Kenexa (KNXA) 10-Q 2008 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2008

OR

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

For the transition period from                    to                    

Commission File number 000-51358

Kenexa Corporation

(Exact Name of Registrant as Specified in Its Charter)

Pennsylvania	23-3024013
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)
650 East Swedesford Road, Wayne, PA	19087
(Address of Principal Executive Offices)	(Zip Code)

Registrant’s Telephone Number, Including Area Code: (610) 971-9171

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

Yes  x    No  ¨

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

Large Accelerated Filer  x             Accelerated filer  ¨            Non-accelerated Filer  ¨            Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨    No  x

On November 4, 2008, 22,559,891 shares of the registrant’s Common Stock, $0.01 par value, were outstanding.

Kenexa Corporation and Subsidiaries

FORM 10-Q

Quarter Ended September 30, 2008

Table of Contents

	Page
PART I: FINANCIAL INFORMATION
Item I: Financial Statements (unaudited)
Consolidated Balance Sheets as of September 30, 2008 (unaudited) and December 31, 2007	3
Consolidated Statements of Operations for the three and nine months ended September 30, 2008 and 2007 (unaudited)	4
Consolidated Statements of Shareholders’ Equity as of September 30, 2008 (unaudited) and December 31, 2007	5
Consolidated Statements of Cash Flows for the nine months ended September 30, 2008 and 2007 (unaudited)	6
Notes to Consolidated Financial Statements (unaudited)	7
Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations	23
Item 3: Quantitative and Qualitative Disclosures about Market Risk	36
Item 4: Controls and Procedures	36
PART II: OTHER INFORMATION
Item 1: Legal Proceedings	37
Item 1A: Risk Factors	37
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds	54
Item 3: Defaults Upon Senior Securities	54
Item 4: Submission of Matters to a Vote of Security Holders	55
Item 5: Other Information	55
Item 6: Exhibits	55
Signatures	56
Exhibit Index	57

2

PART I FINANCIAL INFORMATION

Item 1: Financial Statements

Kenexa Corporation and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share data)

	September 30, 2008			December 31, 2007
		(unaudited	)
Assets
Current Assets
Cash and cash equivalents	$	19,498		$	38,032
Short-term investments		6,597			58,423
Accounts receivable, net of allowance of doubtful accounts of $1,791 and $761		37,439			31,893
Unbilled receivables		8,573			2,423
Income tax receivable		—			2,008
Deferred income taxes		3,432			2,399
Prepaid expenses and other current assets		4,030			3,356
Total Current Assets		79,569			138,534
Long-term investments		17,820			—
Property and equipment, net of accumulated depreciation		27,571			17,620
Software, net of accumulated amortization		3,157			1,557
Goodwill		191,104			173,502
Intangible assets, net of accumulated amortization		14,920			10,134
Deferred financing costs, net of accumulated amortization		439			663
Other assets		8,986			5,879
Total assets	$	343,566		$	347,889
Liabilities and Shareholders’ Equity
Current liabilities
Accounts payable	$	7,259		$	5,812
Notes payable, current		40			49
Commissions payable		961			1,025
Accrued compensation and benefits		6,117			8,363
Other accrued liabilities		6,502			6,298
Deferred revenue		36,996			35,076
Capital lease obligations		187			140
Total current liabilities		58,062			56,763
Capital lease obligations, less current portion		121			94
Notes payable, less current portion		49			73
Deferred income taxes		8,006			3,246
Other liabilities		74			65
Total liabilities		66,312			60,241
Commitments and Contingencies
Shareholders’ Equity
Preferred stock, par value $0.01; 100,000 shares authorized; no shares issued or outstanding		—			—
Common stock, par value $0.01; 100,000,000 shares authorized; 22,559,891 and 24,032,446 shares issued and outstanding, respectively		225			240
Additional paid-in-capital		268,408			291,942
Accumulated other comprehensive (loss) income		(1,601	)		1,407
Retained earnings (Accumulated deficit)		10,222			(5,941	)
Total shareholders’ equity		277,254			287,648
Total liabilities and shareholders’ equity	$	343,566		$	347,889

See notes to consolidated financial statements.

3

Kenexa Corporation and Subsidiaries

Consolidated Statements of Operations

(In thousands, except share and per share data)

(Unaudited)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2008		2007		2008		2007
Revenues:
Subscription	$	43,031	$	38,233	$	125,855	$	109,929
Other		10,995		8,564		32,819		24,249
Total revenues		54,026		46,797		158,674		134,178
Cost of revenues		16,461		13,705		46,739		37,737
Gross profit		37,565		33,092		111,935		96,441
Operating expenses:
Sales and marketing		10,298		8,816		31,175		26,140
General and administrative		12,649		9,625		37,487		29,063
Research and development		3,756		4,717		12,605		13,337
Depreciation and amortization		3,337		2,269		8,766		5,175
Total operating expenses		30,040		25,427		90,033		73,715
Income from operations		7,525		7,665		21,902		22,726
Interest income, net		255		1,072		1,216		2,169
Income before income taxes		7,780		8,737		23,118		24,895
Income tax expense		2,356		1,660		6,955		7,310
Net income	$	5,424	$	7,077	$	16,163	$	17,585
Basic net income per share	$	0.24	$	0.28	$	0.71	$	0.70
Weighted average shares used to compute net income per share – basic		22,551,225		25,455,504		22,852,499		24,948,592
Diluted net income per share	$	0.24	$	0.27	$	0.70	$	0.69
Weighted average shares used to compute net income per share – diluted		22,788,468		25,846,605		23,084,524		25,362,312

See notes to consolidated financial statements.

4

Kenexa Corporation and Subsidiaries

Consolidated Statements of Shareholders’ Equity

(in thousands)

	Common stock			Additional paid-in capital			(Accumulated deficit) Retained earnings			Accumulated other comprehensive income (loss)			Total stockholders’ equity			Comprehensive income
Balance, December 31, 2006	$	209		$	176,345		$	(29,489	)	$	96		$	147,161		$	16,019
Common stock repurchase		(15	)		(25,467	)		—			—			(25,482	)		—
Gain on currency translation adjustment		—			—			—			1,415			1,415			1,415
Unrealized loss on short-term investments		—			—			—			(104	)		(104	)		(104	)
Share-based compensation expense		—			3,793			—			—			3,793			—
Excess tax benefits from share-based payment arrangements		—			1,284			—			—			1,284			—
Option exercises		2			1,558			—			—			1,560			—
Employee stock purchase plan					251			—			—			251			—
Public stock offering, net		43			130,355			—			—			130,398			—
Common stock issuance for earn out		—			650			—			—			650			—
Common stock issuance for acquisition		1			3,173			—			—			3,174			—
Net income		—			—			23,548			—			23,548			23,548
Balance, December 31, 2007	$	240		$	291,942		$	(5,941	)	$	1,407		$	287,648		$	24,859
Common stock repurchase		(16	)		(29,826	)		—			—			(29,842	)		—
Loss on currency translation adjustment		—			—			—			(1,739	)		(1,739	)		(1,739	)
Unrealized loss on investments		—			—			—			(1,269	)		(1,269	)		(1,269	)
Share-based compensation expense		—			4,430			—			—			4,430			—
Excess tax benefits from share-based payment arrangements		—			192			—			—			192			—
Option exercises		—			366			—			—			366			—
Employee stock purchase plan		—			255			—			—			255			—
Common stock issuance for earn out		1			1,049			—			—			1,050			—
Net income		—			—			16,163			—			16,163			16,163
Balance, September 30, 2008 (unaudited)	$	225		$	268,408		$	10,222		$	(1,601	)	$	277,254		$	13,155

See notes to consolidated financial statements.

5

Kenexa Corporation and Subsidiaries

Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

	Nine months ended September 30,
	2008			2007
Cash flows from operating activities
Net income	$	16,163		$	17,585
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization		8,766			5,175
Non-cash interest expense		—			22
Share-based compensation expense		4,430			2,959
Excess tax benefits from share-based payment arrangements		(192	)		(1,353	)
Amortization of deferred financing costs		224			659
Bed debt expense		146			180
Deferred income tax (benefit)		1,213			(942	)
Changes in assets and liabilities, net of business combinations
Accounts and unbilled receivables		(2,558	)		(1,273	)
Prepaid expenses and other current assets		(462	)		7
Other assets		(2,659	)		(372	)
Accounts payable		584			403
Accrued compensation and other accrued liabilities		(2,424	)		(1,368	)
Commissions payable		(64	)		(457	)
Deferred revenue		1,919			1,888
Other liabilities		8			(112	)
Net cash provided by operating activities		25,094			23,001
Cash flows from investing activities
Purchases of property and equipment		(16,609	)		(7,360	)
Purchase of available-for-sale securities		(25,195	)		(81,737	)
Sale of available-for-sale securities		57,931			—
Acquisitions, net of cash acquired		(29,747	)		(11,406	)
Net cash deposited in escrow for acquisitions		(80	)		(1,610	)
Net cash used in investing activities		(13,700	)		(102,113	)
Cash flows from financing activities
Repayments under line of credit					(65,000	)
Repayments of notes payable		(33	)		(324	)
Proceeds from common stock issued through Employee Stock Purchase Plan		255			159
Repurchase of common stock		(29,842	)		—
Excess tax benefits from share-based payment arrangements		192			1,353
Net proceeds from public stock offering		—			130,398
Deferred financing costs		—			(102	)
Net proceeds from option exercises		366			1,555
Repayment of capital lease obligations		(174	)		(170	)
Net cash (used in) provided by financing activities		(29,236	)		67,869
Effect of exchange rate changes on cash and cash equivalents		(692	)		882
Net decrease in cash and cash equivalents		(18,534	)		(10,361	)
Cash and cash equivalents at beginning of period		38,032			42,502
Cash and cash equivalents at end of period	$	19,498		$	32,141
Supplemental disclosures of cash flow information
Cash paid during the period for:
Interest expense	$	138		$	740
Income taxes	$	2,987		$	3,948
Non-cash investing and financing activities
Capital lease obligations incurred	$	260		$	19
Common stock issuance for acquisition	$	—		$	3,174
Common stock issuance for earn out	$	1,050		$	650

See notes to consolidated financial statements

6

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements - Unaudited

(All amounts in thousands, except share and per share data, unless noted otherwise)

1. Organization

Kenexa Corporation and its subsidiaries (collectively, the “Company”) commenced operations in 1987 as a provider of recruiting services to a wide variety of industries. In 1993, the Company offered its first automated talent management system. Between 1994 and September 30, 2008, the Company acquired 28 businesses that enable it to offer comprehensive human capital management, or HCM, services integrated with web-based technology.

The Company began its operations in 1987 under its predecessor companies, Insurance Services, Inc., or ISI, and International Holding Company, Inc., or IHC. In December 1999, the Company reorganized its corporate structure by merging ISI and IHC with and into Raymond Karsan Associates, Inc., or RKA, a Pennsylvania corporation and a wholly owned subsidiary of Raymond Karsan Holdings, Inc., or RKH, a Pennsylvania corporation. Each of RKA and RKH were newly created to consolidate the businesses of ISI and IHC. In April 2000, the Company changed its name to TalentPoint, Inc. and changed the name of RKA to TalentPoint Technologies, Inc. In November 2000, the Company changed its name to Kenexa Corporation and changed the name of TalentPoint Technologies, Inc. to Kenexa Technology, Inc., or Kenexa Technology. Currently, Kenexa transacts business primarily through Kenexa Technology.

The Company provides software, services and proprietary content that enable organizations to more effectively recruit and retain employees. Its solutions are built around a suite of easily configurable software applications that automate talent acquisition and employee performance management best practices. In addition, the Company offers the software applications that form the core of its solutions on an on-demand basis, which materially reduces the costs and risks associated with deploying traditional enterprise applications, and is complemented by software applications with tailored combinations of outsourcing services, consulting services and proprietary content based on the Company’s 21 years of experience assisting clients in addressing their human resource requirements.

2. Summary of Significant Accounting Policies

The accompanying consolidated financial statements as of and for the three and nine months ended September 30, 2008 and 2007 have been prepared by the Company without audit. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position and the results of operations and cash flows for the three and nine months ended September 30, 2008 and 2007 have been made. The results for the three and nine months ended September 30, 2008 are not necessarily indicative of the results to be expected for the year ended December 31, 2008 or for any other interim period. Certain information and footnote disclosures normally included in the Company’s annual consolidated financial statements have been condensed or omitted and, accordingly, the accompanying financial information should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K, filed with the United States Securities and Exchange Commission for the year ended December 31, 2007. Certain reclassifications have been made in the prior period consolidated financial statements to conform to the current period presentation.

Principles of Consolidation

The consolidated financial statements of the Company include the accounts of Kenexa Corporation and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Cash and Cash Equivalents

Cash and cash equivalents consist of highly liquid investments with remaining maturities of three months or less at the time of purchase. Cash which is restricted for lease deposits is included in other assets.

Cash and cash equivalents in foreign denominated currencies which are held in foreign banks at September 30, 2008 and December 31, 2007 totaled $8,540 and $11,072, respectively, and represented 43.8% and 29.1%, respectively, of our total cash and cash equivalents balance at the end of each period.

7

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements – Unaudited (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

2. Summary of Significant Accounting Policies (Continued)

Short-Term and Long-Term Investments

At September 30, 2008, short-term investments include municipal bonds that may readily be converted to cash within 7 days and are rated AA to AAA by various rating agencies. Short-term investments are recorded at fair value based on current market rates and are classified as available-for-sale. At September 30, 2008 long-term investments include ARS with reset periods ranging from less than a month to nine months and are rated AA to AAA by various rating agencies. Changes in the fair value are included in accumulated other comprehensive income (loss) in the accompanying consolidated financial statements. (See footnote 13 for additional discussion on these investments.)

Prepaid Expenses and Other Assets

Prepaid expenses and other current assets consist primarily of prepaid software maintenance agreements, deferred implementation costs, insurance and other current assets. Deferred implementation costs represent internal payroll and other costs incurred in connection with the configuration of the sites associated with our internet hosting arrangements. These costs are deferred over the implementation period which precedes the hosting period, typically three to four months, and are expensed ratably when the hosting period commences, typically one to three years. These amounts aggregated $2,932 and $1,512 at September 30, 2008 and December 31, 2007, respectively. The current portion of these deferred costs of $383 and $222 at September 30, 2008 and December 31, 2007, respectively, is included in other current assets and the non-current portion of $2,549 and $1,290 at September 30, 2008 and December 31, 2007, respectively, is included in other assets in the accompanying consolidated balance sheets.

Other Long-Term Assets

Other long-term assets primarily include cash held in escrow balances in connection with our acquisitions. These amounts will remain in other assets until the escrow term lapses after which, if there are no claims to the escrow balance, the amounts will be released from escrow as required under our acquisition agreements. The amounts are then accounted for as additional purchase consideration of the respective acquisition.

Outstanding amounts as of September 30, 2008 and December 31, 2007:

	September 30, 2008		December 31, 2007
Acquisition related escrow balances:
Knowledge Workers	$	—	$	100
Gantz Wiley		—		600
Psychometrics Services Ltd.		758		758
StraightSource		1,200		1,200
HRC Human Resources Consulting GmbH		410		410
Quorum International Holdings Limited		780		—
Total escrow balances		3,148		3,068
Other long-term assets		5,838		2,811
Total other long-term assets	$	8,986	$	5,879

8

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements – Unaudited (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

2. Summary of Significant Accounting Policies (Continued)

Software Developed for Internal Use

In accordance with EITF 00-3, “Application of AICPA Statement of Position 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware”, the Company applies AICPA Statement of Position No. 98-1,Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. The costs incurred in the preliminary stages of development are expensed as incurred. Once an application has reached the development stage, internal and external costs, if direct and incremental, will be capitalized until the software is substantially complete and ready for its intended use. Capitalization ceases upon completion of all substantial testing. The Company also capitalizes costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality. Maintenance and training cost are expensed as incurred. Internal use software is amortized on a straight-line basis over its estimated useful life, generally three years. Management evaluates the useful lives of these assets on an annual basis and tests for impairments whenever events or changes in circumstances occur that could impact the recoverability of these assets. There were no impairments to internal software in any of the periods covered in this report.

The Company capitalized internal-use software costs for the three and nine months ended September 30, 2008 and the year ended December 31, 2007 of $2,364, $5,872 and $3,321, respectively. Amortization of capitalized internal-use software costs for the three and nine months ended September 30, 2008 and the year ended December 31, 2007 was $459, $951 and $1,163 respectively.

Revenue Recognition

The Company derives its revenue from two sources: (1) subscription revenue for solutions, which is comprised of subscription fees from clients accessing our on-demand software, consulting services, outsourcing services and proprietary content, and from clients purchasing additional support beyond the standard support that is included in the basic subscription fee; and (2) other fees for discrete professional services. Because the Company provides its solutions as a service, the Company follows the provisions of Securities and Exchange Commission Staff Accounting Bulletin No. 101,Revenue Recognition in Financial Statements, as amended by Staff Accounting Bulletin No. 104,Revenue Recognition. On August 1, 2003, the Company adopted Emerging Issues Task Force Issue No. 00-21,Revenue Arrangements with Multiple Deliverables. The Company recognizes revenue when all of the following conditions are met:

• There is persuasive evidence of an arrangement;

• The service has been provided to the client;

• The collection of the fees is probable; and

• The amount of fees to be paid by the client is fixed or determinable.

Subscription fees and support revenues are recognized ratably on a monthly basis over the hosting period. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met.

Discrete professional services and other revenues, when sold with subscription and support offerings, are accounted for separately since these services have value to the customer on a stand-alone basis and there is objective and reliable evidence of fair value of the delivered elements. The Company’s arrangements do not contain general rights of return. Additionally, when professional services are sold with other elements, the consideration from the revenue arrangement is allocated among the separate elements based upon the relative fair value. Professional services and other revenues are recorded as follows: Consulting revenues are recognized upon completion of the contracts that are of short duration (generally less than 60 days) and as the services are rendered for contracts of longer duration.

9

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements – Unaudited (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

2. Summary of Significant Accounting Policies (Continued)

In determining whether revenues from professional services can be accounted for separately from subscription revenue, the Company considers the following factors for each agreement: availability from other vendors, whether objective and reliable evidence of fair value exists of the undelivered elements, the nature and the timing of when the agreement was signed in comparison to the subscription agreement start date and the contractual dependence of the subscription service on the client’s satisfaction with the other services. If the professional service does not qualify for separate accounting, the Company recognizes the revenue ratably over the remaining term of the subscription contract. In these situations the Company defers the direct and incremental costs of the professional service over the same period as the revenue is recognized.

Deferred revenue represents payments received or accounts receivable from the Company’s clients for amounts billed in advance of subscription services being provided.

In accordance with EITF 01-14, “Out-of-Pocket Expenses Incurred”the Company records reimbursements received for out-of-pocket expenses as other revenue and not netted with the applicable costs. These items primarily include travel, meals and certain telecommunication costs. For the three and nine months ended September 30, 2008 and 2007, reimbursed expenses totaled $1,343 and $3,464 and $868 and $2,361 respectively.

Self-Insurance

The Company is self-insured for the majority of its health insurance costs, including claims filed and claims incurred but not reported subject to certain stop-loss provisions. The Company estimated the liability based upon management’s judgment and historical experience. At September 30, 2008 and December 31, 2007, self-insurance accruals totaled $507 and $355, respectively. Management continuously reviews the adequacy of the Company’s stop-loss insurance coverage. Material differences may result in the amount and timing of insurance expense if actual experience differs significantly from management’s estimates.

Concentration of Credit Risk

Financial instruments that potentially expose the Company to concentration of credit risk consist primarily of accounts receivable. Credit risk arising from receivables is mitigated due to the large number of clients comprising the Company’s client base and their dispersion across various industries. While the clients are concentrated primarily in the Company’s U.S. market area, an increasing number are non-U.S. At September 30, 2008, no client represented more than 10% of the net accounts receivable balance. For the three and nine months ended September 30, 2008, no client individually exceeded 10% of the Company’s revenues.

Cash balances are maintained at several banks. Accounts located in the United States are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $100 (which has been temporarily increased to $250 through December 31, 2009). Certain operating cash accounts may periodically exceed the FDIC limits.

10

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements – Unaudited (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

2. Summary of Significant Accounting Policies (Continued)

Earnings Per Share

The Company follows SFAS 128, “Earnings Per Share.” Under SFAS 128, companies that are publicly held or have complex capital structures are required to present basic and diluted earnings per share on the face of the statement of operations. Earnings per share are based on the weighted average number of shares and common stock equivalents outstanding during the period. In the calculation of diluted earnings per share, shares outstanding are adjusted to assume conversion of the Company’s exercise of options if they are dilutive. In the calculation of basic earnings per share, weighted average numbers of shares outstanding are used as the denominator. The computation of common stock equivalents excluded options to purchase shares of common stock as their effect was antidilutive of 764,400 for the three and nine months ended September 30, 2008 and 391,101 and 413,720 for the three and nine months ended September 30, 2007, respectively.

Basic and diluted earnings per share are computed as follows:

	Three months ended September 30,				Nine months ended September 30,
	2008		2007		2008		2007
Numerator:
Net income	$	5,424	$	7,077	$	16,163	$	17,585
Denominator:
Weighted average shares used to compute net income per share - basic		22,551,225		25,455,504		22,852,499		24,948,592
Effect of dilutive stock options		237,243		391,101		232,025		413,720
Weighted average shares used to compute net income per share – dilutive		22,788,468		25,846,605		23,084,524		25,362,312
Basic net income per share	$	0.24	$	0.28	$	0.71	$	0.70
Diluted net income per share	$	0.24	$	0.27	$	0.70	$	0.69

Share-based Compensation Expense

On January 1, 2006, the Company adopted SFAS No. 123R using the Modified Prospective Approach (“MPA”). The MPA requires that compensation expense be recorded for restricted stock and all unvested stock options as of January 1, 2006. Since the adoption, the Company continues to recognize the cost of previously granted share-based awards on a straight-line basis and recognize the cost for new share-based awards on a straight-line basis over the requisite service period.

Adoption of new accounting pronouncement

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair-value hierarchy that prioritizes the information used to develop those assumptions. Under SFAS No. 157, fair-value measurements would be separately disclosed by level within the fair-value hierarchy. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The Company’s adoption of SFAS No. 157 for financial assets and liabilities on January 1, 2008 did not have a material impact on the Company’s consolidated financial statements. In February 2008, the FASB issued FASB Staff Position (FSP) No. FSP 157-1 and FSP 157-2. FSP 157-1 amends SFAS 157 to exclude SFAS No. 13 “Accounting for Leases” and other accounting pronouncements that address fair value measurements for purposes of lease classifications or measurement under SFAS 13. FSP 157-2 delays the effective date of SFAS 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). FSP 157-2 defers the effective date of SFAS No. 157 to fiscal years beginning after November 15, 2008 and interim periods within those fiscal years for items within its scope. Effective for the first quarter of fiscal 2009, the Company will adopt SFAS 157 except as it applies to those nonfinancial assets and nonfinancial liabilities noted in FSP 157-2. The Company is currently analyzing the requirements of SFAS 157 and has not yet determined the impact on its financial position or results of operations.

11

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements – Unaudited (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

2. Summary of Significant Accounting Policies (Continued)

New Accounting Pronouncements

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 permits entities to choose to measure certain financial assets and liabilities at fair value at specified election dates. The fair value option may be applied instrument by instrument (with a few exceptions), is irrevocable and is applied only to entire instruments and not to portions of instruments. Unrealized gains and losses on items for which the fair value option has been elected are to be reported in earnings at each subsequent reporting date. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company has chosen not to elect the fair value option, therefore the adoption of SFAS 159 did not have an impact on the Company’s financial statements.

In December 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141(R), Business Combinations (“SFAS 141(R)”) and SFAS No. 160, Accounting and Reporting of Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin No. 51 (“SFAS 160”). Changes for business combination transactions pursuant to SFAS 141(R) include, among others, expensing of acquisition-related transaction costs as incurred, the recognition of contingent consideration arrangements at their acquisition date fair value and capitalization of in-process research and development assets acquired at their acquisition date fair value. Changes in accounting for noncontrolling (minority) interests pursuant to SFAS 160 include, among others, the classification of noncontrolling interest as a component of consolidated shareholders equity and the elimination of “minority interest” accounting in results of operations. SFAS 141(R) and FAS 160 are required to be adopted simultaneously and are effective for fiscal years beginning on or after December 15, 2008. The adoption of SFAS 141(R) will impact the accounting for the Company’s future acquisitions. The Company does not however, believe the adoption of SFAS 160 will have a material impact on our consolidated financial position, results of operations or cash flows.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Fair Value of Financial Instruments

The carrying amounts of the Company’s financial assets and liabilities, including cash and cash equivalents, accounts receivable and accounts payable at September 30, 2008 and December 31, 2007, approximate fair value of these instruments.

12

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements – Unaudited (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

3. Acquisitions

Quorum International Holdings Limited

On April 2, 2008, the Company acquired all of the outstanding stock of Quorum International Holdings Limited (“Quorum”), a provider of recruitment process outsourcing services based in London, England, for a purchase price of approximately $27,950, in cash, of which $19,753 was paid in April 2008 and $8,197 was paid in July 2008. The total cost of the acquisition, including legal, accounting, and other professional fees of $569, was approximately $28,519, including acquired intangibles of $8,633, with an estimated useful life between 3 and 10 years. In connection with the acquisition, $780 of the purchase price was deposited into an escrow account to cover any claims for indemnification made by the Company against Quorum under the acquisition agreement. The escrow agreement will remain in place for approximately two years from the acquisition date, and any funds remaining in the escrow account at the end of the two year period will be distributed to the former stockholders of Quorum. In addition, the acquisition agreement contains an earn out provision which provides for the payment of additional consideration by the Company based upon the gross margins of Quorum. The Company expects that the acquisition of Quorum will broaden our presence in the global recruitment market. The purchase price has been allocated on a preliminary basis to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill. In accordance with Statement of Financial Accounting Standard No. 141, the purchase price and related purchase price allocation may be updated to reflect changes such as any additional transaction fees or the finalization of the valuation of assets acquired or liabilities assumed. Quorum’s results of operations were included in the Company’s consolidated financial statements beginning on April 2, 2008.

HRC Human Resources Consulting GmbH

On August 20, 2007, the Company acquired all of the outstanding stock of HRC Human Resources Consulting GmbH (“HRC”), a consultancy for business-orientated employee surveys, based in Munich, Germany, for a purchase price of approximately $3,757 in cash. The total cost of the acquisition, including legal, accounting, and other professional fees of $529, was approximately $4,286. In connection with the acquisition, $410 of the cash portion of the purchase price was deposited into an escrow account to cover any claims for indemnification made by the Company against HRC under the acquisition agreement. The escrow agreement will remain in place for approximately five years from the acquisition date, and any funds remaining in the escrow account at the end of the five year period will be distributed to the former stockholders of HRC. The Company expects that the acquisition of HRC will provide us with a presence in Germany and enhances our expansion in European countries. The purchase price has been allocated to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill. HRC’s results of operations were included in the Company’s consolidated financial statements beginning on August 20, 2007.

StraightSource

On June 8, 2007, the Company acquired all of the outstanding stock of Strategic Outsourcing Corporation (“StraightSource”), a provider of recruitment process outsourcing services, based in Richardson, Texas, for a purchase price including contingent consideration of approximately $12,150 in cash and $4,224 in stock consideration. The total cost of the acquisition, including legal, accounting, and other professional fees of $40, was approximately $16,414, including acquired intangibles of $7,963, with an estimated useful life between 2.5 and 9 years. The payment of additional consideration by the Company was based upon the annual revenues of StraightSource through December 31, 2007. Based upon these results, the Company accrued $2,100 at December 31, 2007 and accrued an additional $2,100 during the first quarter of 2008. The contingent consideration of $4,200 was paid in cash and equity during the first quarter of 2008 to the former shareholders of StraightSource. In connection with the acquisition, $1,200 of the cash portion of the purchase price was deposited into an escrow account to cover any claims for indemnification made by the Company against StraightSource under the acquisition agreement. The escrow agreement will remain in place for three years from the acquisition date, and any funds remaining in the escrow account at the end of the three year period will be distributed to the former stockholders of StraightSource. The Company expects that the acquisition of StraightSource will provide additional efficiency to our exempt and non-exempt recruitment offering and expand our distribution capabilities in the Southwest market. The purchase price has been allocated to the assets acquired and liabilities assumed based upon management’s best estimate of fair value with any excess over the net tangible and intangible assets acquired allocated to goodwill. StraightSource’s results of operations were included in the Company’s consolidated financial statements beginning on June 8, 2007.

13

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements – Unaudited (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

4. Property, Equipment and Software

A summary of property, equipment and software and related accumulated depreciation as of September 30, 2008 and December 31, 2007 is as follows:

	September 30, 2008		December 31, 2007
Equipment	$	14,799	$	11,667
Software		13,750		10,945
Office furniture and fixtures		2,574		1,791
Leasehold improvements		2,777		1,575
Land		684		752
Building construction in progress		—		4,881
Building		8,124		—
Software in development		6,281		2,960
		48,989		34,571
Less accumulated depreciation and amortization		18,260		15,394
	$	30,729	$	19,177

Equipment, office furniture and fixtures included capital leases in the amount of $2,843 at September 30, 2008. Depreciation and amortization expense, including amortization of assets under capital leases, were $4,945 and $5,172 for the nine months ended September 30, 2008 and year end December 31, 2007, respectively.

5. Other Accrued Liabilities

Other accrued liabilities consist of the following:

	September 30, 2008		December 31, 2007
Accrued professional fees	$	314	$	70
Straight line rent accrual		1,882		932
Other taxes payable (non-income tax)		435		973
Income taxes payable		1,795		818
Other liabilities		1,420		1,405
Contingent purchase price		656		2,100
Total other accrued liabilities	$	6,502	$	6,298

14

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements – Unaudited (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

6. Line of Credit

On November 13, 2006, the Company entered into a secured credit agreement with PNC Bank, N.A. (the “Credit Agreement”), as administrative agent, in connection with an acquisition. This Credit Agreement replaced the prior $25,000 revolving credit agreement with PNC Bank and increased the maximum amount available under the credit facility from $25,000 to $75,000, including a $25,000 revolving credit facility, a $50,000 term loan and a sublimit of up to $2,000 for letters of credit. Borrowings under the new credit facility are secured by substantially all of Kenexa Corporation’s assets and the assets of its subsidiaries. As of December 31, 2006, the Company had borrowings of $65,000 outstanding under the Credit Agreement with a weighted average interest rate of 7.9% per annum. In January 2007, the Company used a portion of the net proceeds of its public offering to repay all outstanding borrowings, including the entire balance of the term loan under the Credit Agreement.

On March 26, 2007, the Company entered into a First Amendment to Credit Agreement (the “Amendment”) with PNC Bank, N.A. The Amendment increased the maximum amount available under the revolving credit facility portion of the Credit Agreement from $25,000 to $50,000, including a sublimit of up to $2,000 for letters of credit. The Amendment provides that the Credit Agreement will terminate, and all borrowings will become due and payable, on March 26, 2010. Kenexa Corporation and each of the U.S. subsidiaries of Kenexa Technology are guarantors of the obligations of Technology under the Credit Agreement, as amended by the Amendment. As of September 30, 2008, there were no outstanding borrowings under the Credit Agreement.

The Company’s borrowings under the Credit Agreement bear interest at tiered rates based upon the ratio of Net Funded Debt to EBITDA as defined in the Third Amendment. The Company may also elect interest rates on its borrowings calculated by reference to LIBOR plus a margin based upon the ratio of its Net Funded Debt to EBITDA. Interest on LIBOR borrowings is calculated on an actual/360 day basis and is paid on the last day of each interest period. LIBOR advances are available for periods of 1, 2, 3 or 6 months. LIBOR pricing is adjusted for any statutory reserves.

Borrowings under the revolving credit facility portion of the Credit Agreement are collateralized generally by the Company’s assets, including a pledge of the capital stock of its subsidiaries. The Credit Agreement contains various terms and covenants that provide for restrictions on capital expenditures, payment of dividends, dispositions of assets, investments and acquisitions and require the Company, among other things, to maintain minimum levels of tangible net worth, net income and fixed charge coverage. The Company was in compliance with these financial statement covenants at September 30, 2008.

The Company has issued an irrevocable stand-by letter of credit for $500 for security on its sublease for its Waltham, MA office facility. The stand-by letter of credit automatically renews annually on June 30, with 60 days cancellation notice until its expiration on June 28, 2011.

15

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

7. Commitments and Contingencies

Litigation

We are involved from time to time in claims that arise in the ordinary course of business. In the opinion of management, we have made adequate provision for potential liabilities, if any, arising from any such matters. However, litigation is inherently unpredictable, and the costs and other effects of pending or future litigation, governmental investigations, legal and administrative cases and proceedings (whether civil or criminal), settlements, judgments and investigations, claims and changes in any such matters, and developments or assertions by or against us relating to intellectual property rights and intellectual property licenses, could have a material adverse effect on our business, financial condition and operating results.

8. Equity

Rollforward of Shares

The Company’s common shares issued and repurchased for the nine months ended September 30, 2008 and the year ended December 31, 2007 are as follows:

	Common Shares Class A
December 31, 2006 ending balance	20,897,777
Repurchase of common shares	(1,448,091	)
Shares from public stock offering	4,312,500
Stock option exercises	136,673
Employee stock purchase plan	10,152
Restricted shares issued	16,200
Shares issued for acquisition	107,235
December 31, 2007 ending balance	24,032,446
Repurchase of common shares	(1,608,202	)
Stock option exercises	67,021
Employee stock purchase plan	12,750
Shares issued for earn out	55,876
September 30, 2008 ending balance	22,559,891

Refer to the accompanying consolidated statements of shareholders’ equity and this note for further discussion.

On February 20, 2008, Kenexa Corporation’s Board of Directors (the “Board”) authorized a stock repurchase plan providing for the repurchase of up to 3,000,000 shares of our common stock, of which 1,056,293 shares were repurchased at an aggregate cost of $19,994 as of September 30, 2008. These shares were restored to original status and accordingly are presented as authorized but not issued. The timing, price and volume of repurchases were based on market conditions, relevant securities laws and other factors. As of September 30, 2008, the number of shares available for repurchase under the stock repurchase plan was 1,943,707.

On November 8, 2007, the Board authorized a stock repurchase plan providing for the repurchase of up to 2,000,000 shares of our common stock, of which 1,448,091 shares were repurchased at an aggregate cost of $25,482 as of December 31, 2007. These shares were restored to original status prior to December 31, 2007 and accordingly are presented as authorized but not issued. The timing, price and volume of repurchases were based on market conditions, relevant securities laws and other factors. As of December 31, 2007, the number of shares available for repurchase under the stock repurchase plan was 551,909. Through January 24, 2008, the remaining 551,909 shares available for repurchase under the stock repurchase plan were repurchased at an aggregate cost of $9,848.

On January 18, 2007, the Company completed a public offering of 3,750,000 shares of its common stock at a price of $31.86 per share. The Company also sold an additional 562,500 shares of common stock to cover over-allotments of shares. Net proceeds to the Company after payment of all offering expenses and commissions aggregated approximately $130,398.

16

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

9. Stock Plans

Employee Stock Option Plan

The Company’s 2005 Equity Incentive Plan (the “2005 Option Plan”), which was adopted by the Board in March 2005 and was approved by the Company’s shareholders in June 2005, provides for the granting of stock options to employees and directors at the discretion of the Board or a committee of the Board. The 2005 Option Plan replaced the Company’s 2000 Stock Option Plan (the “2000 Option Plan”).

As of September 30, 2008, there were options to purchase 1,956,754 shares of common stock outstanding under the 2005 Option Plan. The Company is authorized to issue up to an aggregate of 4,842,910 shares of its common stock pursuant to stock options granted under the 2005 Option Plan. As of September 30, 2008, 2,263,406 shares of common stock not subject to outstanding options were available for issuance under the 2005 Option Plan. The purpose of stock options is to recognize past services rendered and to provide additional incentive to contribute to the continued success of the Company. Stock options granted under both the 2005 Option Plan and the 2000 Stock Option Plan expire between the fifth and tenth anniversary of the date of grant and generally vest on the third anniversary of the date of grant. Unexercised stock options may expire up to 90 days after an employee’s termination.

SFAS 123R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. In 2008 and 2007, the fair value of each grant was estimated using the Black-Scholes valuation model. Expected volatility was based upon a weighted average of peer companies and the Company’s stock volatility. The expected life was determined based upon an average of the contractual life and vesting period of the options, in accordance with SAB 110. The estimated forfeiture rate was based upon an analysis of historical data. The risk-free rate was based on U.S. Treasury zero coupon bond yields at the time of grant. The following table provides the assumptions used in determining the fair value of the share-based awards for the period ended September 30, 2008 and the year ended December 31, 2007, respectively.

	Quarter ended September 30, 2008		Quarter ended June 30, 2008		Quarter ended March 31, 2008		Year ended December 31, 2007
Expected volatility	57.52	%	57.53	%	56.23	%	47.26 – 54.95	%
Expected dividends	0		0		0		0
Expected term (in years)	3.75		3		3.75		4 – 5
Risk-free rate	1.87	%	2.77	%	2.56	%	2.5 – 4.6	%

A summary of the status of the Company’s vested and non-vested stock options as of September 30, 2008 and December 31, 2007 and changes during the periods then ended is as follows:

	Options & Restricted Stock Outstanding						Options Exercisable
	Shares Available for Grant		Shares		Wtd. Avg. Exercise Price		Shares	Wtd. Avg. Exercise Price
Balance at December 31, 2006	3,138,046		1,302,008		$	14.63	321,208	$	14.26
Granted – options	(539,400	)	539,400			35.40	—		—
Granted – restricted stock	(16,200	)	16,200			0.00	—		—
Exercised	—		(136,673	)		11.42	—		—
Forfeited or expired	119,900		(119,900	)		22.24	—		—
Balance at December 31, 2007	2,702,346		1,601,035		$	21.18	241,335		14.96
Granted – options	(524,200	)	524,200			19.16	—		—
Exercised	—		(83,221	)		4.41	—		—
Forfeited or expired	85,260		(85,260	)		28.76	—		—
Balance at September 30, 2008	2,263,406		1,956,754		$	21.03	358,514		13.04

The total intrinsic values of options outstanding, exercisable and exercised for and during the nine months ended September 30, 2008 were $3,119, $1,623 and $1,249, respectively. The weighted average fair values for options granted during the nine months ended September 30, 2008 and the year ended December 31, 2007 were $8.39 and $14.91, respectively. The weighted-average remaining contractual terms (in years) of options outstanding and exercisable as of September 30, 2008 were 4.60 and 5.24, respectively.

17

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

9. Stock Plans (continued)

A summary of the status of the Company’s nonvested share options and restricted stock as of September 30, 2008 and December 31, 2007 is presented below:

Nonvested Shares	Shares		Wtd. Avg. Grant Date Fair Value
Nonvested at December 31, 2006	980,800		$	8.65
Granted - options	539,400			14.91
Granted - restricted stock	16,200			31.46
Vested	(56,800	)		13.26
Forfeited or expired	(119,900	)		9.78
Nonvested at December 31, 2007	1,359,700		$	10.73
Granted - options	524,200			8.39
Vested	(201,000	)		9.46
Forfeited or expired	(84,500	)		12.04
Nonvested at September 30, 2008	1,598,400		$	10.08

Between January 1, 2008 and September 30, 2008, the Company granted options to certain employees and to non-employee members of the Board to purchase an aggregate of 524,200 shares of the Company’s common stock at a weighted exercise price of $19.16 per share. The Company granted the options at exercise prices equal to prevailing market prices ranging from $18.66 to $21.80 per share.

Between January 1, 2007 and December 31, 2007, the Company granted options to certain employees and to non-employee members of the Board to purchase an aggregate of 539,400 shares of the Company’s common stock at a weighted exercise price of $35.40 per share. The Company granted the options at exercise prices equal to prevailing market prices ranging from $29.94 to $36.87 per share.

On August 14, 2007, the Company granted to each non-employee member of the Board 2,700 shares of restricted stock, or an aggregate of 16,200 shares of restricted stock. These restrictions lapsed on May 19, 2008. The grant date fair value of the restricted stock was $31.46.

SFAS No. 123R also requires us to change the classification of any tax benefits realized upon exercise of stock options in excess of that which is associated with the expense recognized for financial reporting purposes. These amounts are presented as a financing cash inflow rather than as a reduction of income taxes paid in our consolidated statement of cash flows.

In accordance with Staff Accounting Bulletin No. 107, we classified share-based compensation within cost of revenue, sales and marketing, general and administrative and research and development expenses corresponding to the same line as the cash compensation paid to respective employees, officers and non-employee directors.

The following table shows total share-based compensation expense included in the Consolidated Statement of Operations:

	Three months ended September 30,				Nine months ended September 30,
	2008		2007		2008		2007
Cost of revenue	$	96	$	91	$	267	$	307
Sales and marketing		68		326		636		777
General and administrative		985		578		3,193		1,599
Research and development		107		180		333		276
Pre-tax share-based compensation		1,256		1,175		4,429		2,959
Income tax benefit		414		438		1,383		1,085
Share-based compensation expense, net	$	842	$	737	$	3,046	$	1,874

18

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

9. Stock Plans (continued)

Employee Stock Purchase Plan

The Employee Stock Purchase Plan approved in May 2006 (the “Plan”) enables substantially all U.S. and foreign employees to purchase shares of our common stock at a 5% discounted offering price off the closing market price of our common stock on the NASDAQ National Market, LLC on the offering date. We have granted rights to purchase up to 500,000 common shares to our employees under the Plan. The Plan is not considered a compensatory plan in accordance with SFAS 123(R) and requires no compensation expense to be recognized. For the nine months ended September 30, 2008 and the year ended December 31, 2007, 12,750 and 10,152 shares of our common stock, respectively, were purchased under the Plan.

10. Related Party Transactions

One of the Company’s directors, Barry M. Abelson, is a partner in the law firm of Pepper Hamilton LLP. This firm has represented the Company since 1997. For the three and nine months ended September 30, 2008 and 2007, the Company paid Pepper Hamilton LLP, $52, $127, $50 and $1,335, respectively, for general legal matters. The amounts payable to Pepper Hamilton as of September 30, 2008 and December 31, 2007 were $203 and $33, respectively. The amounts expensed in connection with Pepper Hamilton’s services for the three and nine months ended September 30, 2008 and 2007 were $306, $503, $127 and $533, respectively.

11. Income Taxes

The Company’s tax provision for interim periods is determined using an estimate of its annual effective tax rate. The 2008 effective tax rate is estimated to be lower than the 35% statutory U.S. Federal rate primarily due to anticipated earnings in subsidiaries outside the U.S. in jurisdictions where the effective rate is lower than in the U.S. and tax exempt interest income.

On January 1, 2007, we adopted the Financial Accounting Standard Board’s Interpretation No. 48,Accounting for Income Tax Uncertainties (“FIN 48”). FIN 48 clarifies the accounting for uncertain income tax positions recognized in financial statements and requires the impact of a tax position to be recognized in the financial statements if that position is more likely than not of being sustained by the taxing authority. We do not expect that the amount of unrecognized tax benefits will significantly increase or decrease within the next twelve months. Our policy is to recognize interest and penalties on unrecognized tax benefits in the provision for income taxes in the consolidated statements of operations. Tax years beginning in 2004 are subject to examination by taxing authorities, although net operating loss and credit carryforwards from all years are subject to examinations and adjustments for at least three years following the year in which the attributes are used.

19

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

12. Geographic Information

The following table summarizes the distribution of revenue by geographic region as determined by billing address for the three and nine months ended September 30, 2008 and 2007.

	For the three months ended September 30,						For the nine months ended September 30,
	2008			2007			2008			2007
United States	$	38,780		$	41,796		$	118,490		$	117,545
United Kingdom		4,183			2,088			14,184			6,925
Germany		3,013			704			7,666			876
The Netherlands		1,404			479			2,663			1,669
Other European Countries		3,501			1,029			7,950			4,126
Canada		982			533			2,638			1,488
Other		2,163			168			5,083			1,549
Total	$	54,026		$	46,797		$	158,674		$	134,178
The following table summarizes the distribution of revenue as a percentage of total revenue by geographic region as determined by billing address for the three and nine months ended September 30, 2008 and 2007.
	For the three months ended September 30,						For the nine months ended September 30,
	2008			2007			2008			2007
United States		71.8	%		89.3	%		74.7	%		87.6	%
United Kingdom		7.7	%		4.5	%		8.9	%		5.2	%
Germany		5.6	%		1.5	%		4.8	%		0.6	%
The Netherlands		2.6	%		1.0	%		1.7	%		1.2	%
Other European Countries		6.5	%		2.2	%		5.0	%		3.1	%
Canada		1.8	%		1.1	%		1.7	%		1.1	%
Other		4.0	%		0.4	%		3.2	%		1.2	%
Total		100.0	%		100.0	%		100.0	%		100.0	%
The following table summarizes the distribution of assets by geographic region as of September 30, 2008 and December 31, 2007.
	September 30, 2008						December 31, 2007
Country	Assets			Assets as a percentage of total assets			Assets			Assets as a percentage of total assets
United States	$	269,426			78.4	%	$	306,276			88.0	%
United Kingdom		44,244			12.9	%		16,889			4.9	%
India		13,619			4.0	%		14,436			4.1	%
Germany		8,573			2.5	%		6,888			2.0	%
Poland		3,026			0.9	%		—			—	%
Canada		2,865			0.8	%		2,428			0.7	%
Other		1,813			0.5	%		972			0.3	%
Total	$	343,566			100.00	%	$	347,889			100.0	%

20

Kenexa Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(All amounts in thousands, except share and per share data, unless noted otherwise)

13. Short-term and long-term investments

On September 30, 2008 the Company had the following investments at fair market value:

Type of investment:	Asset classification	Amount
Municipal securities	Short-term	$	6,597
Auction rate securities	Short-term		—
Total short-term investments			6,597
Auction rate securities	Long-term		17,820
Total investments:		$	24,417

During the period from June 2008 to September 2008, the Company experienced failed auctions for 15 tax exempt auction rate securities (“ARS”) issues, backed by student educational loans, representing principal and accrued interest of $20,843. However, in July 2008, the Company successfully sold 2 ARS issues with principal balances totaling $3,000. The Company determined that a temporary impairment of its ARS has occurred and therefore recorded a charge of $1,293, with no tax benefit, to accumulated other comprehensive income as of September 30, 2008. Additionally, due to the current uncertainty surrounding the ability to liquidate its ARS securities over the next twelve months, the Company has reclassified $17,820 of these investments, representing investments that were not recently liquidated, to long-term assets from short-term assets as of September 30, 2008. These securities will continue to accrue interest at the contractual rate and will be auctioned every 90 days until sold. Based on the size of this investment, the Company’s ability to access cash and other short-term investments, and expected operating cash flows, the Company does not anticipate the illiquidity of this investment to affect its operations.

As a result of the changes in the ARS market we have adjusted the fair value of our ARS investment portfolio using a discounted cash flow model to determine the estimated fair value of our ARS investments as of September 30, 2008. The assumptions used in preparing the discounted cash flow model include level three inputs, as defined in SFAS No. 157, Fair Value Measurements, such as estimates for interest rates, the amount of cash flows and an expected holding period of the ARS. Based upon our assessment, the fair value of our ARS investments declined approximately $1,080 for the nine months ended September 30, 2008 to $17,820, which was deemed temporary and was recognized in accumulated other comprehensive (loss) income. In the future, we will continue to monitor the ARS market and depending upon market conditions and our own cash requirements may record additional temporary losses if appropriate.

On October 8, 2008 the Company received an ARS Rights offer from its investment bank to sell eligible ARSs, as defined in the agreement, at par value to the bank during the two year period between June 30, 2010 and July 2, 2012. The agreement also contains a provision for those clients who accept the offer to receive a “no net cost” loan up to the par value of eligible ARS until June 30, 2010. Following an evaluation of the terms and conditions of the offer the Company accepted the offer.

On September 30, 2008 the fair value for the Company’s investments was determined based upon the inputs presented below:

Description	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Municipal Bonds	$	6,597	6,597	—	—
Auction Rate Securities		17,820		—	17,820
Total	$	24,417	6,597	—	17,820

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A summary of the activity of investments using significant unobservable inputs (Level 3) for the period ended September 30, 2008 is as follows:

	Auction Rate Securities
December 31, 2007 balance	$	29,900
Total gains or losses (realized/unrealized)
Included in earnings		—
Included in other comprehensive income		(1,080	)
Purchases, issuances and settlements		(11,000	)
Transfers in and/or out of Level 3		—
September 30, 2008 balance	$	17,820

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

This Quarterly Report on Form 10-Q, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995, that involve a number of risks and uncertainties. These forward-looking statements include, but are not limited to, plans, objectives, expectations and intentions and other statements contained herein that are not historical facts and statements identified by words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” or words of similar meaning. These statements may contain, among other things, guidance as to future revenue and earnings, operations, prospects of the business generally, intellectual property and the development of products. These statements are based on our current beliefs or expectations and are inherently subject to various risks and uncertainties, including those set forth under the caption “Risk Factors” in our most recent Annual Report on Form 10-K as filed with the Securities and Exchange Commission, as amended and supplemented under the caption “Risk Factors” in our subsequent Quarterly Reports on Form 10-Q filed with the Securities and Exchange Commission, including this Quarterly Report on Form 10-Q. Actual results may differ materially from these expectations due to changes in global political, economic, business, competitive, market and regulatory factors, our ability to implement business and acquisition strategies or to complete or integrate acquisitions. We do not undertake any obligation to update any forward-looking statements contained herein as a result of new information, future events or otherwise. References herein to “Kenexa,” “we,” “our,” and “us” collectively refer to Kenexa Corporation, a Pennsylvania corporation, and all of its direct and indirect U.S., U.K., Canada, India, and other foreign subsidiaries.

1. Overview

We provide software, services and proprietary content that enable organizations to more effectively recruit and retain employees. Our solutions are built around a suite of easily configurable software applications that automate talent acquisition and employee performance management best practices. We offer the software applications that form the core of our solutions on an on-demand basis, which materially reduces the costs and risks associated with deploying traditional enterprise applications. We complement our software applications with tailored combinations of outsourcing services, consulting services and proprietary content based on our 21 years of experience assisting clients in addressing their human resource requirements. Together, our software applications and services form solutions that we believe enable our clients to improve the effectiveness of their talent acquisition programs, increase employee productivity and retention, measure key HR metrics and make their talent acquisition and employee performance management programs more efficient.

Since 1999, we have focused on providing talent acquisition and employee performance management solutions on a subscription basis and currently generate a significant portion of our revenue from these subscriptions. For the nine months ended September 30, 2008 and 2007, revenue from these subscriptions comprised approximately 79.3% and 81.9%, respectively, of our total revenue. We generate the remainder of our revenue from discrete professional services that are not provided as part of an integrated solution on a subscription basis. These subscription-based solutions provide us with a recurring revenue stream and we believe represent a more compelling opportunity in terms of growth and profitability than discrete professional services.

We sell our solutions to large and medium-sized organizations through our direct sales force. As of December 31, 2007, we had a client base of approximately 4,000 companies, including approximately 199 companies on the Fortune 500 list published in April 2007. Our client base includes companies that we billed for services during the year ended December 31, 2007 and does not necessarily indicate an ongoing relationship with each such client. Our top 80 clients by revenue contributed approximately $87.8 million, or 55.3%, of our total revenue for the nine months ended September 30, 2008.

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2. Recent Events

On September 10, 2008 we reduced our revenue guidance for the remainder of 2008 due to the challenging macroeconomic environment and strengthening U.S. dollar as a number of project implementations have slowed or been delayed. Following this announcement, on November 3, 2008, due to the widespread deterioration in our business climate, we announced a restructuring program involving staff reductions of approximately 12% which included one-time severance and outplacement benefits in the range of $2.0 to $2.5 million. We expect to complete our program in the fourth quarter of 2008.

On April 2, 2008, we acquired Quorum International Holdings Limited (“Quorum”), a provider of recruitment process outsourcing services based in London, England, for a purchase price of approximately $27.9 million, in cash. The total cost of the acquisition, including legal, accounting, and other professional fees of $0.6 million, was approximately $28.5 million. We expect that the acquisition of Quorum will broaden our presence in the global recruitment market.

On February 20, 2008, our board of directors authorized a stock repurchase plan providing for the repurchase of up to 3,000,000 shares of our common stock, of which 1,056,293 shares were repurchased at an aggregate cost of $20.0 million as of September 30, 2008. These shares were restored to original status and accordingly are presented as authorized but not issued. The timing, price and volume of repurchases were based on market conditions, relevant securities laws and other factors. As of September 30, 2008, the number of shares available for repurchase under the stock repurchase plan was 1,943,707.

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3. Sources of Revenue

We derive revenue primarily from two sources: (1) subscription revenue for our solutions, which is comprised of subscription fees from clients accessing our on-demand software, consulting services, outsourcing services and proprietary content, and from clients purchasing additional support that is not included in the basic subscription fee; and (2) fees for discrete professional services.

Our clients primarily purchase renewable subscriptions for our solutions. The typical term is one to three years, with some terms extending up to five years. The majority of our subscription agreements are not cancelable for convenience although our clients have the right to terminate their contracts for cause if we fail to provide the agreed upon services or otherwise breach the agreement. A client does not generally have a right to a refund of any advance payments if the contract is cancelled. Although our renewal rate for the quarter ended September 20, 2008 dropped slightly, the decrease was predominantly due to the postponement of a renewal by a single client that has been delayed for several months and which we expect will eventually be renewed, we continue to expect that we will maintain our historical renewal rate of approximately 90.0% of the aggregate contract value up for renewal for calendar year 2008. The revenue derived from subscription fees is recognized ratably over the term of the subscription agreement. We generally invoice our clients in advance in monthly or quarterly installments and typical payment terms provide that our clients pay us within 30 days of the invoice date. Amounts that have been invoiced are recorded in accounts receivable prior to the receipt of payment and in deferred revenue to the extent revenue recognition criteria have not been met. As of September 30, 2008, deferred revenue increased to $37.0 million from $35.1 million as of December 31, 2007. We generally price our solutions based on the number of software applications and services included and the number of client employees. Accordingly, subscription fees are generally greater for larger organizations and for those that subscribe for a broader array of software applications and services.

A small portion of our clients purchase discrete professional services. These services primarily consist of consulting and training services. In addition, we recognize a small amount of revenue from sales of perpetual software licenses. The revenue from these services and licenses is recognized differently depending on the type of service or license provided as described in greater detail below under “Critical Accounting Policies and Estimates.”

We generate a majority of our revenue within the United States. Approximately 71.8% and 74.7% of our total revenue was derived from sales in the United States for the three and nine months ended September 30, 2008, respectively. We expect that the international portion of our business relative to our United States based business will remain consistent as a percentage of our total revenues. Approximately 10.0% and 8.2% of our total revenue was generated from clients in Canada, Germany and the Netherlands for the three and nine months ended September 30, 2008, respectively. Approximately 7.7% and 8.9% of our total revenue was generated from clients in United Kingdom for the three and nine months ended September 30, 2008, respectively. Approximately 10.5% and 8.2% of our total revenue was derived from sales in other countries for the three and nine months ended September 30, 2008, respectively.

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4. Key Performance Indicators

The following tables summarize the key performance indicators that we consider to be material in managing our business, in thousands:

	For the three months ended September 30,						For the nine months ended September 30,
	2008			2007			2008			2007
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Total Revenue	$	54,026		$	46,797		$	158,674		$	134,178
Subscription revenue as a percentage of total revenue		79.6	%		81.7	%		79.3	%		81.9	%
Income from operations	$	7,525		$	7,665		$	21,902		$	22,726
Net cash provided by operating activities	$	8,667		$	10,811		$	25,094		$	23,001
							As of September 30,
							2008			2007
							(unaudited)			(unaudited)
Deferred revenue							$	36,996		$	33,259

The following is a discussion of significant terms used in the tables above.

Subscription revenue as a percentage of total revenue. Subscription revenue as a percentage of total revenue can be derived from our consolidated statements of operations. This performance indicator illustrates the continued evolution of our business towards subscription-based solutions, which provide us with a recurring revenue stream and which we believe to be a more compelling revenue growth and profitability opportunity. We expect that the percentage of subscription revenue will be in the range of 75% to 80% of our total revenues through at least 2008. Subscription revenue as a percentage of total revenue may be impacted by the nature of the revenue earned by entities that we acquire.

Net cash provided by operating activities. Net cash provided by operating activities is taken from our consolidated statement of cash flows and represents the amount of cash generated by our operations that is available for investing and financing activities. Generally, on a cumulative basis, our net cash provided by operating activities has exceeded our operating income primarily due to the positive impact of deferred revenue. We expect this trend to continue because of the advance payment structure of our subscription agreements and as our sales increase, we expect incremental costs to decline.

Deferred revenue. We generate revenue primarily from multi-year subscriptions for our on-demand talent acquisition and employee performance management solutions. We recognize revenue from these subscription agreements ratably over the hosting period, which is typically one to three years. We generally invoice our clients in quarterly or monthly installments in advance. Deferred revenue, which is included in our consolidated balance sheets, is the amount of invoiced subscriptions in excess of the amount recognized as revenue. Deferred revenue represents, in part, the amount that we will record as revenue in our consolidated statements of operations in future periods.

The following table reconciles beginning and ending deferred revenue for each of the periods shown, in thousands:

	For the year ended December 31,			For the three months ended September 30,						For the nine months ended September 30,
	2007			2008			2007			2008			2007
				(unaudited)			(unaudited)			(unaudited)			(unaudited)
Deferred revenue at the beginning of the period	$	31,251		$	38,741		$	32,007		$	35,076		$	31,251
Total invoiced subscriptions during period		152,367			41,286			39,392			127,775			111,817
Deferred revenue from acquisitions		120			—			93			—			120
Subscription revenue recognized during period		(148,662	)		(43,031	)		(38,233	)		(125,855	)		(109,929	)
Deferred revenue at end of period	$	35,076		$	36,996		$	33,259		$	36,996		$	33,259

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5. Results of Operations

Three and nine months ended September 30, 2008 compared to three and nine months ended September 30, 2007

The following table sets forth for the periods indicated, the amount and percentage of total revenues represented by certain items reflected in our unaudited consolidated statements of operations:

Kenexa Corporation Consolidated Statements of Operations

(In thousands)

(Unaudited)

	For the three months ended September 30,								For the nine months ended September 30,
	2008				2007				2008				2007
	Amount		Percent of Revenues		Amount		Percent of Revenues		Amount		Percent of Revenues		Amount		Percent of Revenues
Revenue:
Subscription	$	43,031	79.6	%	$	38,233	81.7	%	$	125,855	79.3	%	$	109,929	81.9	%
Other		10,995	20.4	%		8,564	18.3	%		32,819	20.7	%		24,249	18.1	%
Total revenue		54,026	100.0	%		46,797	100.0	%		158,674	100.0	%		134,178	100.0	%
Cost of revenue		16,461	30.5	%		13,705	29.3	%		46,739	29.5	%		37,737	28.1	%
Gross profit		37,565	69.5	%		33,092	70.7	%		111,935	70.5	%		96,441	71.9	%
Operating expenses:
Sales and marketing		10,298	19.1	%		8,816	18.8	%		31,175	19.6	%		26,140	19.5	%
General and administrative		12,649	23.4	%		9,625	20.6	%		37,487	23.6	%		29,063	21.7	%
Research and development		3,756	7.0	%		4,717	10.1	%		12,605	7.9	%		13,337	9.9	%
Depreciation and amortization		3,337	6.2	%		2,269	4.8	%		8,766	5.5	%		5,175	3.9	%
Total operating expenses		30,040	55.6	%		25,427	54.3	%		90,033	56.7	%		73,175	54.9	%
Income from operations		7,525	13.9	%		7,665	16.4	%		21,902	13.8	%		22,726	16.9	%
Interest income, net		255	0.5	%		1,072	2.3	%		1,216	0.8	%		2,169	1.6	%
Income before income taxes		7,780	14.4	%		8,737	18.7	%		23,118	14.6	%		24,895	18.6	%
Income tax expense		2,356	4.4	%		1,660	3.5	%		6,955	4.4	%		7,310	5.4	%
Net income	$	5,424	10.0	%	$	7,077	15.1	%	$	16,163	10.2	%	$	17,585	13.1	%

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Revenue

Our total quarterly revenue increased $7.2 million or 15.4% to $54.0 million, subscription revenue increased $4.8 million or 12.6% to $43.0 million and other revenue increased by $2.4 million or 28.4% to $11.0 million for the three months ended September 30, 2008, compared to the same periods in 2007. Subscription and other revenue represented approximately 79.6% and 20.4% of our total revenue, respectively, for the three months ended September 30, 2008. Other revenue included the sale of two perpetual licenses during the quarter ended September 30, 2008, totaling $0.7 million. The increase in our revenue for the three months ended September 30, 2008, as compared to the same period in 2007, is attributable to an increase in demand for our hiring solutions of $4.6 million and an increase in demand for our retention solutions of $2.6 million. The increase in demand for our hiring solutions was enhanced by our acquisition of Quorum which contributed $3.7 million run rate, partially offset by a decrease of $1.5 million due to the loss of one customer.

Year-to-date total revenue increased $24.5 million or 18.3% to $158.7 million, subscription revenue increased $15.9 million or 14.5% to $125.9 million and other revenue increased by $8.6 million or 35.3% to $32.8 million for the nine months ended September 30, 2008, compared to the same periods in 2007. Subscription revenue represented approximately 79.3% of our total revenue for the nine months ended September 30, 2008. The increase in our revenue for the nine months ended September 30, 2008, as compared to the same period in 2007, is attributable primarily to an increase in demand for our hiring solutions of $13.7 million and an increase in demand for our retention solutions of $10.8 million. The increase in demand for our hiring solutions was enhanced by our acquisition of Quorum which contributed $3.7 million run rate, partially offset by a decrease of $3.0 million due to the loss of one customer. For the remainder of 2008 we expect total revenue to decrease from the prior year due to the increasingly difficult macroeconomic environment and portion of our revenue outside the U.S. affected by the strengthening of the U.S. dollar. More specifically we expect revenues from our service offerings and the strengthening U.S. dollar to reduce our revenue by approximately $6.0 to $7.0 million and approximately $3.0 million, respectively, in the quarter ending December 31, 2008 from the quarter ended June 30, 2008, to $46 million. We believe revenue from our software offerings will remain consistent with 2007, primarily as a result of the global economic slowdown and increased scrutiny by client of investments in solutions such as ours.

Cost of Revenue

Our cost of revenue primarily consists of compensation, employee benefits and travel-related expenses for our employees and independent contractors who provide consulting or other professional services to our clients. Additionally, our application hosting costs, amortization of third-party license royalty costs, technical support personnel costs, allocated overhead and reimbursed expenses are also recorded as cost of revenue. Many factors affect our cost of revenue, including changes in the mix of products and services, pricing trends, changes in the amount of reimbursed expenses and fluctuations in our client base. Since cost as a percentage of revenue is higher for professional services than for software products, an increase in the services component of our solutions or an increase in discrete professional services as a percentage of our total revenue would reduce gross profit as a percentage of total revenue. For the remainder of the year, as our business contracts in response to the macroeconomic environment, we expect personnel costs associated with the delivery of our solutions to decrease and to fall within a range of approximately 26% to 32% of revenue.

Cost of revenue increased by $2.8 million or 20.1% to $16.5 million and $9.0 million or 23.9% to $46.7 million during the three and nine month period ended September 30, 2008, respectively, compared to the same periods in 2007. As a percentage of revenue cost of revenue increased by 1.2% to 30.5% and 1.3% to 29.5% for the three and nine months ended September 30, 2008, compared to the same periods in 2007. The $2.8 million and $9.0 million increases during the three and nine month period ended September 30, 2008, respectively, were due in part by the addition of 195 employees, primarily brought on by our recent acquisitions which contributed approximately $1.8 million and $6.3 million for the three and nine months ended September 30, 2008, respectively, compared to the same periods in 2007. Additionally, other consulting and external services needed to support our customer’s requirements added approximately $0.4 million and $1.7 million to the increase for the three and nine months ended September 30, 2008, respectively.

Sales and Marketing (“S&M”) Expense

S&M expense primarily consists of personnel and related costs for employees engaged in sales and marketing, including salaries, commissions and other variable compensation, travel expenses and costs associated with trade shows, advertising and other marketing efforts and allocated overhead. We expense our sales commissions at the time the related revenue is recognized, and we recognize revenue from our subscription agreements ratably over the term of the agreements. For the remainder of the year we expect our sales and marketing expense to decrease as our revenues and business activity decreases.

S&M expense increased $1.5 million or 16.8% to $10.3 million during the three month period ended September 30, 2008, compared to the same periods in 2007. The $1.5 million increase for the three months ended September 30, 2008 was due primarily to increased salary and other sales expense of approximately $1.6 million, partially offset by $0.1 million decrease in other expenses, compared to the same periods in 2007. The increase in salary expense was attributable to the addition of 68 employees to support our increased sales efforts. As a percentage of revenue, S&M expense was approximately 19% for the three months ended September 30, 2008.

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S&M expense increased $5.0 million or 19.3% to $31.2 million during the nine month period ended September 30, 2008, compared to the same periods in 2007. The $5.0 million increase for the nine months ended September 30, 2008 was due primarily to increased salary and bonus of $4.3 million and $0.7 million, respectively, compared to the same periods in 2007. As a percentage of revenue, S&M expense remained the same at approximately 19.5%, for the nine months ended September 30, 2008, compared to the same periods in 2007.

General and Administrative (“G&A”) Expense

G&A expense primarily consists of personnel and related costs for our executive, finance, human resources and administrative personnel, professional fees and other corporate expenses and allocated overhead. We believe that G&A expense will decrease in absolute dollars and remain flat or decrease as a percentage of revenue in 2008 as our business activity decreases in response to the slowing global economy and the recent reduction in our headcount.

G&A expense increased $3.0 million or 31.5% to $12.7 million during the three month period ended September 30, 2008, compared to the same periods in 2007. The $3.0 million increase for the three months ended September 30, 2008 was due primarily to an increase in staff-related expenses including salary and stock compensation expense of $0.8 million and $0.4 million, respectively. In addition, professional fees, rent, travel, communications and other expenses contributed $0.3 million, $0.4 million, $0.4 million, $0.3 million and $0.4 million, respectively, to the increase during the three months ended September 30, 2008, compared to the same period in 2007. As a percentage of revenue, G&A expense increased from approximately 20.6% to 23.4% for the three months ended September 30, 2008, compared to the same period in 2007.

G&A expense increased $8.4 million or 29.0% to $37.5 million during the nine month period ended September 30, 2008, compared to the same periods in 2007. The $8.4 million increase for the nine months ended September 30, 2008, was primarily due to increased salary and stock option expense of $1.5 million and $1.6 million, respectively, from the prior year. In addition, increased professional fees, rent, travel, communications and other expenses contributed $1.3 million, $1.3 million, $0.9 million, $0.6 million, and $1.2 million respectively, to the increase during the nine months ended September 30, 2008 compared to the prior year. As a percentage of revenue, G&A expense increased from 22.2% to 23.7% for the nine months ended September 30, 2008, compared to the same periods in 2007.

Research and Development (“R&D”) Expense

R&D expense primarily consists of personnel and related costs, including salaries and employee benefits for software engineers, quality assurance engineers, product managers, technical sales engineers and management information systems personnel and third party consultants. Our R&D efforts have been devoted primarily to new product offerings and enhancements and upgrades to our existing products. As a result of these ongoing development efforts, we have capitalized software costs of $2.5 million, $6.3 million, $0.6 million, and $1.2 million for the three and nine months ended September 30, 2008 and 2007, respectively. The remaining R&D activities have been expensed as incurred. For the remainder of 2008 we expect R&D expense to remain flat or decrease in response to the expected slowdown in our business. As a percentage of revenue, we expect R&D expense to remain between 6% to 9% of revenue.

R&D expense decreased by $1.0 million during the three month period ended September 30, 2008, compared to the same period in 2007. This decrease was a result of the strengthening of the U.S. dollar relative to the Indian rupee and an increased number of projects and activities qualifying for expense capitalization in 2008. As a percentage of revenue, R&D expense decreased from approximately 10.1% to 7.0% for the three months ended September 30, 2008, compared to the same period in 2007.

R&D expense decreased by $0.7 million or approximately 5.5% to $12.6 million during the nine month period ended September 30, 2008, compared to the same periods in 2007. The $0.5 million decrease in R&D expense for the nine months ended September 30, 2008 was primarily due to the strengthening of the U.S. dollar relative to the Indian rupee and increased number of projects and activities qualifying for expense capitalization in 2008. As a percentage of revenue, R&D expense decreased from approximately 9.9% to 7.9% for the nine months ended September 30, 2008 compared to the same period in 2007.

Depreciation and Amortization

Depreciation and amortization expense decreased by $1.1 million or 47.1% to $3.3 million and $3.6 million or 69.4% to $8.8 million during the three and nine month period ended September 30, 2008, respectively, compared to the same periods in 2007. Through 2009, we expect depreciation and amortization expense to increase due an increase in capital purchases and the full period effect of our acquired intangibles.

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Income tax expense on operations

Income tax expense on operations increased by $0.7 million or 41.1% to $2.4 million and $0.4 million or 4.9% to $7.0 million during the three and nine month period ended September 30, 2008, respectively, compared to the same periods in 2007. The decrease in expense was due to a larger portion of our taxable income being generated in jurisdictions with lower effective tax rates and decreasing in jurisdictions with higher tax rates.

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6. Liquidity and Capital Resources

Since our formation in 1987, we have financed our operations primarily through internally generated cash flows, our line of credit and the issuance of preferred and common stock. As of September 30, 2008, we had cash and cash equivalents of $19.5 million and short-term investments of $6.6 million.

Our cash provided from operations was $25.1 million and $23.0 million for the nine months ended September 30, 2008 and 2007, respectively. Cash used in investing activities was $13.7 million and $102.1 million for the nine months ended September 30, 2008 and 2007, respectively. Cash used in financing activities was $29.2 million for the nine months ended September 30, 2008 and cash provided by financing activities was $67.9 million for the nine months ended September 30, 2007. Our net decrease in cash and cash equivalents was $18.5 million for the nine months ended September 30, 2008, resulting primarily from our repurchase of our common stock. Our net decrease in cash and cash equivalents was $10.4 million for the nine months ended September 30, 2007, resulting primarily from our investment in short-term investments. We expect positive operating cash flow to continue through 2009.

In connection with our November 8, 2007 and February 20, 2008 stock repurchase plans, we repurchased 1,608,202 shares of our common stock at an average price of $18.56 per share and an aggregate cost of $29.8 million for the nine months ended September 30, 2008.

On March 26, 2007, we entered into a First Amendment to Credit Agreement with PNC Bank. The amendment increased the maximum amount available under the revolving credit facility portion of the Credit Agreement from $25 million to $50 million, including a sublimit of up to $2 million for letters of credit. The First Amendment to the Credit Agreement provides that the Credit Agreement will terminate, and all borrowings will become due and payable, on March 26, 2010. There are currently no borrowings under our credit facility.

Operating Activities

Net cash provided by operating activities was $25.1 million and $23.0 million for the nine months ended September 30, 2008 and 2007, respectively. Net cash provided by operating activities for the nine months ended September 30, 2008 resulted primarily from net income of approximately $16.2 million, non-cash charges to net income of $13.6 million, and an increase in deferred revenue of $1.9 million, partially offset by changes in working capital of $3.8 million, an increase in accounts receivable of $2.6 million and a $0.2 million reduction in taxes payable resulting from the excess tax benefits from share based payments. Net cash provided by operating activities for the nine months ended September 30, 2007 resulted primarily from net income of approximately $17.6 million, non-cash charges to net income of $9.0 million, an increase in deferred revenue of $1.9 million partially offset by changes in working capital of $1.9 million, deferred tax benefit of $0.9 million, an increase in accounts receivables of $1.3 million and a $1.4 million reduction in taxes payable resulting from the excess tax benefits from share based payments.

Investing Activities

Net cash used in investing activities was $13.7 million and $102.1 million for the nine months ended September 30, 2008 and 2007, respectively. Cash flows from investing activities for the nine months ended September 30, 2008 and 2007 consisted of the following (in millions):

	For the nine months ended September 30, 2008			For the nine months ended September 30, 2007
Scottworks acquisition	$	0.1		$	—
Knowledge Workers acquisition		0.1			—
Gantz Wiley Research acquisition		0.6			0.6
BrassRing acquisition		—			0.2
PSL acquisition		—			0.3
StraightSource acquisition		1.1			9.0
HRC acquisition		0.3			2.9
Quorum acquisition		27.6			—
Capitalized software and purchases of computer hardware		16.6			7.4
Purchases of available-for-sale securities		25.2			81.7
Sales of available-for-sale securities		(57.9	)		—
Total cash flows used in investing activities	$	13.7		$	102.1

In the future, we expect our capital expenditures to increase as revenues increase and business needs arise.

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Financing Activities

Net cash used in financing activities was $29.2 million for the nine months ended September 30, 2008 and net cash provided by financing activities was $67.9 million for the nine months ended September 30, 2007. For the nine months ended September 30, 2008, net cash used in financing activity resulted primarily from repurchases of our common shares of $29.8 and repayments of our capital lease obligations of $0.2 million, partially offset by net proceeds from stock option exercises of $0.3 million, excess tax benefits from share-based payment arrangements of $0.2 million and proceeds from our employee stock purchase plan of $0.3 million. For the nine months ended September 30, 2007, net cash provided by financing activity resulted primarily from net proceeds from our public stock offering of $130.4 million, net proceeds from stock option exercises of $1.6 million and excess tax benefits from share-based payment arrangements of $1.4 million, partially offset by the repayment of our credit facility of $65.0 million, capital lease obligations of $0.2 million, notes payable of $0.3 million and deferred financing costs of $0.1 million.

We believe that our cash and cash equivalent balances and cash flows from operations will be sufficient to satisfy our working capital and capital expenditure requirements for at least the next 12 months. We intend to continue to invest our cash in excess of current operating requirements in interest-bearing, investment-grade securities. Changes in our operating plans, lower than anticipated revenue, increased expenses or other events, may cause us to seek additional debt or equity financing. Financing may not be available on acceptable terms, or at all, and our failure to raise capital when needed could negatively impact our growth plans and our financial condition and consolidated results of operations. Additional equity financing would be dilutive to the holders of our common stock, and debt financing, if available, may involve significant cash payment obligations and covenants or financial ratios that restrict our ability to operate our business.

Our short-term and long-term investments consist of auction rate securities (“ARS”) and municipal securities with balances as of September 30, 2008 and December 31, 2007 as follows (in millions):

Type of Investment	September 30, 2008		Total percent		December 31, 2007		Total percent
Short-term investments:
Municipal bonds	$	6.6	27.0	%	$	28.5	48.8	%
Auction rate securities		—	—			29.9	51.2	%
Total short-term investments		6.6	27.0	%		58.4	100.0	%
Long-term investments:
Auction rate securities		17.8	73.0	%		—	—	%
Total investments	$	24.4	100.0	%	$	58.4	100.0	%

Our ARS investments are intended to provide liquidity via an auction process that resets the applicable interest rate in the event there is no new investment in these securities. Due to recent uncertainty in the credit markets some of our holdings in our ARS investment portfolio have failed to settle on their respective settlement dates resulting in illiquidity in these investments. Consequently, we have not been able to access these funds and do not expect to do so until a future auction of these investments is successful or a buyer is found outside the auction process. Although the maturity dates of the underlying securities of our ARS investments range from 4 to 31 years, we currently have sufficient cash and cash equivalents, cash from operations and access to unused credit facilities to meet our short-term liquidity requirements and do not anticipate that we will need to access our ARS investments for additional liquidity.

As a result of the changes in the ARS market we have adjusted the fair value of our ARS investment portfolio using a discounted cash flow model to determine the estimated fair value of our ARS investments as of September 30, 2008. The assumptions used in preparing the discounted cash flow model include level three inputs, as defined in SFAS No. 157, Fair Value Measurements, such as estimates for interest rates, the amount of cash flows and an expected holding period of the ARS. Based upon our assessment, the fair value of our ARS investments declined approximately $1.1 million for the nine months ended September 30, 2008 to $17.8 million, which was deemed temporary and was recognized in accumulated other comprehensive income (loss). In the future we will continue to monitor the ARS market and depending upon market conditions and our own cash requirements may record additional temporary losses if appropriate.

We recently received an ARS Rights offer, which expires on November 14, 2008, from our investment bank to sell eligible ARSs, as defined in the agreement, at par value to our bank during the period between June 30, 2010 and July 2, 2012. The agreement also contains a provision for those clients who accept the offer to receive a “no net cost” loan up to the par value of eligible ARS until June 30, 2010. Following our evaluation of the terms and conditions of the offer we accepted the offer.

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Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and consolidated results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis, including those related to uncollectible accounts receivable and accrued expenses. We base these estimates on historical experience and 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 that are not readily apparent from other sources. Our actual results may differ from these estimates.

We believe that the following critical accounting policies affect our more significant estimates and judgments used in the preparation of our consolidated financial statements:

Revenue Recognition

We derive our revenue from two sources: (1) subscription revenues for solutions, which are comprised of subscription fees from clients accessing our on-demand software, consulting services, outsourcing services and proprietary content, and from clients purchasing additional support beyond the standard support that is included in the basic subscription fee; and (2) other fees for discrete professional services. Because we provide our solutions as a service, we follow the provisions of Securities and Exchange Commission Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, as amended by Staff Accounting Bulletin No. 104, Revenue Recognition. On August 1, 2003, we adopted Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. We recognize revenue when all of the following conditions are met:

• There is persuasive evidence of an arrangement;

• The service has been provided to the client;

• The collection of the fees is probable; and

• The amount of fees to be paid by the customer is fixed or determinable.

Subscription fees and support revenues are recognized on a monthly basis over the terms of the contracts. Amounts that have been invoiced are recorded in accounts receivable or in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met.

Discrete professional services, when sold with subscription and support offerings, are accounted for separately since these services have value to the customer on a stand-alone basis and there is objective and reliable evidence of fair value of the delivered elements. Our arrangements do not contain general rights of return. Additionally, when professional services are sold with other elements, the consideration from the revenue arrangement is allocated among the separate elements based upon the relative fair value. Revenues from professional services are recognized as the services are rendered.

In determining whether revenues from professional services can be accounted for separately from subscription revenue, we consider the following factors for each agreement: availability of professional services from other vendors, whether objective and reliable evidence of the fair value exists of the undelivered elements, the nature and the timing of the agreement execution in comparison to the subscription agreement start date and the contractual dependence of the subscription service on the customer’s satisfaction with the other services. If the professional service does not qualify for separate accounting, we recognize the revenue ratably over the remaining term of the subscription contract. In these situations we defer the direct and incremental costs of the professional service over the same period as the revenue is recognized.

In accordance with EITF 01-14, “Out-of-Pocket Expenses Incurred”we record reimbursements received for out-of-pocket expenses as revenue and not netted with the applicable costs. These items primarily include travel, meals and certain telecommunication costs. Reimbursed expenses totaled $1.3 million, $3.5 million, $0.9 million and $2.4 million for the three and nine months ended September 30, 2008 and 2007, respectively.

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Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses resulting from clients’ inability to pay us. The provision is based on our historical experience and for specific clients that, in our opinion, are likely to default on our receivables from them. In order to identify these clients, we perform ongoing reviews of all clients that have breached their payment terms, as well as those that have filed for bankruptcy or for whom information has become available indicating a significant risk of non-recoverability. In addition, we have experienced significant growth in number of clients, and we have less payment history to rely upon with these clients. We rely on historical trends of bad debt as a percentage of total revenue and apply these percentages to the accounts receivable associated with new clients and evaluate these clients over time. To the extent that our future collections differ from our assumptions based on historical experience, the amount of our bad debt and allowance recorded may be different.

Capitalized Software Research and Development Costs

In accordance with EITF Issue 00-3, “Application of AICPA Statement of Position 97-2 to Arrangements That Include the Right to Use Software Stored on Another Entity’s Hardware,” we apply AICPA Statement of Position No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. The costs incurred in the preliminary stages of development are expensed as incurred. Once an application has reached the development stage, internal and external costs, if direct and incremental, will be capitalized until the software is substantially complete and ready for its intended use. Capitalization ceases upon completion of all substantial testing. We also capitalize costs related to specific upgrades and enhancements when it is probable the expenditures will result in additional functionality. Maintenance and training costs are expensed as incurred. Internal use software is amortized on a straight-line basis over its estimated useful life, generally three years. Management evaluates the useful lives of these assets on an annual basis and tests for impairments whenever events or changes in circumstances occur that could impact the recoverability of these assets. There were no impairments to internal software in any of the periods covered in this report.

Goodwill and Other Identified Intangible Asset Impairment

On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets which superseded Accounting Board Opinion No. 17, Intangible Assets. Upon adoption of SFAS No. 142, we ceased amortization of existing goodwill and are required to review the carrying value of goodwill for impairment. If goodwill becomes impaired, some or all of the goodwill could be written off as a charge to operations. This comparison is performed annually or more frequently if circumstances indicate that the carrying value may not be recoverable. We have reviewed the carrying values of goodwill at the enterprise or Company level by comparing the carrying value to the estimated fair value of the enterprise. The fair value is based on management’s estimate of the future discounted cash flows to be generated by the respective business components and comparable company multiples. Such cash flows consider factors such as future operating income, historical trends, as well as demand and competition. Comparable company multiples are based upon public companies in sectors relevant to our business based on our knowledge of the industry. Changes in the underlying business could affect these estimates, which in turn could affect the recoverability of goodwill. Through September 30, 2008, we have not observed any changes to our enterprise value which would lead us to believe that our goodwill or other identified intangibles’ carrying value exceeds their fair values.

During the month of October 2008, due to a significant adverse change in our business climate, we tested our goodwill for impairment, using a discounted cash flow model and our market capitalization as of September 30, 2008. Utilizing both internal and third party projections and other valuation data for our enterprise fair value, we determined that our fair value as approximated by both the discounted cash flows and market capitalization continued to exceed our enterprise carrying value. Given the recent volatility of our stock price and unprecedented market conditions we will continue to monitor our enterprise fair value, if these conditions persist it is possible that we will record a goodwill impairment in the fourth quarter of 2008.

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Accounting for Stock-Based Compensation

We use a Black-Scholes option-pricing model to calculate the fair value of our stock awards. The calculation of the fair value of the awards using the Black-Scholes option-pricing model is affected by our stock price on the date of grant as well as assumptions regarding the following:

• Volatility is a measure of the amount by which the stock price is expected to fluctuate each year during the expected life of the award and is based on a weighted average of peer companies, comparable indices and our stock volatility. An increase in the volatility would result in an increase in our expense.

• The expected term represents the period of time that awards granted are expected to be outstanding and is currently based upon an average of the contractual life and the vesting period of the options. With the passage of time actual behavioral patterns surrounding the expected term will replace the current methodology. Changes in the future exercise behavior of employees or in the vesting period of the award could result in a change in the expected term. An increase in the expected term would result in an increase to our expense.

• The risk-free interest rate is based on the U.S. Treasury yield curve in effect at time of grant. An increase in the risk-free interest rate would result in an increase in our expense.

Stock-based compensation expense recognized during the period is based on the value of the number of awards that are expected to vest. In determining the stock-based compensation expense to be recognized, a forfeiture rate is applied to the fair value of the award. This rate represents the number of awards that are expected to be forfeited prior to vesting and is based on Kenexa’s employee historical behavior. Changes in the future behavior of employees could impact this rate. A decrease in this rate would result in an increase in our expense.

Accounting for Income Taxes

We account for income taxes in accordance with FASB Statement No. 109, “Accounting for Income Taxes,” or SFAS 109, which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax basis of recorded assets and liabilities. SFAS 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion of all of the deferred tax asset will not be realized.

The realization of the deferred tax assets is evaluated quarterly by assessing the valuation allowance and by adjusting the amount of the allowance, if necessary. The factors used to assess the likelihood of realization are the forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets. We have used tax-planning strategies to realize or renew net deferred tax assets in order to avoid the potential loss of future tax benefits.

In addition, we operate within multiple taxing jurisdictions and are subject to audit in each jurisdiction. These audits can involve complex issues that may require an extended period of time to resolve. In our opinion, adequate provisions for income taxes have been made for all periods.

Self-Insurance

We are self-insured for the majority of our health insurance costs, including claims filed and claims incurred but not reported subject to certain stop-loss provisions. We estimate our liability based upon management’s judgment and historical experience. We also rely on the advice of consulting administrators in determining an adequate liability reserve for self-insurance claims. At September 30, 2008 and December 31, 2007, self-insurance accruals totaled $0.5 million and $0.4 million, respectively. We continuously review the adequacy of our insurance coverage. Material differences may result in the amount and timing of insurance expense if actual experience differs significantly from management’s estimates.

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Item 3: Quantitative and Qualitative Disclosures about Market Risk

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

Foreign Currency Exchange Risk

The financial position and operating results of our foreign operations are consolidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rate of exchange to the U.S. dollar on the balance sheet date, and the local currency revenue and expenses are translated at average rates of exchange to the U.S. dollar during the period. The related translation adjustments were approximately $1.7 million for the nine months ended September 30, 2008, and are included in accumulated other comprehensive income. The foreign currency translation adjustment is not adjusted for income taxes as it relates to an indefinite investment in a non-U.S. subsidiary.

A key component of our business strategy has been to expand our international sales efforts, resulting in increasing exposure and sensitivity to foreign currency exchange rate fluctuations. Primarily as a result of recent acquisitions, including our acquisition of U.K.-based Quorum International in April 2008, the proportion of our revenue derived from sources outside the U.S. has materially increased since the end of 2007. During the nine months ended September 30, 2008, the percentage of our revenue derived from sales to clients outside the U.S. increased to approximately 24% of revenue from approximately 12% for the year ended December 31, 2007. The primary currencies for which we have significant exchange rate exposure are the U.S dollar versus the British pound, the U.S. dollar versus the euro and the U.S. dollar versus the Canadian dollar. As a result of our revenue derived from sales denominated in British pounds, euros and Canadian dollars during the three and nine month periods ended September 30, 2008, a 10% increase in the value of the U.S. dollar relative to these currencies would have resulted in decreased revenue of $1.1 million and $2.6 million for such periods, respectively. As of September 30, 2008, we were not engaged in any foreign currency hedging activities.

Interest Rate Risk

The primary objective of our investment activities is to preserve principal while maximizing income without significantly increasing risk. Some of the securities in which we invest may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and certificates of deposit. Our cash equivalents, which consist solely of money market funds, are not subject to market risk because the interest paid on these funds fluctuates with the prevailing interest rate. We do not believe that a 10% change in interest rates would have a significant effect on our interest income.

Item 4: Controls and Procedures

Under the supervision of and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 as of the end of the period covered by this report, or the Evaluation Date. Based upon the evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the Evaluation Date. Disclosure controls are controls and procedures designed to reasonably ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls include controls and procedures designed to reasonably ensure that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

In connection with this evaluation, our management identified no changes in our internal control over financial reporting that occurred during the most recent fiscal quarter that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II: OTHER INFORMATION

Item 1: Legal Proceedings

We are involved from time to time in claims which arise in the ordinary course of business. In the opinion of management, we have made adequate provision for potential liabilities, if any, arising from any such matters. However, litigation is inherently unpredictable, and the costs and other effects of pending or future litigation, governmental investigations, legal and administrative cases and proceedings (whether civil or criminal), settlements, judgments and investigations, claims and changes in any such matters, and developments or assertions by or against us relating to intellectual property rights and intellectual property licenses, could have a material adverse effect on our business, financial condition and operating results.

Item 1A: Risk Factors

In addition to the other information set forth in this Form 10-Q, you should carefully consider the following risk factors, which contain material changes to , and amend and restate in their entirety, the risk factors set forth in Part I, Item 1A “Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2007 which could materially affect our business, financial condition or future results of operations. The risks described below in this item are not the only risks that we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially adversely affect our business, financial condition and future results of operations.

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Our business will suffer if our existing clients terminate or do not renew their software subscriptions.

We expect to continue to derive a significant portion of our revenue from renewals of subscriptions for our talent acquisition and employee performance management solutions. During the year ended December 31, 2007, our clients renewed more than 90% of the aggregate value of multi-year subscriptions for our on-demand talent acquisition and performance management solution contracts subject to renewal. If our clients terminate their agreements, fail to renew their agreements, renew their agreements upon less favorable terms to us or fail to purchase new solutions from us, our revenue may decline or our future revenue growth may be constrained.

Maintaining the renewal rate of our existing subscriptions is critical to our future success. Factors that may affect the renewal rate for our solutions include:

• the price, performance and functionality of our solutions;

• the availability, price, performance and functionality of competing products and services;

• the effectiveness of our support services;

• our ability to develop complementary products and services; and

• the willingness of our clients to continue to invest their resources in our solutions in light of other demands on those resources.

Most of our existing clients have entered into subscription agreements with us that expire between one and three years from the initial contract date. Our clients have the right to terminate their contracts under certain circumstances and are not obligated to renew their subscriptions for our solutions after the expiration of the initial terms of their subscription agreements. In addition, our clients may negotiate terms which are less favorable to us upon renewal, or may request that we license our software to them on a perpetual basis, which may reduce recurring revenue from these clients. Our future success also depends in part on our ability to sell new solutions to our existing clients.

If the unemployment rate continues to increase, our business may be harmed.

Demand for our solutions depends in part on our clients’ ability to hire and retain their employees. According to the U.S. Bureau of Labor Statistics, the U.S. unemployment rate in October 2008 was 6.5%. It is widely expected that unemployment will continue to increase through the end of 2008 and perhaps 2009 and beyond as a result of the current general downturn in macroeconomic economic conditions in the U.S. If the unemployment rate continues to increase, our existing and potential clients may no longer consider improvement of their talent acquisition and employee performance management systems a necessity and may have less of a need to hire and retain their employees, which could have a material adverse effect on our business, results of operations and financial condition.

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Reductions in information technology spending could limit our ability to grow our business.

Our operating results may vary based on changes in the information technology spending of our clients. The revenue growth and profitability of our business depend on the overall demand for enterprise application software and services. We sell our solutions primarily to large organizations whose businesses fluctuate with general economic and business conditions. As a result, decreased demand for enterprise application software and services, and in particular talent acquisition and employee performance management solutions, caused by a weakening global economy may cause a decline in our revenue. Historically, economic downturns have resulted in overall reductions in corporate information technology spending. In particular, software for talent acquisition and employee performance management software may be viewed by some of our existing and potential clients as a lower priority and may be among the first expenditures reduced as a result of unfavorable economic conditions. As a result, potential clients may decide to reduce their information technology budgets by deferring or reconsidering product purchases, which would negatively impact our operating results.

Because we recognize revenue from the sale of our solutions ratably over the term of the subscription period, a significant downturn in our business may not be immediately reflected in our operating results.

A decline in new or renewed subscriptions in any one quarter may not impact our financial performance in that quarter, but will negatively affect our revenue in future quarters. If a number of contracts expire and are not renewed in the same quarter, our revenue could decline significantly in that quarter and in subsequent quarters.

For the years ended December 31, 2007, 2006 and 2005, we derived approximately 81.7%, 80.7% and 77.7%, respectively, of our total revenue, from the sale of subscriptions for our solutions and expect that a significant portion of our revenue for the foreseeable future will be derived from those subscriptions. We recognize the associated revenue ratably over the term of the subscription agreement, which is typically between one and three years. As a result, a significant portion of the revenue that we report in each quarter reflects the recognition of deferred revenue from subscription agreements entered into during previous periods. Accordingly, the effect of significant declines in sales and market acceptance of our solutions may not be reflected in our short-term results of operations, making our results less indicative of our future prospects.

If our revenue does not meet our expectations, we may not be able to curtail our spending quickly enough and our cost of revenue, compensation and benefits and product development would increase as a percentage of revenue. Our subscription model also makes it difficult for us to rapidly increase our revenue through additional sales in any one period, as revenue from new clients is recognized over the applicable subscription term.

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Our financial performance may be difficult to forecast as a result of our focus on large clients and the long sales cycle associated with our solutions.

Our sales cycles are generally up to nine months and in some cases even longer. Sales cycles lengthen in particular in economic downturns, when clients are more likely to scrutinize their spending decisions, including those related to our solutions, in an effort to conserve resources. These long sales cycles impede our ability to accurately forecast the timing of sales in a given period which could adversely affect our ability to meet our forecasts for that period. The period between an initial sales contact and a contract signing is relatively long due to several factors, including:

• the need to educate potential clients about the uses and benefits of our solutions and the on-demand delivery model;

• the discretionary nature of our clients’ purchase and budget cycles;

• the competitive evaluation of our solutions;

• fluctuations in the talent acquisition and employee performance management requirements of our prospective clients;

• economic downturns and reductions in corporate IT spending;

• announcements or planned introductions of new products or services by us or our competitors; and

• the lengthy purchasing approval processes of our prospective clients.

We focus our sales efforts principally on large organizations with complex talent acquisition and employee performance management requirements. Accordingly, in any single quarter the majority of our revenue from sales to new clients may be composed of large sales made to a relatively small number of clients. Our failure to close a sale in any particular quarter may impede revenue growth until the sale closes, if at all. As a result, substantial time and cost may be spent attempting to close a sale that may not be successful.

If our efforts to attract new clients or to sell additional solutions to our existing clients are not successful, our revenue growth will be adversely affected.

To increase our revenue, we must continually add new clients and sell additional solutions to existing clients. If our existing and prospective clients do not perceive our solutions to be of sufficiently high value and quality, we may not be able to attract new clients or to increase sales to existing clients. Our ability to attract new clients and to sell new solutions to existing clients will depend in large part on the success of our sales and marketing efforts. However, our existing and prospective clients may not be familiar with some of our solutions, or may have traditionally used other products and services for some of their talent acquisition and employee performance management requirements. Furthermore, factors that are beyond our control, such as a general downturn in the economy like the one currently being experienced in the U.S. and abroad, could cause existing and prospective clients to shift resources that they would have otherwise invested in our solutions to other uses. Our existing and prospective clients may also develop their own solutions to address their talent acquisition and employee performance management requirements, purchase competitive product offerings or engage third-party providers of outsourced talent acquisition and employee performance management

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services. Additionally, some clients may require that we license our software to them on a perpetual basis or that we allow them the contractual right to convert from a term license to a perpetual license during the contract term, which may reduce recurring revenue from these clients.

Our business may not continue to grow if the markets for our products do not continue to grow.

Our growth is dependent upon the continued adoption of on-demand software as a key mechanism for delivering solutions in these markets. The rapidly evolving nature of this market reduces our ability to accurately evaluate our future prospects and forecast quarterly or annual performance. The adoption of on-demand talent acquisition and employee performance management solutions, particularly among organizations that have relied upon traditional software applications, requires the acceptance of a new way of conducting business and exchanging and compiling information. Because these markets are new and evolving, it is difficult to predict with any assurance the future growth rate and size of these markets which, in comparison with the overall market for enterprise software applications, is relatively small.

If our on-demand delivery model is not widely accepted, our operating results will be harmed.

The on-demand delivery of enterprise software is new and, to a large extent, unproven, and it is uncertain whether this model will achieve and sustain high levels of demand and market acceptance. The majority of our clients access and use our software solutions on an on-demand basis. If the preferences of our clients change and our clients elect to deploy our software on-site, either upon the initiation of a new agreement or upon the renewal of an existing agreement, we would potentially incur higher costs and encounter greater complexity in providing maintenance and support for our software. Potential clients may be reluctant or unwilling to purchase enterprise software on-demand for a number of reasons, including security and data privacy concerns. If such organizations do not adopt the on-demand delivery model, then the market for our solutions may develop more slowly than we expect. The inability of our on-demand delivery model to achieve widespread market acceptance would harm our business.

If we fail to develop or acquire new products or enhance our existing solutions to meet the needs of our existing and future clients, our revenue may decline.

To remain competitive, we must continually improve and enhance the responsiveness, functionality and features of our existing solutions and develop new solutions that address the talent acquisition and employee performance management requirements of organizations. If we are unable to successfully develop or acquire new solutions or enhance our existing solutions, our revenue may decline and our business and operating results will be adversely affected. We intend to continue to introduce enhanced solutions to generate additional revenue, attract new clients and respond to competition. We may not succeed in developing or introducing new or enhanced solutions or developing or introducing them in a timely manner, and new or enhanced solutions that we develop or introduce may not achieve the market acceptance necessary to generate significant revenue.

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In addition, it is possible that evolving technology may enable new deployment mechanisms that make our on-demand business model obsolete. To the extent that we are not successful in continuing to develop our solutions in correlation with evolving technology, we may not be successful in establishing or maintaining our client relationships.

We may engage in future acquisitions or investments which present many risks, and we may not realize the anticipated financial and strategic goals for any of these transactions.

We have focused on developing solutions for the enterprise talent acquisition and employee performance management market. Our market is highly fragmented and in the future we may acquire or make investments in complementary companies, products, services or technologies. Acquisitions and investments involve a number of difficulties that present risks to our business, including the following:

• we may be unable to achieve the anticipated benefits from the acquisition or investment;

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

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

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

• we may lose customers of those companies that we acquire for reasons such as a particular customer desiring to have multiple service vendors;

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

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

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

The consideration paid for an investment or acquisition may also affect our financial results. If we were to proceed with one or more significant acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available

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cash or obtain debt or equity financing. To the extent that we issue shares of our capital stock or other rights to purchase shares of our capital stock as consideration for an acquisition or in connection with the financing of an acquisition, including options or other rights, our existing shareholders may be diluted, and our earnings per share may decrease. In addition, acquisitions may result in the incurrence of debt, large one-time write-offs, including write-offs of acquired in-process research and development costs, and restructuring charges. Acquisitions in the future may require us to incur additional indebtedness to finance our working capital and may also result in goodwill and other intangible assets that are subject to impairment tests, which could result in future impairment charges.

If we are unable to compete effectively with companies offering enterprise talent acquisition and employee performance management solutions, our revenue may decline.

We may not have the resources or expertise to compete successfully in the future. If we are unable to successfully compete, we could lose existing clients, fail to attract new clients and our revenue would decline. The talent acquisition and employee performance management solutions markets are rapidly evolving and highly competitive, and we expect competition in these markets to persist and intensify. Barriers to entry into our industry are low, new software products are frequently introduced and existing products are continually enhanced. We compete with niche point solution vendors such as Authoria, Inc., iCIMS, Inc., Integrated Performance Systems, Inc., InScope Corporation, Kronos Incorporated, PeopleClick, Inc., Pilat HR Solutions, Inc., Previsor, Inc., SHL Group plc, SuccessFactors, Inc. and Taleo Corporation that offer products that compete with one or more applications contained in our solutions. In some aspects of our business, we also compete with established vendors of enterprise resource planning, or ERP, software with much greater resources, such as Oracle Corporation (PeopleSoft), SAP AG and Lawson, Inc. To a lesser extent, we compete with vendors of employment process outsourcing services and survey services such as Accolo, Inc., The Gallup Organization, Hyrian, LLC and Recruitment Enhancement Services. In addition, many organizations have developed or may develop internal solutions to address enterprise talent acquisition and employee performance management requirements that may be competitive with our solutions.

Some of our competitors and potential competitors, especially vendors of ERP software, have significantly greater financial, support, technical, development, marketing, sales, service and other resources, larger installed client bases, longer operating histories, greater name recognition and more established relationships than we have. In addition, ERP software competitors could bundle their products with, or incorporate capabilities in addition to, talent acquisition and employee performance management functions, such as automated payroll and benefits, in products developed by themselves or others. Products with such additional functions may be appealing to some clients because they would reduce the number of different types of software or applications used to run their businesses. Our niche competitors’ products may be more effective than our solutions at performing particular talent acquisition and employee performance management functions or may be more customized for particular client needs in a given market. Further, our competitors may be able to respond more quickly than we can to changes in client requirements or regulatory changes.

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Mergers or other strategic transactions involving our competitors could weaken our competitive position or reduce our revenue.

We believe that our industry is highly fragmented and that there is likely to be consolidation, which could lead to increased price competition and other forms of competition. Increased competition may cause pricing pressure and loss of market share, either of which could have a material adverse effect on our business, results of operations and financial condition. Our competitors may establish or strengthen cooperative relationships with business process outsourcing vendors, systems integrators, third-party consulting firms or other parties. Established companies may not only develop their own products but may also merge with or acquire our current competitors. In addition, we may face competition in the future from large established companies, as well as from emerging companies that have not previously entered the markets for talent acquisition and employee performance management solutions or that currently do not have products that directly compete with our solutions. It is also possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share or sell their products at significantly discounted prices causing pricing pressure. In addition, our competitors may announce new products, services or enhancements that better meet the price or performance needs of clients or changing industry standards. If any of these events occur, our revenues and profitability could significantly decline.

If we encounter barriers to the integration of our software with software provided by our competitors or with the software used by our clients, our revenue may decline and our research and development expenses may increase.

In some cases our software may need to be integrated with software provided by our competitors. These competitors could alter their products in ways that inhibit integration with our software, or they could deny or delay access by us to advance software releases, which would restrict our ability to adapt our software to facilitate integration with these new releases and could result in lost sales opportunities. In addition, our software is designed to be compatible with the most common third-party ERP systems. If the design of these ERP systems changes, integration of our software with new systems would require significant work and substantial allocation of our time and resources and increase our research and development expenses.

Interruptions or delays in service from our Web hosting facilities could impair the delivery of our service and harm our business.

We provide our service through computer hardware and software that is currently located in a Web hosting facility from Qwest in Sterling, VA that we manage. All Web hosting facilities are vulnerable to damage or interruption from earthquakes, floods, fires, power loss, telecommunications failures and similar events. These facilities are also subject to break-ins, sabotage, intentional acts of terrorism, vandalism and similar misconduct. Despite precautions that we take at these facilities, the occurrence of a natural disaster, act of terrorism or other unanticipated problem at any of these facilities could result in lengthy interruptions in our service. Interruptions in our service may reduce our revenue, cause us to issue credits or pay penalties, cause customers to terminate their subscriptions and adversely affect our renewal rates. Our business will be harmed if our customers and potential customers believe our service is unreliable or if our Disaster Recovery Plan (DRP) fails to provide adequate disaster recovery capabilities.

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If our security measures are breached and unauthorized access is obtained to client data, clients may curtail or stop their use of our solutions, which would harm our business, operating results and financial condition.

Our solutions involve the storage and transmission of confidential information of clients and their existing and potential employees, and security breaches could expose us to a risk of loss of, or unauthorized access to, this information, resulting in possible litigation and possible liability. Although we have never sustained such a breach, if our security measures were ever breached as a result of third-party action, employee error, malfeasance or otherwise, and, as a result, an unauthorized party obtained access to this confidential data, our reputation could be damaged, our business may suffer and we could incur significant liability. Techniques used to obtain unauthorized access or to sabotage systems change frequently and generally are not discovered until launched against a target. As a result, we may be unable to anticipate these techniques or to implement adequate preventative measures. If an actual or perceived breach of our security occurs, the market perception of our security measures could be harmed and we could lose sales and clients.

Because our products collect and analyze applicants’ and employees’ stored personal information, concerns that our products do not adequately protect the privacy of applicants and employees could inhibit sales of our products.

Some of the features of our talent acquisition and employee performance management applications depend on the ability to develop and maintain profiles of applicants and employees for use by our clients. These profiles contain personal information, including job experience, home address and home telephone number. Typically, our software applications capture this personal information when an applicant creates a profile to apply for a job and an employee completes a performance review. Our software applications augment these profiles over time by capturing additional data and collecting usage data. Although our applications are designed to protect user privacy, privacy concerns nevertheless may cause employees and applicants to resist providing the personal data necessary to support our products. Any inability to adequately address privacy concerns could inhibit sales of our products and seriously harm our business, financial condition and operating results.

Funds associated with the auction rate securities held by us that we have historically held as short-term investments may not be liquid or readily available.

Our investments in securities currently consist partially of auction rate securities which are not currently liquid or readily available to convert to cash. During the period from June 2008 to September 2008, we experienced failed auctions for tax exempt auction rate securities representing principal and accrued interest of approximately $20.8 million. As a result of this illiquidity, we recorded a charge of approximately $1.3 million, with no tax benefit, as of September 30, 2008. Additionally, due to the current uncertainty surrounding the ability to liquidate our auction rate securities over the next twelve months, we have reclassified approximately $17.8 million of these investments to long-term assets from short-term assets as of

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September 30, 2008. We have accepted an offer to sell a portion of our auction rate securities at par value between June 30, 2010 and July 2, 2012 to our investment bank. If the global credit crisis continues to intensify and our investment bank is unable to satisfy its obligations to purchase our auction rate securities, or broker-dealers generally do not renew their support of auctions for auction rate securities, the liquidity of our auction-rate securities may be further impacted and we may be required to record further declines in value of these investments.

As our sales and marketing efforts to clients outside the United States increase, we are exposed to additional risks associated with international operations, including the risks of managing a geographically diverse operation and foreign currency exchange rate fluctuations.

As a part of our future business strategy, we have sought to increase our international sales efforts in Canada, Europe and Asia through both organic growth and acquisitions. We currently maintain international sales offices in Toronto, Canada; London, England; Harrow, England; Hyderabad, India; Vizag, India; Munich, Germany; Hong Kong, China; Amsterdam, The Netherlands; Melbourne, Australia; Singapore; and Taipei, Taiwan. We may not, however, be successful in these efforts to grow our business internationally. International operations and sales subject us to risks and challenges that we would otherwise not face if we conducted our business only in the United States. For example, we will depend on third parties to market our solutions through foreign sales channels, and we may be challenged by laws and business practices favoring local competitors. In addition, our ability to succeed in foreign markets will depend on the ability of our software to properly filter foreign languages. We must also adopt our pricing structure to address different pricing environments and may face difficulty in enforcing revenue collection internationally.

As a result of our efforts to become more global, a growing portion of our international sales and operating expenses are denominated in foreign currencies, including British pounds, euros, Canadian dollars and Indian rupees. We expect our exposure to foreign exchange gains and losses to increase in the future. Any fluctuation in the exchange rate of these foreign currencies may negatively affect our business, financial condition and operating results. We have not previously engaged in foreign currency hedging. If we decide to hedge our foreign currency exposure, we may not be able to hedge effectively due to lack of experience, unreasonable costs or illiquid markets.

We may be unsuccessful in transitioning to a new development center in Vizag, India.

In the first quarter of 2008, we opened a facility in Vizag, India to serve as the center of our development activities in India which were formerly located in facilities that we leased in Hyderabad, India. We have moved the majority of our developers from our existing offices in Hyderabad, India to our new facility in Vizag, India. We cannot assure you that the transition of development activities from the existing facility to the new facility will ultimately be successful. Some of our existing developers may not desire to make such a move and as a result may terminate their employment with us. Moreover, we may not be successful in hiring new developers at the facility in Vizag. In addition, Vizag, India may not support all of the necessary infrastructure capabilities that we may require in the future to operate our development center. Accordingly, we may experience network, telecommunications and other infrastructure

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disruptions in connection with our operation of the new facility and we may experience problems hiring or retaining qualified employees or third party service providers that are needed for the successful operation of our development center. If a substantial number of our existing employees do not continue their employment with us at the new facility or if the location of the new facility does not support appropriate infrastructure capabilities to meet our business needs, our business may be harmed and our results of operation may suffer.

Material defects or errors in our software could affect our reputation, result in significant costs to us and impair our ability to sell our solutions, which would harm our business.

The software applications forming part of our solutions may contain material defects or errors, which could materially and adversely affect our reputation, result in significant costs to us and impair our ability to sell our solutions in the future. The costs incurred in correcting any material product defects or errors may be substantial and would adversely affect our operating results. After the release of our products, defects or errors may also be identified from time to time by our internal team and by our clients. Such defects or errors may occur in the future. Any defects that cause interruptions to the availability of our solutions could result in:

• lost or delayed market acceptance and sales of our solutions;

• loss of clients;

• product liability suits against us;

• diversion of development resources;

• injury to our reputation; and

• increased maintenance and warranty costs.

If we fail to adequately protect our proprietary rights, our competitive advantage could be impaired and we may lose valuable assets, experience reduced revenue and incur costly litigation to protect our rights.

Our intellectual property rights are important to our business, and our success is dependent, in part, on protecting our proprietary software and technology and our brand, marks and domain names. We rely on a combination of copyright, trademark, trade secret and other common laws in the United States and other jurisdictions as well as confidentiality procedures and contractual provisions to protect our proprietary technology, processes and other intellectual property. It may be possible for unauthorized third parties to copy our software and use information that we regard as proprietary to create products and services that compete with ours, which could harm our competitive position and cause our revenue to decline.

We have three issued patents, and additionally we have four pending patent applications. There is no guarantee that the U.S. Patent and Trademark Office will grant these patents, or do so in a manner that gives us the protection that we seek. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Existing intellectual property laws only afford limited protection.

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To the extent that we expand our international activities, our exposure to unauthorized copying and use of our software and proprietary information may increase. Some license provisions protecting against unauthorized use, copying, transfer and disclosure of our licensed products may be unenforceable under the laws of certain jurisdictions and foreign countries in which we operate. Further, the laws of some countries, and in particular India, where we develop much of our intellectual property, do not protect proprietary rights to the same extent as the laws of the United States. For example, companies seeking to enforce proprietary rights in India can experience substantial delays in prosecuting trademarks and in opposition proceedings. In the event that we are unable to protect our intellectual property rights, especially those rights that we develop in India, our business would be materially and adversely affected.

Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management resources, either of which could seriously harm our business.

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

We expect that software product developers, such as ourselves, will increasingly be subjected to infringement claims as the number of products and competitors grows and the functionality of products in different industry segments overlaps. Our competitors or other third parties may challenge the validity or scope of our intellectual property rights. A claim may also be made relating to technology that we acquire or license from third parties. If we were subject to a claim of infringement, regardless of the merit of the claim or our defenses, the claim could:

• require costly litigation to defend and resolve, and the payment of substantial damages;

• require significant management time and attention;

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

• require us to discontinue the sale of our solutions;

• create negative publicity that adversely affects the demand for our solutions;

• require us to indemnify our clients; and/or

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

Litigation could be costly for us to defend, have a negative effect on our operating results and financial condition or require us to devote additional research and development resources to change our software.

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Changes in the regulatory environment and general economic condition in India and elsewhere could have a material adverse effect on our business.

Adverse changes in the business or regulatory climate in India could have a material adverse effect on our business. In addition, wages in India are increasing at a faster rate than in the United States. In the event that wages continue to rise, the cost benefit of operating in India and elsewhere may diminish. India has also experienced significant inflation in the past and has been subject to civil unrest and terrorism. There can be no assurance that these and other factors will not have a material adverse effect on our business, results of operations and financial condition.

We employ technology licensed from third parties for use in or with our solutions, and the loss or inability to maintain these licenses on similar terms or errors in the software we license could result in increased costs, or reduced service levels, which would adversely affect our business.

We include in the distribution of our solutions certain technology obtained under licenses from other companies. We anticipate that we will continue to license technology and development tools from third parties in the future. There may not always be commercially reasonable software alternatives to the third-party software that we currently license, or any such alternatives may be more difficult or costly to replace than the third-party software that we currently license. In addition, integration of our software with new third-party software may require significant work and substantial allocation of our time and resources. Also, to the extent we depend upon the successful operation of third-party products in conjunction with our software, any undetected errors in these third-party products could prevent the implementation or impair the functionality of our software, delay new solution introductions and injure our reputation. Our use of additional or alternative third-party software would require us to enter into license agreements with third parties, which could result in higher costs.

Our quarterly operating results may fluctuate significantly, and these fluctuations may cause our stock price to fall.

As a result of fluctuations in our revenue and operating expenses, our quarterly operating results may vary significantly. We may not be able to curtail our spending quickly enough if our revenue falls short of our expectations. We expect that our operating expenses will increase substantially in the future as we expand our selling and marketing activities, increase our new product development efforts and hire additional personnel. Our operating results may fluctuate in the future as a result of the factors described below:

• our ability to renew and increase subscriptions sold to existing clients, attract new clients, cross-sell our solutions and satisfy our clients’ requirements;

• changes in our pricing policies;

• the introduction of new features to our solutions;

• the rate of expansion and effectiveness of our sales force;

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• the length of the sales cycle for our solutions;

• new product and service introductions by our competitors;

• concentration of marketing expenses for activities, such as trade shows and advertising campaigns;

• concentration of research and development costs;

• general economic conditions affecting existing and potential clients and our business; and

• concentration of expenses associated with commissions earned on sales of subscriptions for our solutions.

We believe that period-to-period comparisons of our results of operations are not necessarily meaningful as our future revenue and results of operations may vary substantially. It is also possible that in future quarters our results of operations will be below the expectations of securities market analysts and investors. In either case, the price of our common stock could decline, possibly materially.

If we do not retain our executive officers, our ability to manage our business and continue our growth could be negatively impacted.

We have grown significantly in recent years, and our management remains concentrated in a small number of executive officers, most of whom have been employed with us for at least five years. Our future success will depend to a significant extent on the continued service of these executive officers, namely Nooruddin S. Karsan, Troy A. Kanter, Donald F. Volk, Sarah M. Teten, and Archie L. Jones, Jr. as well as our other key employees, software engineers and senior technical and sales personnel. We have not entered into employment agreements with any of our employees. The loss of the services of any of these individuals or group of individuals could have a material adverse effect on our business, financial condition and results of operations. Competition for qualified personnel in the software industry is intense, and we compete for these personnel with other software companies that have greater financial and other resources than we do. If we lose the services of one or more of our executive officers or other key personnel, or if one or more of them decide to join a competitor or otherwise compete directly or indirectly with us, our business could be harmed. Searching for replacements for key personnel could also divert management’s time and attention and result in increased operating expenses.

We will not be able to maintain our revenue growth if we do not attract, train or retain qualified sales personnel.

If we fail to successfully maintain and expand our sales force, our future revenue and profitability will be adversely affected. We depend on our direct sales force for substantially all of our revenue and intend to make significant expenditures in upcoming years to expand our sales force. Our future success will depend in part upon the continued expansion and increased

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productivity of our sales force. To the extent that we experience attrition in our direct sales force, we will need to hire replacements. We face intense competition for sales personnel in the software industry, and we may not be successful in hiring, training or retaining our sales personnel in accordance with our plans. Even if we hire and train a sufficient number of sales personnel, we may not generate enough additional revenue to exceed the expense of hiring and training the new personnel.

Evolving European Union regulations related to confidentiality of personal data may adversely affect our business.

In order to provide our solutions to our clients, we rely in part on our ability to access our clients’ employee data. The European Union and other jurisdictions have adopted various data protection regulations related to the confidentiality of personal data. To date, these regulations have not restricted our business as we have qualified for a safe harbor available for U.S. companies that collect personal data from areas under the jurisdiction of the European Union. To the extent that these regulations are modified in such a manner that our safe harbor no longer applies, our ability to conduct business in the European Union may be adversely affected.

Any impairment in the value of our goodwill will result in an accounting charge against our earnings, which could negatively impact our stock price.

As of December 31, 2007, we had $173.5 million of goodwill, representing approximately 50% of our total assets as of such date. As a result of acquisitions that we may complete in the future, we may be required to record additional goodwill. In accordance with U.S. generally accepted accounting principles, we conduct an impairment analysis of our goodwill annually and at such other times when an event or change in circumstances occurs which would indicate potential impairment. If we determine significant impairment of our goodwill as a result of any of those tests, we would be required to record a corresponding non-cash impairment charge against our earnings that could negatively affect our stock price.

Evolving regulation of the Internet may increase our expenditures related to compliance efforts, which may adversely affect our financial condition.

As Internet commerce continues to evolve, increasing regulation by federal, state and/or foreign agencies becomes more likely. We are particularly sensitive to these risks because the Internet is a critical component of our business model. For example, we believe that increased regulation is likely in the area of data privacy, and laws and regulations applying to the solicitation, collection, processing or use of personal or consumer information could affect our clients’ ability to use and share data, potentially reducing demand for solutions accessed via the Internet and restricting our ability to store, process and share data with our clients via the Internet. In addition, taxation of services provided over the Internet or other charges imposed by government agencies or by private organizations for accessing the Internet may also be imposed. Any regulation imposing greater fees for Internet use or restricting information exchange over the Internet could result in a decline in the use of the Internet and the viability of Internet-based services, which could harm our business.

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The failure of our solutions to comply with employment laws may require us to indemnify our clients, which may harm our business.

Some of our client contracts contain indemnification provisions that require us to indemnify our clients against claims of non-compliance with employment laws related to hiring. To the extent these claims are successful and exceed our insurance coverages, these obligations would have a negative impact on our cash flow, results of operation and financial condition.

Our reported financial results may be adversely affected by changes in generally accepted accounting principles.

Generally accepted accounting principles in the United States are subject to interpretation by the Financial Accounting Standards Board, or FASB, the American Institute of Certified Public Accountants, the SEC, and various bodies formed to promulgate and interpret appropriate accounting principles. A change in these principles or interpretations could have a significant effect on our historical or future financial results. For example, prior to January 1, 2006, we were not required to record share-based compensation charges if the employee’s stock option exercise price is equal to or exceeds the deemed fair value of the underlying security at the date of grant. However, effective January 1, 2006 we are required to record the fair value of stock options as an expense in accordance with new accounting pronouncements.

Anti-takeover provisions of Pennsylvania law and our articles of incorporation and bylaws could delay and discourage takeover attempts that shareholders may consider to be favorable.

Certain provisions of our articles of incorporation and applicable provisions of the Pennsylvania Business Corporation Law may make it more difficult for a third party to, or prevent a third party from, acquiring control of us or effecting a change in our board of directors and management. These provisions include:

• the classification of our board of directors into three classes, with one class elected each year;

• prohibiting cumulative voting in the election of directors;

• the ability of our board of directors to issue preferred stock without shareholder approval;

• our shareholders may only take action at a meeting of our shareholders and not by written consent;

• prohibiting shareholders from calling a special meeting of our shareholders;

• our shareholders must comply with advance notice procedures in order to nominate candidates for election to our board of directors or to place shareholders proposals on the agenda for consideration at any meeting of our shareholders; and

• prohibiting us from engaging in some types of business combinations with holders of 20% or more of our voting securities without prior approval of our board of directors, unless a majority of our disinterested shareholders approve the transaction.

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The Pennsylvania Business Corporation Law further provides that because our articles of incorporation provide for a classified board of directors, shareholders may remove directors only for cause. These and other provisions of the Pennsylvania Business Corporation Law and our articles of incorporation and bylaws could delay, defer or prevent us from experiencing a change of control or changes in our board of directors and management and may adversely affect our shareholders’ voting and other rights. Any delay or prevention of a change of control transaction or changes in our board of directors and management could deter potential acquirors or prevent the completion of a transaction in which our shareholders could receive a substantial premium over the then current market price for their shares of our common stock.

Our board of directors have approved a share repurchase program, which may restrict our funds available for other actions and negatively affect the market price of our securities.

In February 2008, our board of directors approved a stock repurchase program authorizing, from time to time, the repurchase of up to 3.0 million shares of our common stock on the NASDAQ National Market, 1,056,293 shares of which were repurchased as of September 30, 2008 at an average per share price of $18.90. The share repurchases may not have the effects anticipated by our board of directors and may instead harm the market price of our securities. The full implementation of this repurchase plan would use a significant portion of our cash reserves, and this use of cash could limit our future flexibility to complete acquisition transactions or fund other growth opportunities. In addition, the share repurchases are subject to regulatory requirements. We may become subject to lawsuits regarding the use of our cash for share repurchases or for the failure to follow applicable regulatory requirements in connection with our share repurchase program. Our repurchase plan could result in an increase in the share percentage ownership of our existing shareholders, and such increase may trigger disclosure or other regulatory requirements for our larger shareholders. As a result, certain shareholders may liquidate a portion of their holdings. In addition, our repurchase plan may decrease our public float as shares are repurchased by us on the open market pursuant to the plan and may have a negative effect on our trading volume. Such outcomes may have a negative impact on the liquidity of our common stock, the market price of our common stock and could make it easier for others to acquire a larger percentage of our voting securities.

The market price of our common stock may be particularly volatile, and our shareholders may be unable to resell their shares at a profit.

The market price of our common stock has been subject to significant fluctuations and may continue to fluctuate or decline. Recently, from August 8, 2007 to November 8, 2008, our common stock has been particularly volatile as the price of our common stock has ranged from a high of $42.44 to a low of $6.00. In the past several years, technology stocks have experienced high levels of volatility and significant declines in value from their historic highs. Additionally, as a result of the current global credit crisis and the concurrent economic downturn in the U.S. and globally, there have been significant declines in the values of equity securities generally in both the U.S. and internationally. Factors that could cause fluctuations in the trading price of our common stock include the following:

• price and volume fluctuations in the overall stock market from time to time;

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• significant volatility in the market price and trading volume of software companies in general, and HR software companies in particular;

• actual or anticipated changes in our earnings or fluctuations in our operating results;

• general economic conditions and trends;

• major catastrophic events;

• the timing and magnitude of stock repurchases pursuant to our stock repurchase plan;

• sales of large blocks of our stock; or

• departures of key personnel.

In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been brought against that company. If our stock price continues to be volatile, we may become the target of securities litigation. Securities litigation could result in substantial costs and divert our management’s attention and resources from our business.

Item 2: Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities.

The following table provides information regarding our repurchase of our common stock during the third quarter of 2008:

Period	Total Number of Shares Purchased	Weighted Average Price paid Per Share	Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs [1]
July 1, 2008 – July 31, 2008	—	—	—	1,993,007
August 1, 2008 – August 30, 2008	—	—	—	1,943,707
September 1, 2008 – September 30, 2008	—	—	—	1,943,707
Total	—	—	—	1,943,707

[1] On February 20, 2008, our board of directors authorized a stock repurchase plan providing for the repurchase of up to 3,000,000 shares of our common stock.

Item 3: Defaults Upon Senior Securities

Not applicable.

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

Not applicable.

Item 5: Other Information

Not applicable.

Item 6: Exhibits

The following exhibits are filed herewith:

31.1	Certification by Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).
31.2	Certification by Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).
32.1	Certification Furnished Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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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.

November 10, 2008

Kenexa Corporation

/s/ Nooruddin S. Karsan

Nooruddin S. Karsan

Chairman of the Board and Chief Executive Officer

/s/ Donald F. Volk

Donald F. Volk

Chief Financial Officer

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EXHIBIT INDEX

Exhibit Number and Description

Exhibit 31.1	Certification by Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a).
Exhibit 31.2	Certification by Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a).
Exhibit 32.1	Certification Furnished Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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