk and remaining maturities. The carrying values of these obligations, as of each period presented, approximate their respective fair values.

Segment Reporting

We report segment results in accordance with SFAS No. 131, “Segment Reporting” (“SFAS 131”). Under SFAS 131, reportable segments represent an aggregation of operating segments that meet certain criteria for aggregation specified in SFAS 131.

Our two primary business units, service sales and lead generation, have been aggregated into one reportable segment. The aggregation of operating segments is based on management by the chief operating decision-maker for the segment as well as similarities of products, production processes, and economic characteristics. We primarily operate in one geographical segment, North America. Substantially all of our sales are made to our client’s customers in the United States.

Recently Issued Accounting Standards

In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) 153, “Exchanges of Nonmonetary Assets” (“SFAS 153”). SFAS 153 amends the guidance in APB Opinion No. 29, “Accounting for Nonmonetary Transactions” to eliminate certain exceptions to the principle that exchanges of nonmonetary assets be measured based on the fair value of the assets exchanged. SFAS 153 eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. This statement is effective for nonmonetary asset exchanges in fiscal years beginning after June 15, 2005. The adoption of SFAS 153 on January 1, 2005 did not have an impact on our consolidated results of operations, financial position or cash flows.

3. Net Loss Per Share

Basic net loss per common share is computed using the weighted-average number of shares of common stock outstanding during the year, less shares subject to repurchase. Diluted earnings per common share also gives effect, as applicable, to the potential dilutive effect of outstanding stock options, using the treasury stock method, and convertible securities, using the if converted method, as of the beginning of the period presented or the original issuance date, if later.

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


	Three Months Ended March 31,
	2006			2005
Net income (loss)	$	820		$	(2,506	)

Weighted-average common shares of common stock outstanding – basic		12,496			9,269
Plus: Outstanding dilutive options and warrants outstanding		1,653			—
Less: weighted-average shares subject to repurchase		(1,081	)		—

Weighted-average shares used to compute diluted net loss per share		13,068			9,269

Basic net income (loss) per share	$	0.06		$	(0.27	)

Diluted net income (loss) per share	$	0.07		$	(0.27	)

The Company has excluded all outstanding warrants and stock options from the calculation of basic and diluted net loss per share because these securities are antidilutive for the period ended March 31, 2005. Options and warrants to purchase 1,416,137 shares of common stock have been excluded for the quarter ended March 31, 2005.

On December 15, 2005, we effected a 1-for-5 reverse stock split. All per share and share amounts have been restated to reflect the reverse stock split. Basic and diluted loss per common share are calculated by dividing net income (loss) by the weighted average number of common shares outstanding during the period.

4. Sunset Direct Acquisition

On February 8, 2005, we acquired all of the issued and outstanding voting securities of Sunset Direct by means of a merger of Sunset Direct and a wholly owned subsidiary of Rainmaker, with Sunset Direct continuing as the surviving corporation. The results of Sunset Direct’s operations have been included in the consolidated financial statements since that

date. Sunset Direct is an outsource provider of lead generation services primarily to high-tech companies. As a result of the acquisition, Sunset Direct has been accretive to our financial results and has provided certain other benefits including cross-selling, client diversification, expanded service offering and a larger, more cost-effective talent pool. Pursuant to our Agreement and Plan of Merger (the “Merger Agreement”) with Sunset Direct, we paid approximately $3.5 million in cash that was used to retire approximately $3.3 million of debt and certain liabilities retained by Sunset Direct, issued 664,080 shares of common stock in exchange for the outstanding capital stock of Sunset Direct, and incurred approximately $910,000 of acquisition related costs. The estimated value of the 664,080 shares of Rainmaker common stock was $2.2 million computed at a per share price of $3.32, the average closing price for the period from February 8, 2005 through February 14, 2005.

Our acquisition of Sunset Direct has been accounted for as a business combination. Assets acquired and liabilities assumed were recorded at their estimated fair values as of February 8, 2005. The total purchase price was $6.6 million as follows:


	(in thousands)
Issuance of 664,080 shares of Rainmaker Common Stock	$	2,205
Cash payment for acquisition of Sunset Direct		3,476
Acquisition related transaction costs		910

Total purchase price	$	6,591

Using the purchase method of accounting, the total purchase price was allocated to Sunset Direct’s net tangible and identifiable intangible assets based on their estimated fair values as of February 8, 2005. The excess of the purchase price over the net tangible and identifiable intangible assets was recorded as goodwill. Based upon a valuation by management, the total purchase price was allocated as follows:


	(in thousands)
Tangible assets acquired	$	1,866
Identifiable intangible assets		4,300
Goodwill		3,663
Net liabilities assumed		(3,238	)

Total purchase price allocation	$	6,591

Goodwill represents the excess of the purchase price over the fair value of tangible and identifiable intangible assets acquired. Goodwill amounts are not amortized, but rather are tested for impairment at the reporting unit level at least annually. In the event that we determine that the value of goodwill has become impaired, we will incur an accounting charge for the amount of impairment during the fiscal quarter in which such determination is made.

Identifiable intangible assets acquired consist of developed technology, customer relationships, trade names, and a proprietary database. The estimated fair value of identifiable intangible assets was determined by management. Amortization of the intangible assets is calculated using an accelerated method for customer relationships that is based on the estimated future cash flows of the relationships, and the straight-line method for the proprietary database and developed technology. The weighted-average useful life of the amortizable intangible assets acquired is approximately five years. The “Sunset Direct” trade name is expected to be used indefinitely and is not being amortized, but will be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the trade name may not be recoverable.

On June 30, 2005, the Company filed a registration statement with the Securities and Exchange Commission with respect to the shares were issued to Sunset Direct’s shareholders that was declared effective July 19, 2005. Pursuant to that registration statement all shares are available for public sale.

The following unaudited pro forma information presents a summary of the results of operations of the Company assuming the acquisition of Sunset Direct occurred at the beginning of each respective period and assumes the amortization of intangible assets and recording additional interest expense. In August 2004, Sunset Direct acquired certain assets and assumed certain liabilities of a private Texas lead generation company. The following unaudited financial information of Sunset Direct also gives effect to such acquisition as if it occurred on January 1, 2005. (in thousands, except per share amounts):


	Quarter Ended March 31, 2005
	(Unaudited)
Revenues	$	7,411

Net income (loss)	$	(2,800	)

Pro forma – basic net income (loss) per share:	$	(0.29	)

Pro forma – fully diluted net income (loss) per share:	$	(0.29	)

Pro forma weighted average shares outstanding – basic:		9,550

Pro forma weighted average shares outstanding - diluted:		9,550

5. Property and Equipment


Property and equipment:	Estimated Useful Life	March 31, 2006			December 31, 2005
Property and equipment:	Estimated Useful Life	March 31, 2006			December 31, 2005
Computer equipment	3 years	$	6,123		$	5,934
Capitalized software and development (1)	2-5 years		12,056			8,830
Furniture and fixtures	5 years		570			511
Leasehold improvements	Lease term		166			103

			18,915			15,378
Accumulated depreciation and amortization			(14,312	)		(13,851	)
Construction in process (1)			4			2,883

Property and equipment, net		$	4,607		$	4,410

(1)

During late 2004 and throughout 2005, we developed a replacement for our existing system to identify potential service sales opportunities, track the sales contacts and process the sale of the service contracts. During the three months ended March 31, 2006 we deployed and begin depreciating the new order entry system. In total, we have invested $3.2 million in the new order entry system including $163,000 in capitalized interest costs. We will depreciate this asset on a straight line basis over an estimated life of 5 years.

6. Stockholders’ Equity

Private Placement

exemptions provided by Section 4(2) of the Securities Act and Regulation D promulgated there under and in reliance on similar exemptions under applicable state laws. Under the Securities Purchase Agreements, the Company also granted certain registration rights to each of the investors pursuant to which the Company filed a registration statement on Form S-3 that became effective on March 21, 2006, with respect to the common stock issued under the Securities Purchase Agreements and the common stock issuable upon conversion of the related warrants.

Stock Option Plans

In 2003, the board of directors adopted and the shareholders approved the 2003 Stock Incentive Plan (the “2003 Plan”). The 2003 Plan provides for the issuance of incentive stock options or nonqualified stock options to employees, consultants and non-employee members of the board of directors, and issuance of shares of common stock for purchase or as a bonus for services rendered. Options granted under the 2003 Plan are priced at not less than 100% of the fair value of the common stock on the date of grant and have a maximum term of ten years from the date of grant. In the case of incentive stock options granted to employees who own 10% or more of our outstanding common stock, the exercise price may not be less than 110% of the fair value of the common stock on the date of grant and such options will have a maximum term of five years from the date of grant. Options granted to employees and consultants become exercisable and vest in one or more installments over varying periods ranging up to five years as specified by the board of directors. Unexercised options expire upon, or within, six months of termination of employment, depending on the circumstances surrounding termination.

The 2003 Plan provides for a fixed issuance amount to non-employee members of the board of directors at prices not less than 100% of the fair value of the common stock on the date of grant and a maximum term of ten years from the date of grant. Generally, options granted to non-employee members of the board of directors are immediately exercisable and vest in two or more installments over periods ranging from twelve to twenty-four months from the date of grant. Unvested options expire twelve months from the date termination of service as a non-employee member of the board of directors.

The number of shares authorized for grant under the 2003 Plan automatically increases annually on the first trading date of January by an amount equal to the lesser of 4% of our outstanding common stock at December 31 or 3,000,000 shares.

In 1999, the board of directors adopted and the shareholders approved the 1999 Stock Incentive Plan (the “1999 Plan”). The 1999 Plan provides for the issuance of incentive stock options or nonqualified stock options to employees, consultants and non-employee members of the board of directors, and issuance of shares of common stock for purchase or as a bonus for services rendered. Options granted under the 1999 Plan are priced at not less than 100% of the fair value of the common stock on the date of grant and have a maximum term of ten years from the date of grant. In the case of incentive stock options granted to employees who own 10% or more of our outstanding common stock, the exercise price may not be less than 110% of the fair value of the common stock on the date of grant and such options will have a maximum term of five years from the date of grant. Options granted to employees and consultants become exercisable and vest in one or more installments over varying periods ranging up to five years as specified by the board of directors. Unexercised options expire upon, or within, six months of termination of employment, depending on the circumstances surrounding termination.

The 1999 Plan provides for a fixed issuance amount to non-employee members of the board of directors at prices not less than 100% of the fair value of the common stock on the date of grant and a maximum term of ten years from the date of grant. Generally, options granted to non-employee members of the board of directors are immediately exercisable and vest in two or more installments over periods ranging from twelve to twenty-four months from the date of grant. Unvested options expire twelve months from the date termination of service as a non-employee member of the board of directors. No additional shares will be granted under the 1999 Plan.

Stock-based compensation expense

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment, (SFAS 123(R)) which establishes standards for the accounting of transactions in which an entity exchanges its equity instruments for goods or services, primarily focusing on accounting for transactions where an entity obtains employee services in share-based payment transactions. SFAS No. 123R requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments, including stock options, based on the grant-date fair value of the award and to recognize it as compensation expense over the period the employee is required to provide service in exchange for the award, usually the vesting period. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees (APB 25) for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).

Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’s Consolidated Statement of Operations for the first quarter of fiscal 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). As stock-based compensation expense recognized in the Consolidated Statement of Operations for the first quarter of fiscal 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We included no estimated forfeiture rate for the three months ended March 31, 2006. As a result of the acceleration of vesting of 1,126,439 “out-of-the-money” options in December 2005, which was done in order to avoid compensation expense under the provisions of SFAS 123(R),there were a small number of unvested options remaining that were held by directors, officers and long term employees. The remaining options had relatively short vesting periods remaining with strike prices below the current market price for the stock. Therefore we expected all options to be exercised. In the Company’s pro forma information required under SFAS 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred.

SFAS 123(R) requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options to be classified as financing cash flows. Due to the Company’s historical losses and significant NOLs, we did not record such tax benefits during the three months ended March 31, 2006. Prior to the adoption of Statement SFAS 123(R) those benefits would have been reported as operating cash flows had the Company received any tax benefits related to stock option exercises.

The fair value of stock-based awards to employees is calculated using the Black-Scholes option pricing model, even though this model was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company’s stock options. The Black-Scholes model also requires subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. The risk-free rate is based on the U.S Treasury rates in effect during the corresponding period of grant. The expected volatility is based on the historical volatility of our stock price. These factors could change in the future, which would affect the stock-based compensation expense in future periods.

Valuation and Expense Information under SFAS 123(R)

The weighted-average fair value of stock-based compensation to employees is based on the single option valuation approach. No forfeitures were estimated and it is assumed no dividends will be declared. The estimated fair value of stock-based compensation awards to employees is amortized using the straight-line method over the vesting period of the options. We calculate the estimated compensation expense separately for Employee Stock Options (“Options”) and Employee Stock Purchase Plan (“Purchase Plan”). There were no stock option grants during the three months ended March 31, 2006 and accordingly no fair value calculations were prepared. The stock-based compensation expense during the three months ended March 31, 2006 relates to awards previously issued.

We expense stock-based compensation to the same operating expense categories that the respective award grantee’s salary expense is reported. The table below reflects stock based compensation expense under SFAS 123(R) for the Options and Purchase Plan for the three months ended March 31, 2005 as follows (in thousands):


	Three Months Ended March 31, 2006
	Options		Purchase Plan		Total
Stock based compensation expense included:
Cost of services	$	—	$	1	$	1
Technology		1		1		2
General & administrative		8		3		11

	$	9	$	5	$	14

At March 31, 2006, an immaterial amount of stock-based compensation related to unvested awards had not been amortized and will be expensed during the remainder of fiscal 2006.

The table below reflects net income and basic and diluted net income per share for the three months ended March 31, 2006 compared with the pro forma information for the three months ended March 31, 2005 as follows (in thousands except per-share amounts):


	Actual Results under SFAS 123R for the Three Months Ended March 31, 2006			Pro Forma Results under SFAS 123R for the Three Months Ended March 31, 2005
Net loss as reported for the comparative period⁽¹⁾		N/A		$	(2,506	)
Stock-based employee compensation expense⁽²⁾		(14	)		(231	)

Net income (loss) including effect of stock based compensation⁽³⁾	$	820		$	(2,737	)

Basic and diluted loss reported for the comparative period ⁽³⁾		N/A		$	(0.27	)

Basic net income (loss) including effect of stock based compensation⁽³⁾	$	0.06		$	(0.30	)

Diluted net income (loss) including effect of stock based compensation⁽³⁾	$	0.07		$	(0.30	)

⁽¹⁾	Net loss and net loss per share prior to fiscal 2006 did not include stock-based compensation expense for employee stock options under SFAS 123 because the Company did not adopt the recognition provisions of SFAS 123.

⁽²⁾	Stock-based compensation expense prior to fiscal 2006 is calculated based on the pro forma application of SFAS 123.

⁽³⁾	Net income and net income per share prior to fiscal 2006 represents pro forma information based on SFAS 123.

Prior to fiscal 2006, the weighted-average fair value of stock-based compensation to employees was based on the single option valuation approach. Forfeitures were recognized as they occurred and it was assumed no dividends would be declared. The estimated fair value of stock-based compensation awards to employees was amortized using the straight-line method over the vesting period of the options. The weighted-average fair value calculations used for the pro forma presentation of results including stock based compensation were based on the following weighted-average assumptions:


	Three Months Ended March 31, 2005
	Options		Purchase Plan
Expected life in years	4.00		0.5
Volatility	1.75		0.91
Risk-free interest rate	3.1	%	1.6	%

A summary of activity under our Stock Incentive Plans for the three months ended March 31, 2006 is as follows:


	Options Outstanding
	Available for Grant	Number of Shares		Weighted Average Exercise Price
Balance at December 31, 2005	712,629	1,831,411		$	4.75
Authorized	452,277	—		$	—
Granted	—	—		$	—
Exercised	—	(25,840	)	$	3.50
Canceled	17,488	(17,488	)	$	8.00

Balance at March 31, 2006	1,182,394	1,788,083		$	3.56

The following table summarizes information about stock options outstanding as of March 31, 2006:


	Outstanding Options				Options Exercisable
Range of Exercise Prices	Number of Shares	Weighted Average Contractual Life (In Years)	Weighted Average Exercise Price		Number of Shares	Weighted Average Exercise Price
$1.10 -$1.35	138,697	4.35	$	1.15	138,499	$	1.15
$1.36 - $2.29	141,296	4.85	$	1.61	124,735	$	1.54
$2.30 - $2.55	598,147	9.35	$	2.51	598,141	$	2.51
$2.56 - $2.80	446,570	9.34	$	2.60	446,570	$	2.60
$2.81 - $3.90	130,363	9.12	$	2.99	130,362	$	2.99
$3.91 - $7.70	74,596	7.29	$	5.73	74,595	$	5.73
$7.71 - $13.28	250,334	8.03	$	9.47	250,328	$	9.47
$13.29 - $20.32	8,080	7.18	$	16.42	8,080	$	16.42

$1.10 - $20.32	1,788,083	8.31	$	3.56	1,771,310	$	3.58

Employee Stock Purchase Plan

In 1999, our board of directors adopted and our shareholders approved the 1999 Employee Stock Purchase Plan (the “Purchase Plan”). The Purchase Plan is available for all full-time employees possessing less than 5% of combined voting power on all outstanding classes of stock. The Purchase Plan provides for the issuance of common stock at a purchase price of 85% of the fair value of the common stock at the beginning or end of the offering period, whichever is lower. Purchase of shares is made through employee payroll deductions and may not exceed 15% of an employee’s total compensation. Unless terminated earlier at the discretion of our board of directors, the Purchase Plan terminates on the earlier of the last business day in October 2009, the date on which all shares available for issuance have been sold or the date on which all purchase rights are exercised in connection with a change in control. The number of shares available for future issuance under the Purchase Plan automatically increases annually on the first trading day of January by an amount equal to the lesser of 1% of our outstanding common stock at the end of the calendar year, or 400,000 shares. As of March 31, 2006, a total of 135,498 shares had been issued under the Purchase Plan and 455,779 shares were available for future issuance. At March 31, 2006, our employees had subscribed to purchase 10,225 shares of stock which will settle during the quarter ended June 30, 2006.

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

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Form 10-Q contains forward-looking statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of such terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risks outlined under “Risk Factors”, that may cause our, or our industry’s, actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activities, performance or achievements expressed or implied by such forward-looking statements.

Among the important factors which could cause actual results to differ materially from those in the forward-looking statements are general market conditions, unfavorable economic conditions, our ability to integrate acquisitions and expand our call center without disruption to our business, our ability to execute our business strategy, the effectiveness of our sales team and approach, our ability to target, analyze and forecast the revenue to be derived from a client and the costs associated with providing services to that client, the date during the course of a calendar year that a new client is acquired, the length of the integration cycle for new clients and the timing of revenues and costs associated therewith, our client concentration given that the Company is currently dependent on a few large client relationships, potential competition in the marketplace, the ability to retain and attract employees, market acceptance of our service programs and pricing options, our ability to maintain our existing technology platform and to deploy new technology, our ability to sign new clients and control expenses, the possibility of the discontinuation of some client relationships, the financial condition of our clients’ business, our ability to raise additional equity or debt financing and other factors detailed in Part II Item 1A – “Risk Factors” of this Form 10-Q.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of such statements. We assume no obligation to update such forward-looking statements publicly for any reason even if new information becomes available in the future.

Overview

Rainmaker is a leading provider of business-to-business sales and marketing services, leveraging integrated telesales, marketing, web technologies, and data analytics to achieve higher revenue for clients. Our core activities include lead qualification and nurturing management, lead generation for product sales, subscription and service contract sales, and contract renewals and warranty extension sales. Our services are available individually or as an integrated solution.

We focus on providing services to our clients that enable them to grow their revenues more efficiently for their products and services. With the expertise of our people, the efficiency of our processes, and our proprietary technology, we offer individual and integrated services that increase our clients’ revenue potential.

Our core activities are data development and analytics, lead generation, lead management and nurturing, installed base sales, and subscription and service contract sales. In addition to helping to generate increased revenue for our clients, we also enable our clients to deepen the relationship they have with the customers we contact on behalf of our clients. By selecting Rainmaker to assist them with improving the efficiency of their sales and marketing activities, clients can focus their attention on other business priorities

To date, the majority of our revenues have been derived from marketing and selling our client’s service contracts. Because of this, our quarterly and annual revenues are subject to fluctuation based on the total service contracts available for renewal or conversion in that period. As a result of this as well as general economic conditions in the United States, our net revenue has fluctuated in the past and may do so again. If the economic conditions in the United States worsen or if a wider or global economic slowdown occurs, we may experience a material adverse impact on our business, operating results, and financial condition. During unfavorable economic periods, it may be more difficult to sign new clients or expand relationships with existing clients. In addition, during unfavorable economic periods, spending on existing and new technology may decrease, resulting in downgrades of service contracts or fewer new service contracts, which may have a material adverse impact on our business. This impact may be offset as technology companies may compensate for decreased spending on new technology and technology upgrades with expanded service contracts on their existing technology.

Our quarterly and annual operating results may continue to fluctuate in the future based on a number of factors, many of which are beyond our control. We believe that period-to-period comparisons of operating results should not be relied upon as predictive of future performance. Our operating results are expected to vary significantly from quarter to quarter and are difficult to predict. Our historical revenue has tended to fluctuate based on seasonal buying patterns of our clients and their customers. Our prospects must be considered in light of the risks, expenses and difficulties encountered by technology companies, particularly given that we operate in new and rapidly evolving markets, and face an uncertain economic environment. We may not be successful in addressing such risks and difficulties. See Part II Item 1A – “Risk Factors” of this Form 10-Q.

Critical Accounting Policies/Estimates

Our 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. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts in our consolidated financial statements. We evaluate our estimates on an on-going basis, including those related to our revenues, asset impairments, restructuring charges, income taxes and commitments and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Although actual results have historically been reasonably consistent with management’s expectations, the actual results may differ from these estimates or our estimates may be affected by different assumptions or conditions.

Management has discussed the development of our critical accounting policies with the audit committee of the board of directors and they have reviewed the disclosures of such policies and management’s estimates in this Management’s Discussion and Analysis of Financial Condition and Results of Operations.

On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment, (SFAS 123(R)) which, among other things, requires us to amortize as expense the estimated intrinsic value of our employee share-based compensation. As disclosed in Note 6 in the Condensed Consolidated Financial Statements in Part I Item 1 of this Form 10-Q, we incurred $14,000 of share-based compensation during the three months ended March 31, 2006.

Other than the adoption of SFAS 123 (R), management believes there have been no significant changes during the three months ended March 31, 2006 to the items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005.

Results of Operations

The following table sets forth for the periods given selected financial data as a percentage of our revenue. The table and discussion below should be read in connection with the financial statements and the notes thereto which appear elsewhere in this report as well as with our financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005.


	Quarter Ended March 31,
	2006		2005
Net revenue	100.0	%	100.0	%

Operating expenses:
Costs of services	49.7	%	60.6	%
Sales and marketing	6.6	%	11.6	%
Technology	11.0	%	14.0	%
General and administrative	18.7	%	40.6	%
Depreciation and amortization	6.3	%	12.1	%

Total operating expenses	92.3	%	138.9	%

Operating income (loss)	7.7	%	(38.9	)%
Interest and other (expense) income, net	0.2	%	(0.01	)%
Provision for income taxes	0.5	%	0	%

Net income (loss)	7.4	%	(39.0	)%

Comparison of three months ended March 31, 2006 and 2005

Net Revenue. Net revenue increased 72% to $11.1 million for the three months ended March 31, 2006 from $6.4million for the comparable period in 2005. The increase in revenue was primarily the result of $2.2 million growth of revenues contributed by our services sales activities and a $2.5 million increase in reported revenue from lead generation

activities. The revenue growth from service sales activities is from within our existing client base as we were able expand our presence with our clients as well as execute on our sales and marketing strategies. While lead generation revenue did grow during the comparative periods, a significant part of the reported increase is related to the comparative period only reflecting revenue from February 8, 2005 through March 31, 2005.

Our quarterly and annual operating results have fluctuated in the past and are likely to do so in the future. In particular, our revenues are not predictable with any significant degree of certainty and are affected by changes in our clients’ service program offerings, including service contract fees, and by general economic conditions in the United States. In the current economic environment, we have limited visibility over anticipated revenue trends in future periods. Our liquidity, including our ability to comply with loan agreement covenants, may be adversely affected if we were to lose a significant client.

Costs of services. Costs of services increased 42% to $5.5 million for the three months ended March 31, 2006 from $3.9 million for the three months ended March 31, 2005. Costs of services decreased as a percentage of revenue from 60.6% in the three months ended March 31, 2005 to 49.7% for the three months ended March 31, 2006. The total increase of $1.6 million for the comparative three month periods was mostly due to an overall increase of approximately 243 employees and temporary personnel in direct sales and marketing as a result of our acquisition of Sunset Direct in February 2005. Only those costs from the acquisition date thru March 31, 2005 are included in the comparative quarter then ended. We also incurred additional variable costs such as sales commissions and transactional expense due to our increase in revenue. The decrease in the percentage of cost of services to revenue (or inversely the improvement in gross margin) is due largely to our completion of the transition to our Austin, Texas call center. The Austin call center provides us with a lower cost environment where, over the past year, we have been able to improve productivity per sales rep by approximately 11%. Costs of services in absolute dollars and as a percentage of revenue have both fixed and variable components. These costs are expected to continue to fluctuate based on our client mix and our revenue levels.

Sales and Marketing Expenses. Sales and marketing expenses declined 2% to $732,000 for the three months ended March 31, 2006 from $744,000 for the three months ended March 31, 2005. The three month period ended March 31, 2005 included $139,000 of severance costs that were not incurred in the quarter ended March 31, 2006. Excluding the severance item, the relative increase of $127,000 reflects the addition of 5 salespeople focused on adding new clients to our business. The increase also reflects a full quarter of costs associated with lead generation sales and marketing activities from our Sunset Direct acquisition which were only included in part of the quarter ended March 31, 2005.

Technology Expenses. Technology expenses increased 36% to $1.2 million for the three months ended March 31, 2006 from $900,000 for the three months ended March 31, 2005. As we invest in on-going upgrades to our IT infrastructure we have incurred higher consulting and support fees. These costs include monthly hosting fees for our existing IT infrastructure which is now being co-located as well as hosting fees related to our new order entry system which was brought into production during the quarter ended March 31, 2006. In addition, part of the comparative increase is attributable to the addition of technology personnel and operations through our acquisition of Sunset Direct which were only included in part of the quarter ended March 31, 2005.

General and Administrative Expenses. General and administrative expenses decreased 21% to $2.1 million for the three months ended March 31, 2006, as compared to $2.6 million for the comparable period of 2005. The three month period ended March 31, 2005 included $493,000 of severance costs that were not incurred in the quarter ended March 31, 2006. The comparative period ended March 31, 2005 includes only part of the expenses from our Sunset Direct acquisition. Despite the addition of a full quarter of costs from the Sunset Direct acquisition, our costs have declined due to the integration of the two organizations and the elimination of redundant staff and other costs.

Depreciation and Amortization Expenses. Depreciation and amortization expenses decreased 11% to $696,000 for the three months ended March 31, 2006, from $778,000 for the comparable period in 2004. Amortization expense associated with intangibles acquired in connection with our acquisition of Sunset Direct are reported in both comparable periods with $235,000 and $162,000 in the three months ended March 31, 2006 and 2005, respectively. Sunset Direct intangible amortization was only included in part of the quarter ended March 31, 2005. The overall decrease in depreciation and amortization expense is the result of assets becoming fully depreciated during the third and fourth quarters of 2005. These include our legacy order entry system and the leasehold improvements on our former headquarters in Scotts Valley. In March of 2006, we placed in service our new order entry system and began depreciation of this $3.2 million asset over its estimated useful life of five years on a straight line basis.

Interest and Other (Expense) Income, Net. The components of interest and other income (expense), net are as follows (dollars in thousands):


	Quarter Ended March 31,						Increase (Decrease)
	2006			2005			$ Amt		%
Interest income	$	34		$	32		$	2		6.2	%
Interest expense		(11	)		(35	)		39		111	%
Other		(2	)		—			2		100	%

	$	21		$	(3	)	$	24	$	50

The increase in interest income is attributable to an increase in cash available due to the proceeds of our private equity placement that raised $5.3 million, net of expenses which was completed on February 7, 2006. As explained further in “Liquidity and Sources of Capital” our cash balances will fluctuate throughout each quarter due to our terms for payment to our clients for the service contracts that we sell.

The decrease in interest expense is the result of the capitalization of interest cost. During the development of our client management system and while we capitalize internal costs, we are required to capitalize interest on the costs of assets under development. Accordingly, $63,000 in interest costs were capitalized to our client management system during the quarter ended March 31, 2006. During the year of the comparative periods, we increased our borrowings, primarily the $3.0 million Term Loan obtained in February 2005 in connection with the acquisition of Sunset Direct and interest on the June 2005 Term Loan to fund the purchase and implementation of our new client management system, in addition to interest on obligations of Sunset Direct under capital leases. Our cost for interest during the three months ended March 31, 2006 was $74,000 before the deduction for capitalized interest.

Liquidity and Sources of Capital

To date, we have funded operations from net cash proceeds from the sale of common stock and the incurrence of debt. During the three months ended March 31, 2006, we achieved profitability and generated cash from operations in the amount of $3.3 million. On February 7, 2006, we raised $5.3 million, net of issuance costs, from a private placement of our common stock. In December 2005, our lender increased our line of credit facility from $2 million to $4 million. In June 2005, we raised $2.6 million, net of issuance costs, from a private placement of our common stock. In June 2005, we also obtained a $1.5 million term loan that is being utilized to fund the purchase and implementation of our new client management system. In February 2005, we obtained a $3 million term loan to retire certain indebtedness and certain other liabilities of Sunset Direct in connection with our acquisition of Sunset Direct. In February 2004, we raised $6.3 million, net of issuance costs, from a private placement of our common stock.

Cash and cash equivalents were $15.4 million at March 31, 2006 as compared to $9.7 million at December 31, 2005. We had negative working capital of $3.8 million at December 31, 2005. As a result of the net $5.3 million raised in a private placement of our common stock in February 2006, the negative working capital at December 31, 2005 has been fully funded and we now have positive working capital of $2.1 million. Our cash balances may fluctuate throughout each quarter due to our terms for payment to our clients for the service contracts that we sell.

Operating activities for the quarter ended March 31, 2006 provided cash of $3.3 million as compared to cash provided by operating activities of $1.9 million in the comparable quarter in 2005. Cash provided by operating activities during the quarter ended March 31, 2006 is primarily the result of the $3.5 million combined increase in accounts payable, deferred revenue and accrued compensation and benefits, and the reduction of other accrued liabilities. These are offset by increases in accounts receivable and prepaid assets totaling $1.8 million. Together, the change in operating assets and liabilities contributed $1.7 million in operating cash during the quarter ended March 31, 2006. For the quarter ended March 31, 2006 we generated net income of $820,000. The non-cash expenditures of depreciation and amortization of property and intangibles, stock-based compensation and the provision for allowance for doubtful accounts totaled $799,000. Together, net income and non-cash expenditures contributed $1.6 million to cash from operating activities.

During the three months ended March 31, 2006, we achieved profitability and generated cash from operations in the amount of $3.3 million. While we have not been profitable in the past, our ability to generate a profit in the three months ended March 31, 2006 was the result of investments in technology, sales and marketing and personnel that in turn resulted in the successful execution of our business strategy. While we are hopeful that we can continue to be profitable and generate cash from operations in the future, there can be no assurances that we will continue to do so. We expect to continue to invest in technology and marketing strategies as well as the potential acquisition of businesses. Accordingly, in order to fully execute these long-term business strategies, we may continue to raise cash proceeds from the sale of stock and the incurrence of debt.

Accounts receivable increased at March 31, 2006 as compared to December 31, 2005 as a result of higher first quarter sales in 2006 as compared to the fourth quarter of 2005 as well as the comparative quarter ended March 31, 2005. We experienced higher sales related to our largest client who ended their fiscal year during our quarter ended March 31, 2006 and therefore provided us with a seasonal revenue increase. Our days sales outstanding (DSO), improved to 26 days at March 31, 2006 from 28 days at December 31, 2005. Our accounting treatment for net revenue (see “Revenue Recognition and Presentation” under Note 2 to the Condensed Consolidated Financial Statements) requires that we report revenue net of the obligation to our clients for our cost of the service sales contracts we sell on their behalf. Since we record the gross billing to the end customer of our clients in our accounts receivable, we calculate DSO based on our ability to collect those gross billings from the end customers.

The increase in accounts payable was primarily due to the timing of payments to our clients for service and maintenance contracts we sold on their behalf. The increase in accrued compensation and benefits at March 31, 2006 as compared to December 31, 2005 is due to higher accruals for commissions and bonuses as result of higher sales volumes and positive operating results. Deferred revenue increased because we invoiced several large customers in advance of lead generation work to be performed. The decrease in other accrued liabilities is attributable to the reduction of liabilities related to cash received for non-service payments inadvertently paid to the Company by its customers instead of paid directly to the Company’s clients. At the time of cash receipt the Company records a current liability for the amount of non-service payments received.

Cash used in investing activities was $552,000 and $5.7 million for the quarters ended March 31, 2006 and 2005, respectively. The decrease in cash used in investing activities was primarily due to our investment in Sunset Direct that totaled $4.2 million and was reported in the comparative period last year. In both periods reported, we invested similar amounts to improve the capacity of our systems and software to support the expansion of our client business. We invested $658,000 and $786,000, primarily, to upgrade our computer system in the quarter ended March 31, 2006 and 2005, respectively. Restricted cash as of March 31, 2006 decreased by $106,000 during the quarter ended March 31, 2006, as compared to an increase of $700,000 in the comparable period in 2005.

Cash provided by financing activities was $2.8 million for the three months ended March 31, 2006 as compared to cash provided by financing activities of $2.7 million for the comparative period in 2005. Cash provided by financing activities in 2006 was primarily a result of net proceeds totaling $5.3 million from our placement of private equity which was completed on February 7, 2006. This amount was offset by principal payments totaling $2.5 million on our line of credit, term loans and other financing obligations. Cash provided by financing activities in the 2005 comparative period was primarily the result of term loan proceeds of $3.0 million, partially offset by the repayment of capital lease and other financing arrangements.

Our principal source of liquidity as of March 31, 2006 consisted of $15.4 million of cash and cash equivalents and $3.0 million remaining on our Revolving Credit Facility. In connection with a financial covenant related to our Term Loan and the June 2005 Term Loan, we are required to maintain unrestricted cash deposits of $3.0 million with our lender Bridge Bank, N.A., which is included in the $15.4 million of cash and cash equivalents. We anticipate that our existing capital resources and cash flow expected to be generated from future operations will enable us to maintain our current level of operations, our planned operations and our planned capital expenditures for at least the next twelve months.

In December 2005, our Business Loan Agreement and Commercial Security Agreement with Bridge Bank, N.A. (the “Revolving Credit Facility”) was increased to $4.0 million from the then existing $2.0 million. In addition, the maturity date was extended to December 2006 from May 2006. We had originally entered into this Revolving Credit Facility with our lender in April 2004. A component of the Revolving Credit Facility is a $1.0 million Letter of Credit facility. Borrowings and letter of credit issuances are subject to borrowing base calculations and other limitations. As of December 31, 2005, we had borrowed $2.0 million under the Revolving Credit Facility, which was repaid in full in January 2006. As of March 31, 2006, we had no borrowings under the Revolving Credit Facility. Interest on the Revolving Credit Facility is a variable rate of prime per annum (7.75% at March 31, 2006), but not less than 4% per annum. In addition, three letters of credit in the aggregate face amount of $925,000 were outstanding under the Revolving Credit Facility as of March 31, 2006 (as described below).

In July 2005, we issued an Irrevocable Standby Letter of Credit in the amount of $100,000 to our landlord for a security deposit for our new corporate headquarters located in Campbell, California. In 2004, we issued Irrevocable Standby Letters of Credit to two of our clients. The letters of credit were issued in the amounts of $325,000 and $500,000 as guarantees for service contracts sold by us on behalf of our clients and both expire in September 2006. The letters of credit were issued under the Revolving Credit Facility described above. As of March 31, 2006, no amounts have been drawn against the letters of credit.

In June 2005, we entered into a Business Loan Agreement with Bridge Bank, N.A., pursuant to which we obtained a $1.5 million term loan (the “June 2005 Term Loan”) that is being utilized to fund the purchase and implementation of our new client management system. The June 2005 Term Loan is to be repaid in 36 monthly installments of $42,000 plus interest at a variable rate of prime plus 1.00% per annum (8.75% per annum at March 31, 2006).

Concurrent with the closing of the merger transaction with Sunset Direct in February 2005, we entered into a Business Loan Agreement and Commercial Security Agreement with Bridge Bank, N.A., and obtained a $3.0 million term loan (the “Term Loan”) that that was utilized to retire certain indebtedness and certain other liabilities of Sunset Direct. The Term Loan is to be repaid in 36 monthly installments of $83,000 plus interest at a variable rate of prime plus 1.00% per annum (8.75% per annum at March 31, 2006).

The Term Loan, June 2005 Term Loan and Revolving Credit Facility are secured by substantially all of our consolidated assets, including intellectual property. We must comply with certain financial covenants, including maintaining a minimum quick ratio and a minimum tangible net worth and maintaining unrestricted cash of $3.0 million with the Bridge Bank, N.A. The Term Loan, the June 2005 Term Loan and the Revolving Credit Facility contain customary covenants that will, subject to limited exceptions, limit our ability to, among other things, (i) create liens; (ii) make capital expenditures; (iii) pay cash dividends; and (iv) merge or consolidate with another company. The Term Loan, June 2005 Term Loan and the Revolving Credit Facility also provide for customary events of default, including nonpayment, breach of covenants, payment defaults of other indebtedness, and certain events of bankruptcy, insolvency and reorganization that may result in acceleration of outstanding amounts under the Term Loan, the June 2005 Term Loan and Revolving Credit Facility. As of March 31, 2006, we had $1.9 million and $1.1 million outstanding on the Term Loan and June 2005 Term Loan, respectively, and no amount outstanding on the Revolving Credit Facility.

Off-Balance Sheet Arrangements

Leases

As of March 31, 2006, our off-balance sheet arrangements include operating leases for our facilities and certain property and equipment that expire at various dates through 2009, including an additional facility operating lease commitment assumed in connection with the Company’s acquisition of Sunset Direct in February 2005 and the lease for the Company’s corporate headquarters in Campbell, California (as described below). These arrangements allow us to obtain the use of the equipment and facilities without purchasing them. If we were to acquire these assets, we would be required to obtain financing and record a liability related to the financing of these assets. Leasing these assets under operating leases allows us to use these assets for our business while minimizing the obligations and up front cash flow related to purchasing the assets.

On August 4, 2005, the Company executed an operating lease to occupy approximately 16,600 square feet in an existing facility in Campbell, California. The office space serves as the Company’s corporate headquarters. The lease term began on November 1, 2005 and will end on October 31, 2008. The Company has an option to extend the lease term for an additional three years. The base rent for the new corporate headquarters during the initial lease term will escalate from approximately $270,000 for the initial year, to approximately $290,000 for the final year. In addition, the Company must pay its proportionate share of operating costs and taxes. In connection with the execution of the lease, the Company has issued a Letter of Credit to the Landlord in the amount of $100,000 as a security deposit.

In August 2005, we renewed our operating lease for 46,300 square feet of office space for our facility in Austin, Texas. The facility serves as an operations center for our lead generation services as well as a major part of our service sales operations. The renewed term will expire in July 2009. The base rent for the Austin facility will escalate from approximately $325,000 for the initial year, to approximately $383,000 for the final year. In addition, the Company must pay its proportionate share of operating costs and taxes. On March 27, 2006, Sunset Direct entered into an amendment with its landlord in Austin, Texas. The Amendment, among other things, expands Sunset Direct’s premises by an additional 7,623 rentable square feet effective as of March 31, 2006. As a result, the annual base rent in Austin, Texas will be on average an additional $61,000 per year through the remainder of the lease term ending in July 2009. In both the California and the Texas facilities, we pay rent and maintenance on some of the common areas in each of our leased facilities.

Guarantees

Letters of Credit to two of our clients. The letters of credit were issued in the amounts of $325,000 and $500,000 as guarantees for service contracts sold by us on behalf of our clients and both expire in September 2006. The letters of credit were issued under the Revolving Credit Facility described above. As of March 31, 2006, no amounts have been drawn against the letters of credit.

From time to time, we enter into certain types of contracts that contingently require us to indemnify parties against third party claims. These obligations primarily relate to certain agreements with our officers, directors and employees, under which we may be required to indemnify such persons for liabilities arising out of their employment relationship. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. Because the obligated amounts of these types of agreements often are not explicitly stated, the overall maximum amount of the obligations cannot be reasonably estimated. Historically, we have not had to make any payments for these obligations, and no liabilities have been recorded for these obligations on our balance sheets as of March 31, 2006 and December 31, 2005.

Contractual Obligations

Capital Leases

We lease certain property under capital leases that expire at various dates through 2006. The effective annual imputed interest rates on our capital lease obligations range from 2.4% to 17.0%, with a weighted average of 12.0%. The capital lease obligations are collateralized by the related leased property and equipment.

Financing Obligations

In November 2005, we entered into a Commercial Insurance Premium Finance and Security Agreement (“2006 Financing Agreement”) to finance certain of our liability insurance premiums in the amount of $334,000. Amounts owed under the 2006 Financing Agreement bear interest at an annual rate of 6.0% and principal and interest are payable in monthly installments of approximately $33,000, through September 2006. At March 31, 2006, our liability related to the 2006 Financing Agreement was $201,000.

Term Loans

In June 2005, the Company entered into a Business Loan Agreement with Bridge Bank, N.A. (the “Lender”), pursuant to which the Company obtained a $1.5 million term loan (the “ June 2005 Term Loan”) that is being utilized to fund the implementation of the Company’s new client management system. The June 2005 Term Loan is to be repaid in 36 monthly installments of $42,000 plus interest at a variable rate of prime plus 1.00% per annum (8.75% per annum at March 31, 2006). As of March 31, 2006, the Company had $1.1 million outstanding on the June 2005 Term Loan.

In February 2005, concurrent with the closing of the acquisition of Sunset Direct, the Company entered into a Business Loan Agreement and Commercial Security Agreement with the Lender (the “Term Loan”). The Term Loan is to be repaid in 36 monthly installments of $83,000 plus interest at a variable rate of prime plus 1.00% per annum (8.75% per annum at March 31, 2006). As of March 31, 2006, the Company had $1.9 million outstanding on the Term Loan.

Revolving Credit Facility

In April 2004, we entered into a Business Loan Agreement and a Commercial Security Agreement (the “Revolving Credit Facility”) with the Lender. The Revolving Credit Facility originally matured in May 2005, and provided borrowing availability up to a maximum of $3.0 million through a secured revolving line of credit that includes a $1.0 million Letter of Credit facility. In December 2005, the total available under the Revolving Credit Facility was increased to $4.0 million and the maturity was extended to December 2006. As of March 31, 2006, we had no amounts outstanding under the Revolving Credit Facility.

Future payments under our contracts and obligations at March 31, 2006 are as follows:


(In thousands)	Capital Leases		Financing Obligation (1)		Term Loan (1)		June 2005 Term Loan (1)		Operating Leases		Total
2006	$	43	$	201	$	750	$	375	$	504	$	1,873
2007		—		—		1,000		500		704		2,204
2008		—		—		167		250		612		1,029
2009		—		—						229		229


Total minimum payments		43			201		1,917		1,125		2,049		5,335
Less amount representing interest		(3	)		—		—		—		—		(3	)

Net amount of payments	$	40		$	201	$	1,917	$	1,125	$	2,049	$	5,332

(1)	– Excludes interest payments.

Included in future minimum operating lease payments is our obligation relating to our facilities, including the lease for the Company’s corporate headquarters in Campbell, California. The operating lease for our Austin facility expires in July 2009.

ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to changes in interest rates on our variable rate borrowings. Interest rates on our capital lease and financing obligations are fixed, but rates on borrowings under our Term Loan, June 2005 Term Loan and Revolving Credit Facility are variable. In February 2005, the Company entered into a Business Loan Agreement and Commercial Security Agreement pursuant to which the Company obtained a $3.0 million Term Loan that is to be repaid in 36 monthly installments of $83,000 plus interest at a variable rate of prime plus 1.00% per annum (8.75% per annum at March 31, 2006). As of March 31, 2006, the Company had $1.9 million outstanding on the Term Loan. In June 2005, the Company entered into a Business Loan Agreement pursuant to which the Company obtained a $1.5 million term loan (the “June 2005 Term Loan”). The June 2005 Term Loan is to be repaid in 36 monthly installments of $42,000 plus interest at a variable rate of prime plus 1.00% per annum (8.75% per annum at March 31, 2006). As of March 31, 2006, the Company had $1.1 outstanding on the June 2005 Term Loan. Based on our projected cash needs for the foreseeable future, we do not expect that our exposure to changes in interest rates for these borrowings will have a material impact on our interest expense.

Our earnings are affected by changes in short-term interest rates as a result of our two term loans and our Revolving Credit Facility, which bear interest at variable rates based on the prime lending rate (the prime rate was 7.75% at March 31, 2006). Maturity dates on these loans range from December 2006 to May 2008. At December 31, 2005, we had $3.0 million of debt outstanding under these loans. Based on the funding dates for these loans and payments already made during 2006, we estimate that a 1% increase in interest rates would result in $30,000 in additional interest expense for the year ended December 31, 2006. Due to our debt level at March 31, 2006, anticipated cash flows from operations, and the various financial alternatives available to management, should there be an adverse change in interest rates, we do not believe that we have significant exposure to market risks associated with changing interest rates as of March 31, 2006. We do not use derivative financial instruments in our operations.

ITEM 4. CONTROLS AND PROCEDURES

(a) Disclosure Controls and Procedures

Rainmaker’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of Rainmaker’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that Rainmaker’s disclosure controls and procedures as of the end of the period covered by this report have been designed and are functioning effectively to provide reasonable assurance that the information required to be disclosed by Rainmaker in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b) Change in Internal Control over Financial Reporting

No change in Rainmaker’s internal control over financial reporting occurred during Rainmaker’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, Rainmaker’s internal control over financial reporting.

PART II. – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We currently are not a party to any material legal proceedings and are not aware of any pending or threatened litigation that would have a material adverse effect on us or our business.

ITEM 1A. RISK FACTORS

We have incurred recent losses and may incur losses in the future.

Although we reported net income for the quarter ended March 31, 2006, we incurred a net loss of $5.0 million for the year ended December 31, 2005, a net loss of $4.9 million for the year ended December 31, 2004, and a net loss of $3.1 million for the year ended December 31, 2003. Our accumulated losses through December 31, 2005 were $63.0 million. We may incur losses in the future, depending on the timing of signing of new clients, costs to initiate service for new clients, impact of new and existing clients, our decisions to further invest in our technology or infrastructure, and our ability to continue to increase our operating efficiencies.

We may need to raise additional capital which might not be available or which, if available, could be on terms adverse to our common stockholders.

We anticipate that our existing capital resources and cash flow expected to be generated from future operations will enable us to maintain our current level of operations, our planned operations and our planned capital expenditures for at least the next twelve months. We may also require additional capital for the acquisition of businesses, products and technologies that are complementary to ours. Further, if we issue equity securities to raise capital, the ownership percentage of our stockholders would be reduced, and the new equity securities may have rights, preferences or privileges senior to those existing holders of our common stock.

Because we depend on a small number of clients for a significant portion of our revenue, the loss of a single client could result in a substantial decrease in our revenue.

We enter into contracts with our clients to market and sell our clients’ products and services. As a result, we primarily earn revenue from sales to the client’s customer, not the client itself. We have generated a significant portion of our net revenue from sales to customers of a limited number of clients. During the three months ended March 31, 2006, customers of two of our clients accounted for more than 10% of our revenue and collectively represented 48% of our net revenue with the largest representing 38% of our net revenue. In the quarter ended March 31, 2005, customers of these same two clients each accounted for more than 10% of our revenue and collectively represented 57% of our net revenue.

No individual client’s end-user customer accounted for 10% or more of our revenues in any period presented.

We expect that a small number of clients will continue to account for a significant portion of our revenue for the foreseeable future. The loss of any of our principal clients could cause a significant decrease in our revenue. In addition, our software and technology clients operate in industries that experience consolidation from time to time, which could reduce the number of our existing and potential clients. Any loss of a single significant client may have a material adverse effect on our financial position, cash flows and results of operations. Our agreement with Hewlett Packard, a client that represents more than 10% of our revenue, will expire in August 2007 unless renewed. Our agreement with IBM, another significant client, will expire in July 2006 unless renewed.

Our revenue will decline if demand for our clients’ products and services decreases.

Our business primarily consists of marketing and selling our clients’ products and services to their customers. In addition, most of our revenue is based on a “pay for performance” model in which our revenues are based on the amount of our clients’ products and services that we sell. Accordingly, if a particular client’s products and services fail to appeal to its customers for reasons beyond our control, such as preference for a competing product or service, our revenue from the sale of the client’s products and services may decline. In addition, revenue from our lead generation product offering is predominately based on fixed-fee retainer contracts. Our customers are under no obligation to renew their engagements with us when their contracts come up for renewal from time to time.

We are exposed to increased costs and risks associated with complying with increasing and new regulations of corporate governance and disclosure standards.

In March 2005, the SEC postponed, for one year, the compliance date for reporting on internal control by non-accelerated filers. Despite this postponement, we expect to continue to spend an increased amount of management time and internal and external resources to comply with changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ Stock Market rules. In particular, Section 404 of the Sarbanes-Oxley Act of 2002 requires management’s annual review and evaluation of our internal control systems and attestations of the effectiveness of these systems by our independent auditors. We are currently documenting and testing our internal control systems and procedures and considering improvements that may be necessary in order for us to comply with the requirements of Section 404 by the end of 2007; however, as described below, if we become an accelerated filer in 2006, then we will need to comply with the requirements of Section 404 for our fiscal year ending December 31, 2006. This process has required us to hire outside advisory services and has resulted in additional accounting and legal expenses. While we believe that we currently have adequate internal controls over financial reporting, in the event that our chief executive officer, chief financial officer or independent auditors determine that our controls over financial reporting are not effective as defined under Section 404, investor perceptions of our company may be adversely affected and could cause a decline in the market price of our stock.

Under current SEC rules, if our market capitalization, excluding the holdings of officers, directors and other affiliates, exceeds $75 million on June 30, 2006, we will be required to be compliant with Section 404 of the Sarbanes Oxley Act of 2002 for the fiscal year ending December 31, 2006, which would require us to incur additional costs beginning in the current fiscal year to comply with Section 404. If our market capitalization, excluding the holdings of officers, directors and other affiliates, is below $75 million at June 30, 2006, then we will have until December 31, 2007 to comply with the requirements of Section 404.

Terrorist acts and acts of war may harm our business and revenue, costs and expenses, and financial position.

Terrorist acts or acts of war may cause damage to our employees, facilities, clients, our clients’ customers, and vendors, which could significantly impact our revenues, costs and expenses and financial position. The potential for future terrorist attacks, the national and international responses to terrorist attacks or perceived threats to national security, and other acts of war or hostility have created many economic and political uncertainties that could adversely affect our business and results of operations in ways that cannot be presently predicted. We are predominantly uninsured for losses and interruptions caused by terrorist acts and acts of war.

Our quarterly operating results may fluctuate, and if we do not meet market expectations, our stock price could decline.

We believe that quarter-to-quarter comparisons of our operating results are not a good indication of future performance. Although our operating results have generally improved from quarter to quarter, our future operating results may not follow past trends in every quarter, even if they continue to improve overall. In any future quarter, our operating results may be below the expectation of public market analysts and investors.

Factors which may cause our future operating results to be below expectations include:

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the growth of the market for outsourced sales and marketing solutions;

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the demand for and acceptance of our services;

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the demand for our clients’ products and services;

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the length of the sales and integration cycle for our new clients;

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our ability to expand relationships with existing clients;

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our ability to develop and implement additional services, products and technologies (including the assets acquired from Launch Project);

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the success of our direct sales force;

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our ability to retain existing clients; and

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our ability to integrate acquisitions.

The length and unpredictability of the sales and integration cycles for our full solution service offering could cause delays in our revenue growth.

Selection of our services often entails an extended decision-making process on the part of prospective clients. We often must provide a significant level of education regarding the use and benefit of our services, which may delay the evaluation and acceptance process. The selling cycle can extend to approximately nine to twelve months or longer between initial client contact and signing of a contract for our services. Additionally, once our services are selected, the integration of our services often can be a lengthy process, which further impacts the timing of revenue. Because we are unable to control many of the factors that will influence our clients’ buying decisions or the integration of our services, the length and unpredictability of the sales and integration cycles make it difficult for us to forecast the growth and timing of our revenue.

If we are unable to attract and retain highly qualified management, sales and technical personnel, the quality of our services may decline, and our ability to execute our growth strategies may be harmed.

Our success depends to a significant extent upon the contributions of our executive officers and key sales and technical personnel and our ability to attract and retain highly qualified sales, technical and managerial personnel. Competition for personnel is intense as these personnel are limited in supply. We have at times experienced difficulty in recruiting qualified personnel, and there can be no assurance that we will not experience difficulties in the future. Any difficulties could limit our future growth. The loss of certain key personnel, particularly Michael Silton, our chief executive officer, and Steve Valenzuela, our chief financial officer, could seriously harm our business. We have obtained a life insurance policy in the amount of $6.3 million on Michael Silton.

We have strong competitors and may not be able to compete effectively against them.

Competition in CRM services is intense, and we expect such competition to increase in the future. Our competitors include system integrators, ecommerce solutions providers, and other outsource providers of different components of customer interaction management. We also face competition from internal marketing departments of current and potential clients. Additionally, we may face competition from outsource providers with substantial offshore facilities which may enable them to compete aggressively with similar service offerings at a substantially lower price. Many of our existing or potential competitors have greater name recognition, longer operating histories, and significantly greater financial, technical and marketing resources, which could further impact our ability to address competitive pressures. Should competitive factors require us to increase spending for, and investment in, client acquisition and retention or for the development of new services, our expenses could increase disproportionately to our revenues. Competitive pressures may also necessitate price reductions and other actions that would likely affect our business adversely. Additionally, there can be no assurances that we will have the resources to maintain a higher level of spending to address changes in the competitive landscape. Failure to maintain or to produce revenue proportionate to any increase in expenses would have a negative impact on our financial results.

The demand for outsourced sales and marketing services is highly uncertain.

Demand and acceptance of our sales and marketing services is dependent upon companies’ willingness to outsource these processes. It is possible that these outsourced solutions may never achieve broad market acceptance. If the market for our services does not grow or grows more slowly than we currently anticipate, our business, financial condition and operating results may be materially adversely affected.

Our success depends on our ability to successfully manage growth.

Any future growth will place additional demands on our managerial, administrative, operational and financial resources. We will need to improve our operational, financial and managerial controls and information systems and procedures and will need to train and manage our overall work force. If we are unable to manage additional growth effectively, our business will be harmed.

Our business strategy may ultimately include expansion into foreign markets, which would require increased expenditures, and if our international operations are not successfully implemented, they may not result in increased revenue or growth of our business.

Our long-term growth strategy may include expansion into international markets. As a result, we may need to establish international operations, hire additional personnel and establish relationships with additional clients and customers in those markets. This expansion may require significant financial resources and management attention and could have a negative effect on our earnings. In addition, we may be exposed to political risks associated with operating in foreign markets. We cannot assure you that we will be successful in creating international demand for our CRM services or that we will be able to effectively sell our clients’ products and services in international markets.

Any business combinations in which we participate could result in dilution, unfavorable accounting charges and difficulties in successfully managing our business.

As part of our business strategy, we review from time to time business combination prospects (which may include asset acquisitions) that would complement our existing business or enhance our technological capabilities, such as our acquisition of Sunset Direct and our acquisition of assets from Launch Project. Future business combinations by us could result in potentially dilutive issuances of equity securities, large and immediate write-offs, the incurrence of debt and contingent liabilities or amortization expenses related to goodwill and other intangible assets, any of which could cause our financial performance to suffer. Furthermore, business combinations entail numerous risks and uncertainties, including:

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difficulties in the assimilation of operations, personnel, technologies, products and the information systems of the combined companies;

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diversion of management’s attention from other business concerns;

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risks of entering geographic and business markets in which we have no or limited prior experience; and

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potential loss of key employees of acquired organizations.

We cannot be certain that we would be able to successfully integrate any businesses, products, technologies or personnel that might be acquired in the future, and our failure to do so could limit our future growth. Although we do not currently have any agreement with respect to any material business combinations, we may enter into business combinations with complementary businesses, products or technologies in the future. However, we may not be able to locate suitable business combination opportunities.

We rely heavily on our communications infrastructure, and the failure to invest in or the loss of these systems could disrupt the operation and growth of our business and result in the loss of clients or our clients’ customers.

Our success is dependent in large part on our continued investment in sophisticated computer, Internet and telecommunications systems. We have invested significantly in technology and anticipate that it will be necessary to continue to do so in the future to remain competitive. These technologies are evolving rapidly and are characterized by short product life cycles, which require us to anticipate technological developments. We may be unsuccessful in anticipating, managing, adopting and integrating technological changes on a timely basis, or we may not have the capital resources available to invest in new technologies. Temporary or permanent loss of these systems could limit our ability to conduct our business and result in lost revenue.

We make investments in technology and capitalize these costs and begin depreciating once the technology is deployed. Such assets are subject to reviews for impairment in the event they are not fully utilized.

We make technology and system improvements and capitalize those costs until the technology is deployed, at which time we begin to depreciate the asset over the expected useful life of the asset. During the quarter ended March 31, 2006, we deployed our new order entry system for use on one of our clients. We have invested $3.2 million in this system and expect to use it as our order entry platform for all of our service sales clients. If unforeseen events or circumstances prohibit us from using this system with all clients, we may be forced to impair some or all of this asset.

If we are unable to safeguard our networks and clients’ data, our clients may not use our services and our business may be harmed.

Our networks may be vulnerable to unauthorized access, computer hacking, computer viruses and other security problems. A user who circumvents security measures could misappropriate proprietary information or cause interruptions or malfunctions in our operations. We may be required to expend significant resources to protect against the threat of security breaches or to alleviate problems caused by any breaches. Although we intend to continue to implement industry-standard security measures, these measures may be inadequate.

Damage to our facilities may disable our operations.

We have taken precautions to protect ourselves from events that could interrupt our services, such as off-site storage of computer backup data and a backup power source, but there can be no assurance that an earthquake, fire, flood or other disaster affecting any of our facilities would not disable these operations. In February 2005, we acquired Sunset Direct that has its primary facility located in Austin, Texas. We believe our combined operational facilities would help to minimize but not eliminate disruptions to the operations of the Company in the event of a business interruption in any one of our facilities

on a short-term basis. In the event of the loss of a facility in either Campbell or Austin, our business would be impacted until such time as we were able to transfer operations to the sister facility. While we maintain insurance coverage for business interruptions, such coverage does not extend to losses caused by earthquake and such coverage may not be sufficient to cover all possible losses.

If we fail to adequately protect our intellectual property or face a claim of intellectual property infringement by a third party, we may lose our intellectual property rights and be liable for significant damages.

We cannot guarantee that the steps we have taken to protect our proprietary rights will be adequate to deter misappropriation of our intellectual property. In addition, we may not be able to detect unauthorized use of our intellectual property and take appropriate steps to enforce our rights. If third parties infringe or misappropriate our trade secrets, copyrights, trademarks, service marks, trade names or other proprietary information, our business could be seriously harmed. In addition, although we believe that our proprietary rights do not infringe the intellectual property rights of others, other parties may assert infringement claims against us that we violated their intellectual property rights. These claims, even if not true, could result in significant legal and other costs and may be a distraction to management. In addition, protection of intellectual property in many foreign countries is weaker and less reliable than in the United States, so if our business expands into foreign countries, risks associated with protecting our intellectual property will increase. We have applied to register the RAINMAKER SYSTEMS, RAINMAKER (and Design), CONTRACT RENEWALS PLUS, and EDUCATION SALES PLUS services marks in the United States and certain foreign countries, and have received registrations for the RAINMAKER SYSTEMS service mark in the United States, Canada, Australia, the European Community, Switzerland, Norway and New Zealand, the RAINMAKER (and Design) mark in the United States and the European Community, the CONTRACTS RENEWALS PLUS mark in the United States and Switzerland, and the EDUCATION SALES PLUS mark in the United States and Switzerland.

Increased government regulation of the Internet could decrease the demand for our services and increase our cost of doing business.

The increasing popularity and use of the Internet and online services may lead to the adoption of new laws and regulations in the U.S. or elsewhere covering issues such as online privacy, copyright and trademark, sales taxes and fair business practices or which require qualification to do business as a foreign corporation in certain jurisdictions. Increased government regulation, or the application of existing laws to online activities, could inhibit Internet growth. A number of government authorities are increasingly focusing on online privacy issues and the use of personal information. Our business could be adversely affected if new regulations regarding the use of personal information are introduced or if government authorities choose to investigate our privacy practices. In addition, the European Union has adopted directives addressing data privacy that may limit the collection and use of some information regarding Internet users. Such directives may limit our ability to target our clients’ customers or collect and use information. A decline in the growth of the Internet could decrease demand for our services and increase our cost of doing business and otherwise harm our business.

We are subject to government regulation of direct marketing, which could restrict the operation and growth of our business.

The Federal Trade Commission’s (“FTC’s”) telemarketing sales rules prohibit misrepresentations of the cost, terms, restrictions, performance or duration of products or services offered by telephone solicitation and specifically addresses other perceived telemarketing abuses in the offering of prizes. Additionally, the FTC’s rules limit the hours during which telemarketers may call consumers. The Federal Telephone Consumer Protection Act of 1991 contains other restrictions on facsimile transmissions and on telemarketers, including a prohibition on the use of automated telephone dialing equipment to call certain telephone numbers. A number of states also regulate telemarketing and some states have enacted restrictions similar to these federal laws. In addition, a number of states regulate email and facsimile transmissions. The failure to comply with applicable statutes and regulations could result in penalties. There can be no assurance that additional federal or state legislation, or changes in regulatory implementation, or judicial interpretation of existing or future laws would not limit our activities in the future or significantly increase the cost of regulatory compliance.

Our directors, executive officers and their affiliates own a large percentage of our stock and can significantly influence all matters requiring stockholder approval.

Our directors, executive officers and entities affiliated with them together beneficially control approximately 16% of our outstanding shares (based on the number of shares outstanding as of April 28, 2006). As a result, any significant combination of those stockholders, acting together, may have the ability to disproportionately influence all matters requiring stockholder approval, including the election of all directors, and any merger, consolidation or sale of all or substantially all of our assets. Accordingly, such concentration of ownership may have the effect of delaying, deferring or preventing a change in control of Rainmaker, which, in turn, could depress the market price of our common stock.

Our charter documents and Delaware law contain anti-takeover provisions that could deter takeover attempts, even if a transaction would be beneficial to our stockholders.

The provisions of Delaware law and of our certificate of incorporation and bylaws could make it difficult for a third party to acquire us, even though an acquisition might be beneficial to our stockholders. Our certificate of incorporation provides our board of directors the authority, without stockholder action, to issue up to 20,000,000 shares of preferred stock in one or more series. Our board determines when we will issue preferred stock, and the rights, preferences and privileges of any preferred stock. In addition, our bylaws establish an advance notice procedure for stockholder proposals and for nominating candidates for election as directors. Delaware corporate law also contains provisions that can affect the ability to take over a company.

Our stock price may be volatile resulting in potential litigation.

If our stock price is volatile, we could face securities class action litigation. In the past, following periods of volatility in the market price of their stock, many companies have been the subjects of securities class action litigation. If we were sued in a securities class action, it could result in substantial costs and a diversion of management’s attention and resources and could cause our stock price to fall. The trading price of our common stock could fluctuate widely due to:

•

quarter to quarter variations in results of operations;

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loss of a major client;

•

announcements of technological innovations by us or our competitors;

•

changes in, or our failure to meet, the expectations of securities analysts;

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new products or services offered by us or our competitors;

•

changes in market valuations of similar companies;

•

announcements of strategic relationships or acquisitions by us or our competitors;

•

other events or factors that may be beyond our control; or

•

if we raise additional cash, this would likely be highly dilutive to investors and our stock price may decline.

In addition, the securities markets in general have experienced extreme price and trading volume volatility in the past. The trading prices of securities of many business process outsourcing companies have fluctuated broadly, often for reasons unrelated to the operating performance of the specific companies. These general market and industry factors may adversely affect the trading price of our common stock, regardless of our actual operating performance.

We may have difficulty obtaining director and officer liability insurance in acceptable amounts for acceptable rates.

Like most other public companies, we carry insurance protecting our officers and directors and us against claims relating to the conduct of our business. This insurance covers, among other things, the costs incurred by companies and their management to defend against and resolve claims relating to management conduct and results of operations, such as securities class action claims. These claims typically are extremely expensive to defend against and resolve. Hence, as is customary, we purchase and maintain insurance to cover some of these costs. We pay significant premiums to acquire and maintain this insurance, which is provided by third-party insurers. Since 1999, the premiums we have paid for this insurance have increased substantially. One consequence of the current economic climate and decline in stock prices has been a substantial general increase in the number of securities class actions and similar claims brought against public corporations and their management. Many, if not all, of these actions and claims are, and will likely continue to be, at least partially insured by third-party insurers. Consequently, insurers providing director and officer liability insurance have in recent periods sharply increased the premiums they charge for this insurance, raised retentions (that is, the amount of liability that a company is required to itself pay to defend and resolve a claim before any applicable insurance is provided), and limited the amount of insurance they will provide. Moreover, insurers typically provide only one-year policies. We renewed our director and officer insurance in the fourth quarter of 2005 for a one-year term. Particularly in the current economic environment, we cannot assure that we will be able to obtain sufficient director and officer liability insurance coverage at acceptable rates and with acceptable deductibles and other limitations. Failure to obtain such insurance could materially harm our financial condition in the event that we are required to defend against and resolve any future securities class actions or other claims made against us or our management. Further, the inability to obtain such insurance in adequate amounts may impair our future ability to retain and recruit qualified officers and directors.

Our business may be subject to additional obligations to collect and remit sales tax and, any successful action by state authorities to collect additional sales tax could adversely harm our business.

We file sales tax returns in certain states within the United States as required by law and certain client contracts for a portion of the outsourced sales and marketing services that we provide. We do not collect sales or other similar taxes in other states and many of the states do not apply sales or similar taxes to the vast majority of the services that we provide. However, one or more states could seek to impose additional sales or use tax collection and record-keeping obligations on us. Any successful action by state authorities to compel us to collect and remit sales tax, either retroactively, prospectively or both, could adversely affect our results of operations and business.

If we fail to meet the NASDAQ Capital Market listing requirements, our common stock will be delisted.

Our common stock is currently listed on the NASDAQ Capital Market. NASDAQ has requirements that a company must meet in order to remain listed on the NASDAQ Capital Market. If we continue to experience losses from our operations, or are unable to raise additional funds or our stock price does not meet minimum standards, we may not be able to maintain the standards for continued listing on the NASDAQ Capital Market, which include, among other things, that our stock maintain a minimum closing bid price of at least $1.00 per share (subject to applicable grace and cure periods). If as a result of the application of such listing requirements our common stock is delisted from the NASDAQ Capital Market, our stock would become harder to buy and sell. Consequently, if we were removed from the NASDAQ Capital Market, the ability or willingness of broker-dealers to sell or make a market in our common stock might decline. As a result, the ability to resell shares of our common stock could be adversely affected.

Shares eligible for sale in the future could negatively affect our stock price.

The market price of our common stock could decline as a result of sales of a large number of shares of our common stock or the perception that these sales could occur. This might also make it more difficult for us to raise funds through the issuance of securities. As of April 28, 2006, we had 13,372,836 outstanding shares of common stock. This amount includes shares issued under the Securities Purchase Agreements on February 7, 2006, as described below. As of March 31, 2006, there were an aggregate of 2,983,284 shares of common stock issuable upon exercise of outstanding stock options and warrants, including 1,788,083 issuable upon exercise of options outstanding under our option plan and 1,195,200 shares of common stock issuable upon exercise of the outstanding warrants issued to the investors in our private placement transactions completed on February 7, 2006, June 15, 2005 and February 20, 2004. Under our existing stock option plan and employee stock purchase plan, we may issue up to an additional 1,182,394 shares and 535,779 shares of our common stock, respectively, subject to the terms and conditions of such plans. We may issue and/or register additional shares, options, or warrants in the future in connection with acquisitions, compensation or otherwise. We have not entered into any definitive agreements regarding any future acquisitions and cannot ensure that we will be able to identify or complete any acquisition in the future.

On February 7, 2006, the Company entered into two Securities Purchase Agreements with certain new and existing investors. Pursuant to the Securities Purchase Agreements, the Company issued a total of 2,000,000 shares of the Company’s common stock at a price of $3.00 per share for gross proceeds of $6.0 million and issued warrants to the investors to purchase an additional 799,999 shares of common stock of the Company at an exercise price of $4.28 per share. The securities issued pursuant to the Securities Purchase Agreements were not registered under the Securities Act of 1933, as amended (the “Securities Act”), or the securities laws of certain states, in reliance on the exemptions provided by Section 4(2) of the Securities Act and Regulation D promulgated there under and in reliance on similar exemptions under applicable state laws. Under the Securities Purchase Agreements, the Company also granted certain registration rights to each of the investors pursuant to which the Company filed a registration statement on Form S-3 that became effective on March 21, 2006, with respect to the common stock issued under the Securities Purchase Agreements and the common stock issuable upon conversion of the related warrants.

In connection with the asset purchase with Launch Project LLC, we filed a registration statement with the SEC with respect to the shares that were issued to Launch Project’s members that was declared effective August 12, 2005. Pursuant to that registration statement, approximately 70,000 of such shares are available for public sale, with an additional 35,000 of such shares available for sale April 1, 2006 and the final 35,000 of such shares available for sale July 1, 2006. In addition 28,000 shares of common stock consideration have been placed in escrow to secure certain indemnity obligations and will not be released until July 1, 2006 subject to potential post closing adjustments.

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

On February 7, 2006, the Company entered into two Securities Purchase Agreements with certain new and existing investors. Pursuant to the Securities Purchase Agreements, the Company issued a total of 2,000,000 shares of the Company’s common stock at a price of $3.00 per share for gross proceeds of $6.0 million and issued warrants to the investors to purchase an additional 799,999 shares of common stock of the Company at an exercise price of $4.28 per share. The securities issued pursuant to the Securities Purchase Agreements were not registered under the Securities Act of 1933, as amended (the “Securities Act”), or the securities laws of certain states, in reliance on the exemptions provided by Section 4(2) of the Securities Act and Regulation D promulgated there under and in reliance on similar exemptions under applicable state laws. Under the Securities Purchase Agreements, the Company also granted certain registration rights to each of the investors pursuant to which the Company filed a registration statement on Form S-3 on March 10, 2006, with respect to the common stock issued under the Securities Purchase Agreements and the common stock issuable upon conversion of the related warrants. The registration statement was declared effective on March 21, 2006.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

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

None.

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS

(a)

Exhibits

The following exhibits are filed with this report as indicated below:


31.1		Certification of Chief Executive Officer, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, filed under Exhibit 31 of Item 601 of Regulation S-K.

31.2		Certification of Chief Financial Officer, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, filed under Exhibit 31 of Item 601 of Regulation S-K.

32.1		Certification of Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, furnished under Exhibit 32 of Item 601 of Regulation S-K.

32.2		Certification of Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, furnished under Exhibit 32 of Item 601 of Regulation S-K.

SIGNATURES

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


		RAINMAKER SYSTEMS, INC.

Dated: May 11, 2006		/s/ MICHAEL SILTON
		Michael Silton
		Chief Executive Officer
		(Principal Executive Officer)

		/s/ STEVE VALENZUELA
		Steve Valenzuela
		Secretary and Chief Financial Officer
		(Chief Accounting Officer)

Positive
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Uncertain
Constraining
Legalese
Litigous
Readability	H.S. sophomore Avg

Rainmaker Systems (VCTL) Inactive 10-Q2006 Q1 Quarterly report

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