Guidance Software 10-Q 2007 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10–Q

(Mark One)

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

For the quarterly period ended March 31, 2007

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 001-33197

GUIDANCE SOFTWARE, INC.

(Exact name of registrant as specified in its charter)

Delaware	95-4661210
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
215 North Marengo Avenue	91101
Pasadena, California	(Zip Code)
(Address of principal executive offices)

Registrant’s telephone number, including area code: (626) 229-9191

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

None.

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

Common Stock

(Title of class)

DOCUMENTS INCORPORATED BY REFERENCE

None

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

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act):

Large accelerated filer  ¨            Accelerated filer  ¨            Non-accelerated filer  x

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

As of May 4, 2007, there were 22,344,502 shares of the registrant’s Common Stock outstanding.

GUIDANCE SOFTWARE, INC.

Form 10-Q

For the Quarterly Period Ended March 31, 2007

Table of Contents

		Page
PART I FINANCIAL INFORMATION		1
Item 1.	Financial Statements	1
	Condensed Consolidated Balance Sheets at December 31, 2006 and March 31, 2007 (unaudited)	1
	Condensed Consolidated Statements of Operations for the three months ended March 31, 2006 and 2007 (unaudited)	2
	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2006 and 2007 (unaudited)	3
	Notes to the Condensed Consolidated Financial Statements (unaudited)	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and results of Operations	11
Item 3.	Quantitative and Qualitative Disclosures About market Risk	20
Item 4.	Controls and Procedures	20
PART II OTHER INFORMATION		20
Item 1.	Legal Proceedings	20
Item 1A.	Risk factors	21
Item 4.	Submission of Matters to a Vote of Security Holders	33
Item 6.	Exhibits	34

ii

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

GUIDANCE SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

(unaudited)

	December 31, 2006			March 31, 2007
ASSETS
Current assets:
Cash and cash equivalents	$	8,041		$	8,875
Investments in marketable debt securities		24,694			24,693
Trade receivable, net of allowance for doubtful accounts of $442 and $234 as of December 31, 2006 and March 31, 2007, respectively		17,513			16,395
Prepaid expenses, inventory and other current assets		2,064			2,623
Total current assets		52,312			52,586
Property and equipment, net		6,526			8,825
Other assets		507			511
Total assets	$	59,345		$	61,922
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	5,494		$	5,041
Accrued expenses		3,974			4,437
Capital leases		942			757
Deferred revenues		18,123			20,447
Total current liabilities		28,533			30,682
Long-term liabilities:
Rent incentives		1,537			2,196
Capital leases		488			580
Deferred revenues		2,098			2,465
Total long-term liabilities		4,123			5,241
Commitments and Contingencies (Notes 3,5,6 and 10)
Stockholders’ equity:
Preferred stock, $0.001 par value: 10,000,000 shares authorized; no shares issued or outstanding at December 31, 2006 and March 31, 2007, respectively		—			—
Common stock, $0.001 par value; 100,000,000 shares authorized; 22,167,000 and 22,344,000 shares issued and outstanding at December 31, 2006 and March 31, 2007, respectively		22			22
Additional paid-in capital		36,330			37,617
Accumulated other comprehensive loss		(17	)		(8	)
Accumulated deficit		(9,646	)		(11,632	)
Total stockholders’ equity		26,689			25,999
Total liabilities and stockholders’ equity	$	59,345		$	61,922

See Notes to Consolidated Financial Statements

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GUIDANCE SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	For the three months ended March 31,
	2006			2007
Revenues:
Product revenue	$	6,203		$	10,088
Services and maintenance revenue		4,968			7,508
Total revenues		11,171			17,596
Cost of revenues (1):
Cost of product revenue		477			745
Cost of services and maintenance revenue		2,608			4,513
Total cost of revenues		3,085			5,258
Gross profit		8,086			12,338
Operating expenses (1):
Selling and marketing		5,108			8,692
Research and development		1,452			2,048
General and administrative		1,711			3,090
Depreciation and amortization		360			699
Total operating expenses		8,631			14,529
Operating loss		(545	)		(2,191	)
Other income and expense:
Interest income		26			358
Interest expense		(9	)		(32	)
Other income, net		34			34
Loss before income taxes		(494	)		(1,831	)
Income tax provision		16			25
Net loss	$	(510	)	$	(1,856	)
Net loss per share:
Basic	$	(.02	)	$	(.08	)
Diluted	$	(.02	)	$	(.08	)
Weighted average number of shares used in per share calculation:
Basic		20,417			22,289
Diluted		20,417			22,289

(1) See Management’s Discussion and Analysis of Financial Condition and Results of Operations for the amount of Share Based Compensation included in the Condensed Consolidated Statements of Operations.

See Notes to Consolidated Financial Statements

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GUIDANCE SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Three Months Ended March 31,
	2006			2007
Cash flows from operating activities:
Net loss	$	(510	)	$	(1,856	)
Adjustments to reconcile net loss to net (used in) cash provided by operating activities:
Depreciation and amortization		360			699
Provision for (recovery of) doubtful accounts		93			(49	)
Share-based compensation		62			888
Loss on disposal of assets		—			27
Changes in operating assets and liabilities:
Trade receivables		(609	)		1,167
Prepaid expenses, inventory and other assets		(573	)		(17	)
Accounts payable		403			(1,937	)
Accrued expenses		(819	)		446
Deferred revenue		445			2,691
Net cash (used in) provided by operating activities		(1,148	)		2,059
Cash flows from investing activities:
Purchase of marketable debt securities		—			(24,693	)
Sale of marketable debt securities		—			24,703
Purchase of property and equipment		(932	)		(1,376	)
Net cash used in investing activities		(932	)		(1,366	)
Cash flows from financing activities:
Distributions to stockholders		(1,710	)		—
Principal payments of capital lease obligations		(127	)		(258	)
Cash paid for offering expense		(25	)		(241	)
Proceeds from the exercise of stock options		23			640
Net cash (used in) provided by financing activities		(1,839	)		141
Net (decrease) increase in cash and cash equivalents		(3,919	)		834
Cash and cash equivalents, beginning of period		7,556			8,041
Cash and cash equivalents, end of period	$	3,637		$	8,875
Supplemental disclosures of cash flow information:
Net cash paid during the year for:
Interest		7			22
Income taxes		—			—
Non-cash activities:
Capital lease obligations incurred to acquire assets	$	113		$	165
Purchase of equipment included in accounts payable	$	72		$	1,484
Rent incentives	$	—		$	546
Recognition of uncertain tax liabilities	$	—		$	130

See Notes to Consolidated Financial Statements

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GUIDANCE SOFTWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1. Description of the Business and Summary of Significant Accounting Policies

General

Guidance Software, Inc. was incorporated in the state of California during 1997 and reincorporated in Delaware on December 11, 2006. Headquartered in Pasadena, California, Guidance is a global provider of software solutions to conduct digital investigations. The Company’s flagship product is EnCase^® Enterprise, a comprehensive, network-enabled digital solution that enables corporations and government agencies to search, collect, preserve and analyze data across all of the servers, desktops and laptops that comprise their entire network from a single location. We also sell EnCase^® Forensic, primarily for use by law enforcement and government agencies for collecting, preserving, analyzing and authenticating electronic computer forensic data for use in criminal and civil court proceedings. We complement our software offerings with a comprehensive array of professional and training services including technical support and maintenance services to help our customers implement our solutions, conduct investigations and train their IT professionals to effectively and efficiently use our software products.

Basis of Presentation

The accompanying condensed consolidated balance sheet as of March 31, 2007 and the condensed consolidated statements of operations and cash flows for the three months ended March 31, 2007 and 2006 are unaudited. These statements should be read in conjunction with the audited consolidated financial statements and related notes, together with management’s discussion and analysis of financial position and results of operations, contained in the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 29, 2007.

The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or (“GAAP”). In the opinion of the Company’s management, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements in the Annual Report on Form 10-K for the year ended December 31, 2006 and include all adjustments necessary for the fair presentation of the Company’s statement of financial position as of March 31, 2007, and its results of operations and cash flows for the three months ended March 31, 2007 and 2006. The condensed consolidated balance sheet as of December 31, 2006 has been derived from the December 31, 2006 audited financial statements. The interim financial information contained in this quarterly report is not necessarily indicative of the results to be expected for any other interim period or for the entire year.

The consolidated financial statements include the accounts of Guidance and its wholly owned subsidiaries. Guidance and its subsidiaries are collectively referred to herein as “Guidance,” “we” or the “Company.” All significant intercompany accounts and transactions have been eliminated.

Concentrations

Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of cash and cash equivalents, marketable debt securities, and accounts receivable. The Company restricts investments in cash and cash equivalents to financial institutions with high credit standing. At March 31, 2007, the majority of the Company’s cash and cash equivalents were held at financial institutions located in California. Accounts at these institutions are insured by the Federal Deposit Insurance Corporation up to $100,000. The Company performs periodic evaluations of the relative credit standing of financial institutions and limits the amount of risk by selecting financial institutions with a strong credit standing. At March 31, 2007, all of the Company’s marketable debt securities were obligations of the U.S. Government. The Company periodically performs credit evaluations of its customers and maintains reserves for potential losses on its accounts receivable.

Recent Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159, “The Fair Value Option for Financial Assets and 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 (the “fair value option”). Unrealized gains and losses, arising subsequent to adoption, are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is required to adopt SFAS 159 in the first quarter of 2008. The Company is currently assessing the impact of SFAS 159 on its consolidated financial statements.

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Note 2. Net Loss Per Share

The Company calculates net loss per share in accordance with SFAS No. 128, “Earnings Per Share.” Under SFAS No. 128, basic net loss per common share is calculated by dividing net loss by the weighted-average number of common shares outstanding during the reporting period. For the three months ended March 31, 2007 and 2006, respectively, weighted average shares of common stock issuable in connection with stock options of 1,283,000 and 1,422,000, respectively were not included in the diluted earnings per share calculation as to do so would have been anti-dilutive.

Note 3. Uncertainty in Tax Position

The company adopted the provisions of FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”),on January 1, 2007. As a result of the adoption of FIN 48, the company performed a comprehensive review of its uncertain tax positions in accordance with the standards established by FIN 48. In this regard, an uncertain tax position represents the company’s expected treatment of a tax position taken in a filed tax return, or planned to be taken in a future tax return, that has not been reflected in measuring income tax expense for financial reporting purposes. As a result of this review, the company recorded uncertain tax positions by recognizing additional liabilities totaling $130,000 through a charge to accumulated deficit. The liability for uncertain tax positions is recorded in other liabilities in the condensed consolidated balance sheet as of March 31, 2007. If the company’s positions are sustained by the taxing authorities in favor of the Company, amounts previously recorded as liabilities would reduce the company’s income tax provision in the period the tax position is sustained. The company does not expect material changes to the estimated amount of liability associated with its uncertain tax positions through January 1, 2008.

The company recognizes interest and penalties related to uncertain tax positions in the income tax provision. Interest and penalties are computed based upon the difference between the company’s uncertain tax positions under FIN 48 and the amount deducted or expected to be deducted in the company’s tax returns. As of March 1, 2007, amounts accrued for interest and penalties were insignificant.

The company files income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions.

As of March 31, 2007, there have been no material changes to the liability for uncertain tax positions.

Note 4. Deferred Revenues

The following table summarizes the change in the Company’s deferred revenues during the three month period ended March 31, 2007:

	Deferred Product Revenue			Deferred Services & Maintenance Revenue			Total Deferred Revenue
Balance as of January 1, 2007	$	9,322		$	10,899		$	20,221
Amounts billed and deferred		3,966			7,540			11,506
Previously deferred amounts recognized as revenue		(2,740	)		(6,075	)		(8,815	)
Balance as of March 31, 2007	$	10,548		$	12,364		$	22,912

Note 5. Debt Obligations

On January 10, 2007, the Company entered into a fifth amendment to its revolving line of credit lowering the interest rate from the Prime Rate minus 0.25% to Prime Rate minus 0.75% and removing the financial covenant limiting the Company’s capital expenditures. As of March 31, 2006, the Company was not in compliance with its minimum earnings covenant. (Note 11)

Note 6. Leases

The Company leases certain of its operating facilities under noncancelable operating leases extending through 2015. The Company also leases certain equipment under capital leases extending through 2011. The Company also subleases certain of its facilities under non-cancellable operating leases. The present value of the remaining future minimum lease payments is recorded as capital leases in the consolidated balance sheet. The following is a schedule of future minimum lease payments under capital leases, operating leases and future noncancellable sublease income:

Years Ending December 31,	Future Minimum Capital Lease Payments			Future Minimum Operating Lease Payments		Future Non-Cancellable Sublease Income			Net Future Minimum Lease Payments
	(in thousands)
2007 (9 months)	$	737		$	2,398	$	(22	)	$	3,113
2008		604			3,283		—			3,887
2009		106			3,155		—			3,261
2010		10			3,089		—			3,099
2011		4			3,170		—			3,174
Thereafter		—			6,755		—			6,755
Total		1,461		$	21,850	$	(22	)	$	23,289
Less amounts representing interest (5.75% - 16.35%)	$	(124	)
	$	1,337

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Note 7. Stock Option Plan and Employee Benefit Plan

In 2004, the Company’s Board of Directors and stockholders approved the 2004 Equity Incentive Plan (the “Plan”). A total of 2,062,000 shares of common stock was initially authorized and reserved for issuance under the Plan in the form of incentive and non-qualified stock options and restricted stock. The Plan was amended in 2005 to increase to 3,977,000 the number of shares available for issuance. On May 3, 2006, the Company’s Board of Directors and its stockholders approved increases in the shares available for issuance under the Plan by an additional 1,127,000 shares on May 3, 2006, an additional 828,000 shares on January 1, 2007, an additional 828,000 shares on January 1, 2008 and an additional 828,000 shares on January 1, 2009. Employees, officers and directors are eligible to receive equity instruments under the Plan, which is administered by the Company’s Board of Directors, who determines the terms and conditions of each grant. The terms of the options granted under the Plan are determined at the time of grant, and generally vest 25% annually over a four-year period and typically must be exercised within 10 years from the date of grant. The options prices are determined by the Company’s Board of Directors.

A summary of the Company’s stock option activity follows:

	Number of Options		Weighted Average Exercise Price		Range of Exercise Price
Outstanding, December 31, 2006	3,904,000		$	6.26	$4.54 - $11.90
Granted	229,000			12.94	$12.94
Exercised	(137,000	)		4.67	$ 4.54 - $6.37
Canceled or forfeited	(71,000	)		8.35	$4.54 - $11.90
Outstanding, March 31, 2007	3,925,000		$	6.67	$4.54 - $12.94

A summary of the status of the Company’s non-vested shares as of March 31, 2007, and the changes during the three months ended March 31, 2007 is presented below:

	Number of Options		Weighted Average Grant Date Fair Value
Nonvested options as of December 31, 2006 (1)	2,979,000			—
Granted	229,000		$	8.62
Vested (1)	(684,000	)		—
Forfeited (1)	(60,000	)		—
Nonvested options as of March 31, 2007	2,464,000			—

(1) During the year ended December 31, 2005, the Company used the minimum-value method afforded by SFAS No. 123 (“SFAS 123”) “Accounting for Stock-Based Compensation,” for disclosure purposes. Accordingly, fair value information is not available.

The following table summarizes information about stock options outstanding at March 31, 2007:

	Options Outstanding						Options Exercisable
Exercise Price	Number of Options	Weighted Average Remaining Contract Life (Years)	Weighted Average Exercise Price		Intrinsic Value		Number of Options	Weighted Average Remaining Contract Life (Years)	Weighted Average Exercise Price		Intrinsic Value
$4.54	2,103,000	7.52	$	4.54	$	15,773,000	1,273,000	7.52	$	4.54	$	9,548,000
$5.34	180,000	8.12		5.34		1,206,000	45,000	8.12		5.34		302,000
$6.17	134,000	8.40		6.17		787,000	34,000	8.40		6.17		199,000
$6.32	50,000	8.63		6.32		286,000	13,000	8.63		6.32		74,000
$6.37	384,000	8.90		6.37		2,177,000	96,000	8.90		6.37		544,000
$7.64	69,000	9.09		7.64		304,000	—	—		7.64		—
$10.75	550,000	9.33		10.75		710,000	—	—		10.75		—
$11.90	226,000	9.61		11.90		31,000	—	—		11.90		—
$12.94	229,000	9.92		12.94		—	—	—		12.94		—
	3,925,000	8.27	$	6.67	$	21,274,000	1,461,000	7.67	$	4.74	$	10,667,000

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	Options Expected to Vest
Exercise Price	Number of Options	Weighted Average Remaining Contract Life (Years)	Weighted Average Exercise Price		Intrinsic Value
$4.54	755,000	7.52	$	4.54	$	5,665,000
$5.34	123,000	8.12		5.34		823,000
$6.17	91,000	8.40		6.17		534,000
$6.32	33,000	8.63		6.32		193,000
$6.37	262,000	8.90		6.37		1,486,000
$7.64	63,000	9.09		7.64		276,000
$10.75	501,000	9.33		10.75		646,000
$11.90	206,000	9.61		11.90		29,000
$12.94	208,000	9.92		12.94		(188,000	)
	2,242,000	8.63	$	6.67	$	9,464,000

The Company defines in-the-money options at March 31, 2007 as options that had exercise prices that were lower than the $12.04 market value of its common stock at that date. The aggregate intrinsic value of options outstanding at March 31, 2007 is calculated as the difference between the exercise price of the underlying options and the market value of the Company’s common stock for the 3,696,000 shares that were in-the-money at that date. There were 1,461,000 in-the-money options exercisable at March 31, 2007. The total intrinsic value of the options exercised during the quarter ended March 31, 2007 was $1,094,000, determined as of the date of exercise.

A total of 1,469,000 options remain available for grant under the Company’s Plan at March 31, 2007.

In February 2007, the Company granted approximately 40,000 restricted shares to certain executives and employees under the Plan. The restricted shares vest in May 2007, and were issued at prices between $12.94 and $13.66 per restricted share. The Company recorded $271,000 of share-based compensation during the three month period ended March 31, 2007 related to the restricted shares.

Note 8. Share-Based Compensation

Prior to January 1, 2006, the Company accounted for the stock options granted under the Plan by applying the intrinsic value-based method of accounting prescribed by Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees”. Under this method, compensation expense is generally recorded over the vesting period, only if the fair value of the underlying stock exceeded the exercise price on the grant date. The Company adopted the disclosure-only requirements of SFAS No. 123 (“SFAS 123”) “Accounting for Stock-Based Compensation,” and SFAS No. 148 (“SFAS 148”), “Accounting for Stock-Based Compensation—Transition and Disclosure—an Amendment of FASB Statement No. 123.” These statements established accounting and disclosure requirements using a fair value-based method of accounting for share-based employee compensation plans. As allowed by SFAS 123 and SFAS 148, the Company elected to continue to apply the intrinsic value-based method described above. Accordingly, no share-based compensation for stock options is recorded in the accompanying financial statements prior to January 1, 2006, as the fair-value of the underlying stock did not exceed the exercise price of the options at the date of grant.

Effective January 1, 2006, the Company adopted SFAS No. 123R (“SFAS 123R”) “Share-Based Payment.” Prior to the adoption of SFAS 123R, the Company used the minimum-value method afforded by SFAS 123 for disclosure purposes; therefore, as prescribed by SFAS 123R, the Company adopted SFAS 123R using the prospective transition method. Accordingly, prior period amounts have not been restated. Under this transition method, compensation cost in 2006 includes the portion related to options vesting in the period for (1) all share-based payments granted prior to, but not vested as of January 1, 2006, based on the grant date intrinsic value of the option estimated in accordance with the provisions of APB 25 and (2) all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. However, as described above, no share-based compensation was recorded related to options granted prior to January 1, 2006, as the fair-value of the underlying stock did not exceed the exercise price of the options at the date of grant.

The fair values of each award granted under the Plan during the three months ended March 31, 2007 were estimated at the date of grant using the Black-Scholes option pricing model and the following weighted average assumptions:

	Three Months Ended March 31, 2006		Three Months Ended March 31, 2007
Risk-free interest rate	4.57	%	4.51	%
Dividend yield	—	%	—	%
Expected life (years)	6.25		6.25
Volatility	71.0	%	69.3	%

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In March 2005, the SEC issued Staff Accounting Bulletin Topic No. 107 (“SAB 107”) which provides guidance on the implementation of SFAS 123R. The Company applied the principles of SAB 107 in conjunction with its adoption of SFAS 123R. The volatility of the Company’s common stock is estimated at the date of grant based on the equally weighted-average of the implied volatility of publicly traded 30-day to 270-day options on the common stock of a select peer group of similar companies (“Similar Companies”) and the historical volatility of the common stock of Similar Companies, consistent with the requirements of SFAS 123R and SAB 107. The risk-free interest rate that was used in the Black-Scholes option valuation model is based on the implied yield in effect at the time of each option grant, based on U.S. Treasury zero-coupon issues with equivalent remaining terms. Management uses an expected dividend yield of zero in the Black-Scholes option valuation model, as it has no intention to pay any cash dividends on its common stock in the foreseeable future. SFAS 123R requires management to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. Management uses historical data to estimate pre-vesting option forfeitures and records share-based compensation expense only for those awards that are expected to vest. The Company amortizes share-based compensation on a straight-line basis. All options are amortized over the requisite service period of the awards, which is generally the vesting period. The expected term of stock option awards granted was calculated using the “simplified method” as defined by SAB 107 as the Company lacks historical data and is unable to make reasonable expectations regarding the future. The weighted average estimated grant date fair value for options granted under the Company’s stock option plan during the three months ended March 31, 2007 was $8.62 per option.

As of March 31, 2007, there was $8.5 million of total unrecognized compensation cost related to non-vested share-based compensation that is expected to be recognized over a weighted-average period of 3.78 years.

Note 9. Income Taxes

In assessing the realizability of the net deferred tax assets, management considers whether it is more likely than not that some or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends upon either the generation of future taxable income during the periods in which those temporary differences become deductible or the carryback of losses to recover income taxes previously paid during the carryback period. As of March 31, 2007, the Company has provided a valuation allowance of approximately $2.8 million to reduce net deferred tax assets to zero.

Note 10. Contingencies

Federal Trade Commission Inquiry

In early January 2006, the Federal Trade Commission (“FTC”) commenced an inquiry into a network security breach at the Company. The Company recorded an accrual of $500,000 with an offsetting charge to general and administrative expense as of and for the year ended December 31, 2005. On September 20, 2006, we executed a consent decree proposed by the FTC that requires, among other activities, that we provide biennial third-party assessments of our information technology security for a period of 10 years. The Company incurred $290,000 of costs associated with this matter during the year ended December 31, 2006. As a result of the consent decree, the Company reversed $115,000 of the related accrual with an offsetting credit to general and administrative expense during the year ended December 31, 2006. As of March 31, 2007, $79,000 remains accrued.

In addition, several customers who were notified of the security breach have sought compensation, which in each case has been satisfied by payment of amounts that are not material to the Company, and one customer has commenced litigation, which was dismissed by a federal court and subsequently settled with the customer for an insignificant amount. Additionally, we have paid approximately $11,500 in fines to credit card processing companies through March 31, 2007.

The Company may face additional legal and administrative action with respect to the security breach. In addition, the Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. While the outcome of these matters is not currently determinable, the Company does not expect that the ultimate costs to resolve these matters will have a material effect on the Company’s consolidated financial position, results of operations, or cash flows, other than as disclosed.

Legal Matters

We are from time to time a party to legal proceedings that arise in the normal course of business. We are not currently involved in any litigation, the outcome of which would, in management’s judgment based on information currently available, have a material adverse effect on our results of operations or financial condition, nor is management aware of any such litigation threatened against us.

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Note 11. Segment Information

The Company has adopted SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This standard requires segmentation based on the Company’s internal organization and reporting of revenue and other performance measures. The Company’s segments are designed to allocate resources internally and provide a framework to determine management responsibility. Operating segments are defined as components of an enterprise about which discrete financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. The Company has four operating segments. The types of products and services provided by each segment are summarized below:

• Products segment – includes EEE solutions, EFE solutions, PLSP solutions and hardware sales.

• Professional services segment – is our division that performs consulting services and implementations. Consulting services include conducting investigations using our software products.

• Training segment – is our division that provides in-house training classes in which we train our customers to effectively and efficiently use our software products.

• Maintenance segment – Maintenance related revenue and costs.

We refer to the revenue generated by our professional services and training segments, collectively, as services revenue. We refer to the revenue generated by our training segment as training revenue. We refer to the revenue generated by our maintenance segment as maintenance revenue.

Currently, the Company does not separately allocate operating expenses to these segments, nor does it allocate specific assets to these segments. Therefore, the segment information reported includes only revenues, cost of revenues and gross profit. The following tables present the operations by each operating segment:

	Three Months Ended March 31, 2006
	Product		Professional Services			Training		Maintenance & Other		Total
						(in thousands)
Revenues	$	6,203	$	1,842		$	1,632	$	1,494	$	11,171
Cost of revenues		477		1,305			1,066		237		3,085
Gross profit	$	5,726	$	537		$	566	$	1,257		8,086
Operating expenses:
Selling and marketing											5,108
Research and development											1,452
General and administrative											1,711
Depreciation and amortization											360
Total operating expenses											8,631
Operating loss											(545	)
Interest income											26
Interest expense											(9	)
Other income, net											34
Loss before income taxes										$	(494	)
	Three Months Ended March 31, 2007
	Product		Professional Services			Training		Maintenance & Other		Total
						(in thousands)
Revenues	$	10,088	$	2,694		$	1,960	$	2,854	$	17,596
Cost of revenues		745		2,753			1,333		427		5,258
Gross profit	$	9,343	$	(59	)	$	627	$	2,427		12,338
Operating expenses:
Selling and marketing											8,692
Research and development											2,048
General and administrative											3,090
Depreciation and amortization											699
Total operating expenses											14,529
Operating loss											(2,191	)
Interest income											358
Interest expense											(32	)
Other income, net											34
Loss before income taxes										$	(1,831	)

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Revenue, classified by the major geographic areas in which the Company operates, is as follows:

	Three Months Ended March 31,
	2006		2007
Revenues
U.S.	$	8,792	$	13,431
Europe		1,049		2,306
Asia		404		870
Other		926		989
	$	11,171	$	17,596

Note 12. Subsequent Events

On May 1, 2007, the Company entered into a sixth amendment to its revolving line of credit removing all financial ratios and earnings requirements. The amendment requires the Company to maintain cash, cash equivalents, and marketable securities of more than $10 million, and not allow a cumulative net loss (excluding share-based compensation) in excess of $4 million during any one fiscal year.

On May 9, 2007, the Company obtained a waiver from the bank for its violation of the minimum earnings covenant.

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

The following discussion of our financial condition and results of operations should be read together with the financial statements and related notes that are included elsewhere in this Annual Report. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors” or in other parts of this Annual Report.

Overview

We develop and provide the leading software solutions for digital investigations, including EnCase^® Enterprise, a network-enabled product primarily for large corporations and government agencies, and EnCase^® Forensic, a desktop-based product primarily for law enforcement agencies. We were incorporated and commenced operations in 1997. From 1997 through 2002, we generated a substantial portion of our revenues from the sale of our EnCase^® Forensic products and related services. Between 2003 and 2007, after the release of our EnCase^® Enterprise products and related services, our revenues were driven by the sales of both our EnCase^® Forensic products and our EnCase^® Enterprise products and related services.

We have experienced increases in our revenue as a result of the release of our EnCase^® Enterprise products in late 2002, which expanded our customer base into corporate enterprises and federal government agencies. In addition, the release of our eDiscovery Suite in late 2005 has increased our average transaction size. On an ongoing basis, we anticipate that sales of our EnCase^® Enterprise products and related services, in particular our eDiscovery Suite and Information Assurance Suite solutions, will comprise a substantial portion of our future revenues.

Sources of Revenues

Product Revenue

We generate product revenue principally from sales of our EnCase^® Enterprise and EnCase^® Forensic products. Substantially all of the EnCase^® Enterprise and EnCase^® Forensic license agreements that we have entered into are perpetual in license term. In conjunction with our EnCase^® Forensic software, we also sell our Premium License Support Program product, which is sold on a subscription basis for a term of several years. In addition, we also resell certain forensic hardware and our FastBloc^® hardware.

Services and Maintenance Revenue

Services revenue is comprised of revenue from professional services and training. Professional services is comprised of consulting services and implementation services. Consulting services are typically billed on a per hour or per disk drive basis or are provided under fixed fee arrangements depending on the scope and size of each individual project. Implementation services are generally included with the purchase of a software license. Training services include a broad range of training course offerings on the general principals of computer forensics and how to use our EnCase^® software products. Training services are typically billed on a per person, per class basis.

Maintenance services represent technical support services for our software solutions and include the right to unspecified product upgrades on a when-and-if available basis. Maintenance services are generally included in the sale of a perpetual license and typically are provided for a period of one year. Upon the expiration of our maintenance contracts, our customers have the right to purchase maintenance contract renewals, which generally cover a period of one year. We also offer maintenance contract renewal options for up to a three-year period.

Cost of Revenues and Operating Expenses

Cost of Revenues

Cost of product revenue consists principally of compensation and related overhead expenses for employees engaged in the distribution of our products, and the cost of producing and shipping our software, including the cost of compact discs, packaging and freight, and our FastBloc^® hardware. Cost of services and maintenance revenue consists of customer support costs, training expenses and professional services expenses, including compensation and related overhead expenses. In addition, the cost of outsourcing certain services work is included in cost of services. Cost of revenues in 2006 and 2007 also includes share-based compensation allocable to production and service personnel.

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Selling and Marketing

Selling and marketing expenses consist primarily of base compensation and related overhead expenses for employees engaged in selling and marketing. Selling and marketing expenses also include sales commissions and expenses relating to advertising, brand building, marketing and trade show events (net of amounts received from sponsors and participants), product management, travel and allocated overhead. Selling and marketing expenses in 2006 and 2007 also include share-based compensation allocable to selling and marketing personnel.

Although we expense our sales commissions at the time the related sale is invoiced to the client, revenues from our EnCase^® Forensic product, Premium License Support Program and consulting, maintenance and implementation are recognized over the relevant performance or license period. Accordingly, we generally experience a delay between increased selling and marketing expenses and the recognition of a portion of the corresponding revenue.

Research and Development

Research and development expenses consist primarily of compensation and related overhead expenses for research and development personnel, translation fees, quality assurance and testing. Research and development expenses in 2006 and 2007 also include share-based compensation allocable to research and development personnel.

General and Administrative

General and administrative expenses consist of compensation and related overhead expenses for personnel engaged in the accounting, legal, information systems, human resources and other administrative functions. In addition, it includes professional service fees, other corporate expenses and related overhead. General and administrative expenses in 2006 and 2007 also include share-based compensation allocable to general and administrative personnel.

Depreciation and Amortization

Depreciation and amortization expenses consist of depreciation and amortization of our lease-hold improvements, furniture and computer equipment.

Income Tax Provision

Our income tax provision consists of expenses related to the taxable income incurred based on our tax rate as an S Corporation. We filed an election to revoke our S Corporation status on December 11, 2006. From and after the revocation of our S Corporation status, we have been treated for federal and state income tax purposes as a C Corporation and, as a result, are subject to state and federal corporate income taxes.

Share-Based Compensation

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R (“SFAS 123R”) “Share-Based Payment.” Prior to the adoption of SFAS 123R, we used the minimum-value method afforded by the Statement of Financial Accounting Standards (“SFAS”) No. 123 (“SFAS 123”) “Accounting for Stock-Based Compensation,” for disclosure purposes; therefore, as prescribed by SFAS 123R, we adopted SFAS 123R using the prospective transition method. Accordingly, prior period amounts have not been restated. Under this transition method, compensation cost for options granted prior to January 1, 2006 that vest after that date will continue to be accounted for based on the grant date intrinsic value of the option estimated in accordance with the provisions of APB 25. Since all of these options were granted at exercise prices that were equal to the fair market value of the underlying stock on the date of the grant, we will not recognize share-based compensation expense as these options continue to vest. All share-based payments granted subsequent to January 1, 2006 will be accounted for based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. The fair market value of a share-based payment is estimated on the date of the grant using the Black-Scholes option pricing model, and is recognized as compensation expense over the vesting period.

Prior to January 1, 2006, we accounted for the stock options granted under our 2004 Equity Incentive Plan by applying the intrinsic value-based method of accounting prescribed by Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” Under this method, compensation expense is generally recorded only if the fair value of the underlying stock exceeded the exercise price on the date of grant. We adopted the disclosure-only requirement of the SFAS123 and SFAS No. 148 (“SFAS 148”), “Accounting for Stock-Based Compensation—Transition and Disclosure—an Amendment of FASB Statement No. 123.” These statements established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS 123 and SFAS 148, we elected to continue to apply the intrinsic value-based method described above for stock options granted prior to January 1, 2006. Accordingly, no share-based compensation for stock options is recorded in the accompanying financial statements prior to January 1, 2006, as the fair-value of the underlying stock did not exceed the exercise price of the options at the date of grant.

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Factors Affecting Our Results of Operations

There are a number of trends that may affect our business and our industry. Some of these trends or other factors include:

• Legislative and Regulatory Developments. Our digital investigation solutions allow law enforcement agencies, government organizations and corporations to conduct investigations within the legal and regulatory framework. Historically, the implementation of new laws and regulations surrounding digital investigations has helped create demand for our products. Future changes in applicable laws or regulations could enhance or detract from the desirability of our products.

• Information Technology Budgets. Deployment of our solutions may require a substantial capital expenditure by our customers. Budgets for information technology-related capital expenditures at corporations and all levels of government organizations are typically cyclical in nature, with generally higher budgets in times of improving economic conditions and lower budgets in times of economic slowdowns.

• Law Enforcement Agency Budgets. We sell our EnCase^® Forensic products primarily to law enforcement agencies. Because of the limited nature of law enforcement budgets, funds are typically initially allocated toward solving issues perceived to be the most pressing. Sales of our products could be impacted by changes in the budgets of law enforcement agencies or in the relative priority assigned to digital law enforcement investigations.

• Number of Hacking Incidents and Spread of Malicious Software. The increasing sophistication of hacking attacks on government and private networks and the global spread of malicious software, such as viruses, worms and rootkits, have increased the focus of corporations and large government organizations on digital investigations and other aspects of network security, which has, in turn, increased demand for our products. Future changes in the number and severity of such attacks or the spread of malicious software could have an effect on the demand for our products.

• Seasonality in Revenues. We experience seasonality in our revenues, with the third and fourth quarters typically having the highest revenues for the year. We believe that this seasonality results primarily from our customers’ budgeting cycles. The federal government budget year ends in the third calendar quarter of the year and a majority of corporate budget years end in the fourth calendar quarter of the year. In addition, our customers also tend to make software purchases near the end of a particular quarter, which tends to make our revenues for a particular period unpredictable for a significant portion of the period in question until software purchase decisions have been made and license agreements have been entered into. We expect that this seasonality within a particular year and unpredictability within a particular quarterly period will continue for the foreseeable future.

Prior S Corporation Status

From our incorporation through September 1998, we were treated as a “C Corporation” under Subchapter C of the Code. In October 1998, we elected to be treated for federal income tax purposes as an “S Corporation” under Subchapter S of the Code. In addition, we also elected or may have been otherwise treated as an S Corporation for certain state tax purposes. We filed an election to revoke our S Corporation status on December 11, 2006. From and after the termination of our S Corporation status, we have been treated for federal and state income tax purposes as a C Corporation under Subchapter C of the Code and, as a result, we are subject to state and federal corporate income taxes.

We have entered into a tax matters agreement with our existing pre-IPO S Corporate stockholders to which we have agreed, among other things, to indemnify and hold harmless our existing pre-IPO S Corporation stockholders in certain circumstances for increases in their tax liability for the periods during which we were an S Corporation.

Application of Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate these estimates, including those related to percentage-of- completion, bad debts, inventories, investments, income taxes, commitments, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed 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. Actual results may differ from these estimates under different assumptions or conditions.

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We consider the following accounting policies to be both those most important to the portrayal of our results of operations and financial condition and those that require the most subjective judgment:

• revenue recognition;

• commitments and contingencies;

• allowance for doubtful accounts; and

• accounting for taxes

Revenue Recognition

We apply the provisions of Statement of Provision (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-9 “Modification of SOP 97-2, Software Revenue Recognition, with respect to certain transactions.” For arrangements that contain a non-software deliverable such as hardware, we apply the provisions of Emerging Issues Task Force (“EITF”) Issue No. 03-05 “Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software” and recognize revenue when all other revenue recognition criteria are met. While these statements govern the basis for revenue recognition, significant judgment and the use of estimates are required in connection with the allocation of revenue between product revenue and services and maintenance revenue, as well as the amount of deferred revenue to be recognized in each accounting period.

Product Revenue. The timing of product revenue recognition is dependent on the nature of the product sold. Product arrangements comprising multiple deliverables including software and hardware are generally categorized into one of the following:

• EnCase^® Enterprise Edition. Revenue associated with these arrangements, exclusive of amounts allocated to maintenance and other undelivered elements for which we have vendor-specific objective evidence (“VSOE”) of fair value, is recognized upon delivery, provided that all other criteria for revenue recognition have been met.

• EnCase^® Forensic Edition Solutions. Prior to 2005, the entire arrangement fee from governmental agencies and corporate customers was recognized as revenue ratably over the longer of the contractual maintenance period (12 months) or the implied maintenance period (12-25 months) because VSOE of fair value of the maintenance element did not exist. Beginning in early 2005, based on substantive renewal provisions, we established VSOE of the fair value of the maintenance element for solutions sold to corporate customers. Accordingly, beginning with the release of EnCase^® Forensic Edition Version 5, revenue from corporate customers, exclusive of amounts allocated to maintenance, for which we have VSOE of fair value, is recognized upon delivery, provided that all other criteria for revenue recognition have been met. We allocate EnCase^® Forensic Edition revenue to government customers, which continues to be recognized ratably, between product and services and maintenance based on our estimated fair value of the services and maintenance portion of the EnCase^® Forensic Edition revenue.

• Premium License Support Program Solutions. The Premium License Support Program is a subscription arrangement entitling the customer to receive unspecified future products and post-contract customer support for a period of several years. Revenue resulting from Premium License Support Program arrangements is recognized ratably over the contractual period beginning with the delivery of the first product.

• Hardware. Revenue associated with the sale of FastBloc^® hardware and other hardware is recognized upon shipment to the customer, provided (i) persuasive evidence of an arrangement exists, (ii) title and risk of ownership has passed to the buyer, (iii) the fee is fixed or determinable and (iv) collection is deemed probable.

Services and Maintenance Revenue. Services and maintenance revenue consists of professional services, training, and maintenance. Revenue from such services is recognized as the services are provided.

Revenue related to technical support and software updates on a when-and-if available basis, which we refer to as maintenance revenue, is also included in services and maintenance revenue. We recognize all maintenance revenue ratably over the applicable maintenance period. We determine the amount of maintenance revenue to be deferred through reference to substantive maintenance renewal provisions contained in the arrangement. We consider substantive maintenance provisions to be provisions where the cost of the maintenance renewal, stated in the contract with our customer as a percentage of the product fee, is comparable to the normal pricing for maintenance only renewals.

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Revenue Recognition Criteria. We recognize revenue when persuasive evidence of an arrangement exists, the element has been delivered, the fee is fixed or determinable and collection of the resulting receivable is probable. A discussion about these revenue recognition criteria and their applicability to our transactions follows:

• Persuasive evidence of an arrangement. We either enter into contracts or receive written purchase orders issued by the customer that legally bind us and the customer as evidence of an arrangement.

• Product delivery. We deem delivery of product to have occurred when the title and risk of ownership has passed to the buyer. Services revenue is recognized as services are delivered.

• Fixed or determinable fee. We consider the fee to be fixed or determinable if the fee is not subject to refund or adjustment and the payment terms are within its normal established practices. If the fee is not fixed or determinable, we recognize the revenue as amounts become due and payable, provided all other revenue recognition criteria have been met.

• Collection is deemed probable. We conduct a credit review for all significant transactions at the time of the arrangement to determine the credit-worthiness of the customer. Collection is deemed probable if we have a reasonable basis to expect that the customer will pay amounts under the arrangement as payments become due.

Commitments and Contingencies

We periodically evaluate all pending or threatened contingencies and commitments, if any, that are reasonably likely to have a material adverse effect on our operations or financial position. We assess the probability of an adverse outcome and determine if it is remote, reasonably possible or probable as defined in accordance with the provisions of SFAS No. 5, “Accounting for Contingencies.” If information available prior to the issuance of our financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of our financial statements, and the amount of the loss, or the range of probable loss can be reasonably estimated, then such loss is accrued and charged to operations. If no accrual is made for a loss contingency because one or both of the conditions pursuant to SFAS No. 5 are not met, but the probability of an adverse outcome is at least reasonably possible, we will disclose the nature of the contingency, if material, and provide an estimate of the possible loss or range of loss, or state that such an estimate cannot be made.

Allowances for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The allowance is established through a provision for bad debt expense. We determine the adequacy of this allowance by evaluating individual customer accounts receivable, through consideration of the customer’s financial condition, credit history and current economic conditions. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Accounting for Taxes

In preparing our consolidated financial statements, we estimate our income tax liability in each of the jurisdictions in which we operate by estimating our current tax exposure and assessing temporary differences resulting from differing treatment of items for tax and financial statement purposes. As a result of the termination of our S Corporation status, we recorded deferred tax assets, which we fully reserved. Management’s judgment will be required in assessing the realizability of this and future deferred tax assets. In performing these assessments, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. In the event that actual results differ from our estimates or we adjust our estimates in future periods, we may need to make or adjust valuation allowances with respect to our deferred tax assets. Our income tax provision is based on calculations and assumptions that may be subject to examination by the Internal Revenue Service and other authorities. Should the actual results differ from our estimates, we would have to adjust the income tax provision in the period in which the facts that give rise to the revision become known. Tax law and rate changes are reflected in the income tax provision in the period in which such changes are enacted.

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Results of Operations

The following table sets forth selected statements of operations data for each of the periods indicated expressed as a percentage of total revenues:

	Three Months Ended March 31,
	2006		2007
Revenues:
Product revenue	55.5	%	57.3	%
Services and maintenance revenue	44.5		42.7
Total revenues	100.0		100.0
Cost of revenues:
Cost of product revenue	4.3		4.2
Cost of services and maintenance revenue	23.3		25.6
Total cost of revenues	27.6		29.8
Gross profit	72.4		70.2
Operating expenses:
Selling and marketing	45.7		49.4
Research and development	13.0		11.6
General and administrative	15.3		17.6
Depreciation and amortization	3.2		4.0
Total operating expenses	77.2		82.6
Operating loss	(4.8	)	(12.4	)
Other income and expense:
Interest income	0.2		2.0
Interest expense	(0.1	)	(0.2	)
Other income, net	0.3		0.2
Loss before income taxes	(4.4	)	(10.4	)
Income tax provision	(0.1	)	(0.1	)
Net loss	(4.5	)%	(10.5	)%

The following table sets forth share-based compensation expense recorded in each of the respective periods:

	Three Months Ended March 31,
	2006		2007
Non-cash Share Based Compensation Data(1):
Cost of product revenue	$	—	$	23
Cost of services and maintenance revenue		11		164
Selling and marketing		20		243
Research and development		4		131
General and administrative		27		327
Total non-cash share based compensation	$	62	$	888

(1) Non-cash share based compensation recorded in the three month period ended March 31, 2006 and 2007 relates to stock options granted to employees measured under the fair value method. See Note 6 and 7 to the condensed consolidated financial statements.

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Comparison of Results for the Years Ended March 31, 2007 and 2006

Revenues

Revenues were $17.6 million for the three months ended March 31, 2007 compared to $11.2 million for the three months ended March 31, 2006, an increase of $6.4 million or 57.5%.

Product revenue was $10.1 million for the three months ended March 31, 2007 compared to $6.2 million for the three months ended March 31, 2006, an increase of $3.9 million or 62.6%. Revenues generated from EnCase^® Enterprise increased to $7.4 million in three months ended March 31, 2007 from $3.3 million in three months ended March 31, 2006 and was the primary reason for the increase in our product revenues. We were able to generate these increases as a result of increased selling and marketing efforts, and a significant increase in head count of commissioned sales personnel in late 2006. The first two quarters of each fiscal year is typically our period of lowest product sales due to the seasonal budgetary cycles of our customers. The third quarter is typically the strongest sales quarter to our federal government customers. Typically, sales to our corporate customers are highest in the fourth quarter.

Services and maintenance revenues were $7.5 million for the three months ended March 31, 2007 compared to $5.0 million for the three months ended March 31, 2006, an increase of $2.5 million or 51.1%. Services revenue grew primarily due to a $1.4 million increase in maintenance revenue, a $0.9 million increase in revenues from professional services, and a $0.3 million increase in training revenues. The increase in maintenance revenue is due to the increasing number customers which carry maintenance contracts. Professional services revenue increased as a result of more billable hours charged for consultation and implementations. Training increased primarily due to an increased number of class offerings during the three months ended March 31, 2007 as compared to the same period a year prior.

Cost of Revenues

Cost of revenues was $5.3 million for the three months ended March 31, 2007 compared to $3.1 million for the three months ended March 31, 2006, an increase of $2.2 million or 70.4%. Gross profit as a percentage of revenues decreased to 70.2% for the three months ended March 31, 2007 compared with 72.4% for the three months ended March 31, 2006.

Cost of product revenue was $0.7 million for the three months ended March 31, 2007 compared to $0.5 million for the three months ended March 31, 2006, an increase of $0.2 million or 56.2%. Product gross margin was 92.6% and 92.3%, respectively, for the three months ended March 31, 2007 and 2006.

Cost of services and maintenance revenue was $4.5 million for the three months ended March 31, 2007 compared to $2.6 million for the three months ended March 31, 2006, an increase of $1.9 million or 73.0%. An increase in compensation expense of $0.9 million and an increase in travel related expenses of $0.2 million were the primary reason for the increase in cost of services. In addition, facilities costs and other overhead costs increased by $0.5 million. Services and maintenance gross margin was 39.9% for the three months ended March 31, 2007 compared to 47.5% for the three months ended March 31, 2006. The decrease in services and maintenance gross margin was due to the hiring of new professional services personnel during late 2006 to meet the increase in demand for our services and services related costs associated with the release of Encase Version 6. In addition, the costs associated with our third-party maintenance renewal vendor increased by approximately $200,000 as a result of increased maintenance bookings.

Selling and Marketing

Selling and marketing expenses increased to $8.7 million for the three months ended March 31, 2007 compared to $5.1 million for the three months ended March 31, 2006, an increase of $3.6 million or 70.2%. The increase was primarily attributable to an increase in selling and marketing compensation expense for marketing personnel and commissioned sales representatives of $2.6 million. General marketing promotions and activities also increased $0.2 million. In addition, facilities costs and other overhead costs associated with selling and marketing activities increased by $0.6 million. Selling and marketing head count increased from 91 to 153 at the respective period ends. Selling and marketing expenses as a percentage of revenue increased to 49.4% for the three months ended March 31, 2007 from 45.7% for the three months ended March 31, 2006.

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Research and Development

Research and development expenses increased to $2.0 million for the three months ended March 31, 2007 compared to $1.5 million for the three months ended March 31, 2006, an increase of $0.5 million or 41.0%. Research and development compensation expense increased $0.4 million due to an increase in research and development personnel from 53 to 61 at the respective period ends to develop new product offerings, continue developing existing products and improve quality assurance. Research and development expenses as a percentage of revenue for the three months ended March 31, 2007 decreased to 11.6% compared to 13.0% for the three months ended March 31, 2006 as a result of increases in revenue exceeding increases in research and development.

General and Administrative

General and administrative expenses increased to $3.1 million for the three months ended March 31, 2007 compared to $1.7 million for the three months ended March 31, 2006, an increase of $1.4 million or 80.6%. An increase in compensation expense of $0.8 million and an increase in outside professional fees, specifically audit and legal, and insurance resulting from public company compliance requirements of approximately $0.7 million contributed to the increase in general and administrative expenses. General and administrative expenses as a percentage of revenue increased to 17.6% for the three months ended March 31, 2007 compared to 15.3% for the three months ended March 31, 2006.

Depreciation and Amortization

Depreciation and amortization expense increased to $0.7 million for the three months ended March 31, 2007 compared to $0.4 million for the three months ended March 31, 2006, an increase of $0.3 million. The primary reason for the increase in depreciation and amortization expense is due to the purchase of computer equipment for our new employees. Furthermore, as we continue to open offices around the United States and abroad, we are investing in leasehold improvements, networks and phone equipment to allow these remote offices to safely access our corporate network. Depreciation and amortization expense as a percentage of revenue increased to 4.0% for the three months ended March 31, 2007 compared to 3.2% for the three months ended March 31, 2006. In three months ended March 31, 2007, we invested in approximately $1.4 million in capital equipment and leasehold improvements as compared to $0.9 million for the three months ended March 31, 2006.

Interest Income and Interest Expense

Interest income increased to $358,000 for the three months ended March 31, 2007 compared to $25,000 for the three months ended March 31, 2006. The increase in interest income is due to the proceeds received from the initial public offering in December 2006. This increase is a result of our initial public offering in December 2006. There was no significant change in interest expense during 2006 as compared to 2005.

Income Tax Provision

The provision for income taxes increased to $25,000 for the three months ended March 31, 2007 compared to $16,000 for the three months ended March 31, 2006. The increase is primarily attributable to estimated taxes due in the United Kingdom. Although the Company receives a domestic tax credit for income taxes paid in the United Kingdom, we have established a full valuation allowance against our deferred tax assets. Accordingly, no benefit has been recognized related to our foreign tax credits.

Liquidity and Capital Resources

Since inception, we have largely financed our operations from our cash flow from operations. In December 2006, we issued and sold 3,250,000 primary shares of our common stock at $11.50 per share, for net proceeds of $34.8 million in our initial public offering. As of March 31, 2007, we had $8.9 million in cash and cash equivalents. In addition, we had $24.7 million in short term marketable debt securities.

We derive cash from operations primarily from cash collected upon the sale of our products and related services. Net cash provided by operating activities was $2.1 million for the three months ended March 31, 2007 compared with net cash used in operations of $1.1 million in the three months ended March 31, 2006. The increase in cash provided by operations principally reflects an increase in cash collected from customers due to increased sales of existing products as well as new offerings, including the release of EnCase^® Forensic Version 6 late in December 2006. Seasonally, the first quarter of our fiscal year is our strongest quarter for cash collections, which is a function of our revenue seasonality. Furthermore, during the three month period ended March 31, 2006, cash used in operations was primarily due to an overall increase in cash payments for employee compensation and increases in prepaid assets, inventory, and other current assets.

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Net cash used in investing activities was $1.4 million and $0.9 million in the three months ended March 31, 2007 and 2006, respectively. The increase in net cash used in investing activities is primarily due to capital expenditures of approximately $1.4 million for the construction and build-out of new office facilities in Pasadena, CA and Emeryville, CA, for which there was not significant comparable cash outflow in the same period one year prior. In addition, the Company continues to invest in computing and networking equipment for the growing employee base. During the three month period ended March 31, 2007, $24.7 million of United States Treasury Bills (“T-Bills”) matured and were re-invested in new short-term T-Bills.

Net cash provided by financing activities was $0.1 million for the three months ended March 31, 2007 compared with net cash used in financing activities of $1.8 million for the three months ended March 31, 2006. The increase in cash provided by financing activities was due to a cash distribution to the shareholders to cover S Corporation taxable earnings in the amount of $1.7 million during the three month period ended March 31, 2006 for which no corresponding payment was made during the same period one year later. In each of the periods, the Company also made payments to fund capital lease obligations and to pay for costs associated with our initial public offering which occurred in December 31, 2006.

We maintain a $3.0 million line of credit with a bank. This line of credit terminates on October 31, 2007. At March 31, 2007, there were no amounts outstanding against this line. This line requires we maintain certain financial covenants. As of December 31, 2006, we were in violation of certain financial covenants contained in our line of credit, which included a requirement to maintain a minimum of $1.0 million of earnings before interest, taxes, depreciation and amortization at the end of each fiscal quarter (calculated using the current quarter just ended and the preceding three fiscal quarters), and a minimum effective tangible net worth at all times equal to or greater than 75% of the net proceeds from the sale of any of our equity interests plus 50% of our annual net income. Minimum effective tangible net worth is defined as our stated net worth plus our subordinated debt and less our intangible assets. We have obtained a waiver of these violations. On May 1, 2007, we entered into a sixth amendment to our credit facility which removed the financial ratio and earnings requirements. However, the amendment does require the Company to maintain cash, cash equivalents, and marketable securities of not less than $10 million, and not allow a cumulative net loss (excluding non-cash shareholder compensation) in excess of $4 million during any one fiscal year

Contractual Obligations

At March 31, 2006, our outstanding contractual cash commitments were limited to our non-cancelable lease obligations, primarily relating to real estate. As part of our Annual Report on Form 10-K, we previously reporting in Part II,Management’s Discussion and Analysis of Financial condition and Results of Operations, that our contractual obligation for these non-cancelable lease obligations as of December 31, 2006 were approximately $22.6 million, of which $3.8 million was due during fiscal year 2007. We entered into two new office leases during the first quarter of 2007 which increased our total contractual cash commitments by $1.4 million. Furthermore, these additional leases increased the amount of cash payments due within fiscal year 2007 by $155,000.

We adopted Financial Interpretation No. 48, “Accounting for Uncertainly in Income Taxes” as of January 1, 2007. As of adoption, the total amount of tax positions that we have determined to be uncertain was $130,000. The timing of payments for this obligation will depend on the progress of examinations, if any, with the taxing authorities. We do not expect a significant tax payment related to these obligations within the next year. The liability as of March 31, 2007 was not materially different from the liability at the date of adoption.

At March 31, 2007, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, special-purpose, or variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we did not engage in trading activities involving non-exchange traded contracts.

Uncertain Tax Positions

The company adopted the provisions of FIN 48 on January 1, 2007. As a result of the adoption of FIN 48, the company performed a comprehensive review of its uncertain tax positions in accordance with standards established by FIN 48. In this regard, an uncertain tax position represents the company’s expected treatment of a tax position taken in a filed tax return, or planned to be taken in a future tax return, that has not been reflected in measuring income tax expense for financial reporting purposes. As a result of this review, the company recorded uncertain tax positions by recognizing additional liabilities totaling $130,000 through a charge to retained earnings. The liability for uncertain tax positions is recorded in other liabilities in the consolidated condensed balance sheet as of March 31, 2007. If the company’s positions are sustained by the taxing authorities in favor of the Company, amounts previously recorded as liabilities would reduce the company’s effective tax rate. The company does not expect any reasonably possible material changes to the estimated amount of liability associated with its uncertain tax positions through January 1, 2008.

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Recent Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and 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 (the “fair value option”). Unrealized gains and losses, arising subsequent to adoption, are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is required to adopt SFAS 159 in the first quarter of 2008. The Company is currently assessing the impact of SFAS 159 on its consolidated financial statements.

Item 3. Quantitative and Qualitative Disclosure about Market Risk

Although we currently bill for our products and services mostly in U.S. dollars, our financial results could be affected by factors such as changes in foreign currency rates or weak economic conditions in foreign markets. A strengthening of the dollar could make our products and services less competitive in foreign markets and therefore could reduce our revenues. We are billed by and pay substantially all of our vendors in U.S. dollars. In the future, an increased portion of our revenues and costs may be denominated in foreign currencies. To date, exchange rate fluctuations have had little impact on our operating results. We do not enter into derivative instrument transactions for trading or speculative purposes.

Fixed income securities are subject to interest rate risk. The fair value of our investment portfolio would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due mainly to the short-term nature of the major portion of our investment portfolio. The portfolio is invested in United States Treasury Bills.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated can provide only reasonable assurance of achieving the desired control objectives and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Rule 13a-15(b) under the Exchange Act, we conducted an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon the foregoing evaluation, our principal executive officer and our principal financial officer concluded that as of March 31, 2007, our disclosure controls and procedures were operating effectively.

Changes in our internal controls

During the quarter ended March 31, 2007, we made material changes in our internal controls as described below:

• We hired additional experienced accounting personnel in an effort to increase the experience level within our accounting department, including the hiring of a new accounts payable manager and accounting manager.

• We modified our general ledger reporting structure to reduce the number of accounts to which we record journal entries. These changes have enabled us to focus more time on the review and analysis of the financial information we report.

For the period ended March 31, 2007, management was not required to and did not perform an evaluation of our internal controls over financial reporting.

PART II OTHER INFORMATION

Item 1. Legal Proceedings

From time to time, we may become involved in various lawsuits and legal proceedings that arise in the ordinary course of business. Litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. We are not currently aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse effect on our business, financial condition or operating results.

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In early January 2006, the Federal Trade Commission (the “FTC”) commenced an inquiry into the December 2005 security breach discussed in “Risk Factors—Computer hackers may damage our products, services and systems, which could cause interruptions in our service and harm to our business, and hackers could gain access to our customers’ personal information which could result in the loss of existing clients, negative publicity and legal liability.” On September 20, 2006, we executed a consent decree proposed by the FTC that includes no monetary penalties. The consent decree finds that we failed to implement proper security measures to protect consumers’ data, and requires us to provide the FTC with initial and biennial third-party assessments of our IT security for a period of 10 years. Additionally, the consent decree requires us to maintain a comprehensive IT security program, retain documentation of such program and provide notice of the consent decree to our executives and employees for a period of 20 years. The FTC formally approved the consent decree on November 15, 2006, and subsequently issued a press release announcing the investigation and its conclusion. Following the FTC press release, there commenced a public comment period of 30 days. On March 30, 2007 we received final notification from the FTC that the decree has become effective and the matter is formally concluded.

Item 1A. Risk Factors

You should consider each of the following factors as well as the other information in this Quarterly Report as well as our Annual Report in evaluating our business and our prospects. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our business operations. If any of the following risks actually occurs, our business and financial results could be harmed. In that case, the trading price of our common stock could decline. You should also refer to the other information set forth in this Quarterly Report, including our financial statements and the related notes.

Our operating results may fluctuate from period to period and within each period, which makes our operating results difficult to predict and could cause our revenues, expenses and profitability to fall short of expectations during certain periods.

Our operating results may fluctuate from period to period or within certain periods as a result of a number of factors, many of which are outside of our control. You should not rely on our past results as an indication of future performance, as our operating results in the future may fall below expectations, expenses could increase and revenues could decrease. Each of the risks described in this section, as well as other factors, may affect our operating results. For example, our quarterly revenues and operating results may fluctuate as a result of a variety of factors, including, but not limited to, our lengthy sales cycle, the proportion of revenues attributable to license fees versus services and maintenance revenue, changes in the level of fixed operating expenses, demand for our products and services, the introduction of new products and product enhancements or upgrades by us or our competitors, changes in customer budgets and capital expenditure plans, competitive conditions in the industry and general economic conditions. In addition, many customers make major software acquisitions near the end of their fiscal years, which tends to cause our revenues to be higher in the third and fourth calendar quarters, the fiscal year ends of many government agencies and corporations, and lower in the first calendar quarter. In addition, many customers tend to make software acquisitions or purchases near the end of a particular quarter, which tends to make our revenues for a particular period unpredictable for a significant portion of the period in question until software purchase decisions have been made. Since our EnCase^® Enterprise product sales are generally large scale license agreements, a short delay in just one of these software sales from one quarter into a subsequent quarter or a loss of one of these potential sales could cause us to deliver results for a quarter that are below projections of securities analysts that follow our results. This could cause our stock price to decline significantly. There can be no assurance that we will be able to successfully address these risks, and we may not be profitable in any future period.

If the corporate market for digital investigation software were not to develop, we would not be able to maintain our growth, and our revenues and results of operations would be adversely affected.

The market for digital investigation software is new and is being developed largely through our efforts. Our growth is dependent upon, among other things, the size and pace at which the market for such software develops. If the market for such digital investigation software decreases, remains constant or grows more slowly than we anticipate, we will not be able to maintain our recent rate of growth. Continued growth in the demand for our products is uncertain resulting from, among other things, the fact that:

• customers and potential customers may decide to use traditional methods of conducting enterprise investigations, such as reliance on in-house professionals or outside consultants to conduct manual investigations;

• customers may experience technical difficulty in utilizing digital investigation software or otherwise not achieve their expected return on their investment in such software; and

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• marketing efforts and publicity related to digital investigation software may not be successful.

Even if digital investigation software gains wide market acceptance, our software may not adequately address market requirements and may not continue to gain market acceptance. If digital investigation software generally, or our software specifically, do not gain wide market acceptance, we may not be able to maintain our recent rate of growth and our revenues and results of operations would be adversely affected.

The failure of the legal community to adopt our eDiscovery Suite solution could negatively affect future sales of EnCase^® Enterprise, which could have a material adverse effect on our results of operations.

We expect to derive a significant amount of sales of EnCase^® Enterprise from continuing demand for our EnCase^® eDiscovery Suite solution. However, widespread adoption of eDiscovery best practices will require a shift in the way the legal community approaches discovery of electronic documents and other electronically stored data. Currently, most large scale electronic discovery projects are conducted by outsourced service providers that manually retrieve documents from each computer subject to review. These service providers have longstanding and entrenched relationships with the corporations that are subject to large-scale discovery inquiries or security breaches and the large law firms that are typically retained in connection with such discovery projects. Corporations and law firms may continue to prefer to use service providers because of these ongoing established relationships, and because the service providers are widely known and accepted within the legal community and may resist adoption of our EnCase^® eDiscovery Suite solution. Moreover, the expense of relying on an outsourced service provider may frequently be covered by the corporation’s insurance policy that is otherwise covering the expense of the litigation, including complying with requests for discovery, while implementation of EnCase^® Enterprise and our EnCase^® eDiscovery Suite would require a significant unreimbursed capital expenditure by the corporation. The failure of corporations and law firms to adopt our EnCase^® eDiscovery Suite or our solutions to be used for eDiscovery could have a material adverse effect on our sales and results of operations.

Courts could reject the use of our products, which would harm our reputation and negatively affect future sales of our products and services.

Our software products and services are often used in connection with legal investigations, civil litigation and criminal prosecutions. The admissibility of results generated by our products as evidence in civil and criminal trials is a key component of our customer value proposition. Evidence and the manner used to collect evidence is regularly the subject of challenges in legal investigations and litigation, and our products or personnel may be the direct or indirect subject of such legal challenges. Persons involved in litigation may, for example, challenge the reliability of our products, the admissibility of evidence generated, discovered or collected using our products, and/or the expertise, credibility or reliability of our personnel. Other unpredictable legal challenges may be brought that could reflect upon the reputation of our products or personnel. To date, courts that have addressed challenges to our products or services have ruled against such challenges. If in the future a court were to find that our products are not reliable or that persons representing us or users of our product are not credible, reliable or lack the expertise necessary to serve as a witness or to authenticate evidence, or that our training and certification process does not adequately prepare individuals to conduct competent digital investigations, this could have a material adverse impact on our revenues and results of operations.

We are dependent on our management and research and development teams, and the loss of any key member of either of these teams may prevent us from executing our business strategy.

Our future success depends in a large part upon the continued services of our executive officers and other key personnel. In particular, Shawn McCreight, our founder, Chairman and Chief Technology Officer, has been significantly responsible for the development of our products. In addition, John Colbert, our Chief Executive Officer, has been responsible for a number of our significant strategic initiatives. We are also substantially dependent on the continued services of our existing research and development personnel. We have fewer research and development employees than many competitors of comparable size due to the high degree of expertise required to work with our complex technology and our stringent hiring standards. The loss of one or more of our key employees, and in particular our research and development personnel, could seriously harm our business development, culture and strategic direction. We do not maintain key person life insurance policies on any of our executives. Any key person life insurance policy we maintain now or in the future would not be sufficient to cover the loss of any of our key personnel and any such loss could seriously harm our business and our ability to execute our business strategy.

Changes or reforms in the law or regulatory landscape could diminish the need for our solutions, and could have a negative impact on our business.

One factor that drives demand for our products and services is the legal and regulatory framework in which our customers operate. Laws and regulations are subject to drastic changes and these could either help or hurt the demand for our products. Thus, certain changes in the law and regulatory landscape, such as tort law or legislative reforms that limit the scope and size of electronic discovery requests or the admissibility of evidence generated by such requests, as well as court decisions, could significantly harm our business. Changes in domestic and international privacy laws could also affect the demand and acceptance of our products, and such changes could have a material impact on our revenues.

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We face direct and indirect competition from other software companies, as well as other companies that provide training, consulting and certification services in computer forensics, which could limit our growth and market share.

The markets for our software products and services are competitive, highly fragmented and subject to rapidly changing technology, shifting customer needs and frequent introductions of new products and services. We expect the intensity of competition to increase in the future as new companies enter our markets, existing competitors develop stronger capabilities and we expand into other markets. Many of our current competitors have longer operating histories, greater name recognition, access to larger customer bases and substantially more extensive resources than we have. They may be able to devote greater resources to the development, promotion and sale of their products than we can to ours, which could allow them to respond more quickly than we can to new technologies and changes in customer needs and achieve wider market acceptance. Because the barriers to entry into software industry segments are generally low, we expect to continue to face competition from new entrants, particularly as we expand into other segments of the software industry.

Several competing companies provide digital investigation software and applications that directly compete or will compete with our products, or offer solutions our products do not address. In addition, if the market for digital investigation software develops as we anticipate, other companies could enter this market through their own software development or through the acquisition of one of our current competitors. If these companies are more successful in providing similar, better or less expensive digital investigation solutions compared to those that we offer, we could experience a decline in customers and revenue. These companies include computer forensic companies, managed security services companies and consulting companies, such as the “Big 4” consulting/accounting firms, many of which have substantially greater resources and customer bases than we do. If our competitors are more successful than we are at generating professional services engagements, our growth rate or revenues may decline.

We also compete with companies or organizations that have developed or are developing and marketing software and services that diminish the need for our solutions or the budget available to our customers to purchase our solutions. These companies include traditional security companies, data storage infrastructure companies and internal IT organizations that develop their own security systems. We also compete indirectly with providers of corporate insurance to the Global 2000, whose policies in question permit and pay for the use of consulting and other services to defend in litigation but not the purchase of digital investigation software to enhance the overall capabilities for a company.

Computer hackers may damage our products, services and systems, which could cause interruptions in our service and harm to our business, and hackers could gain access to our customers’ personal information which could result in the loss of existing clients, negative publicity and legal liability.

Computer hackers often attempt to access information, including personal information for purposes of identify theft and other criminal activity. In particular, due to the nature of our business, the products and services that we offer and the industry in which we operate, we are more likely to be the target of computer hackers who would like to undermine our ability to offer the products and services that we provide to our customers and possibly retaliate for the results or evidence that our products and services generate.

For example, in December 2005, we became aware of a security breach of our electronic records which contained, among other things, credit card information of approximately 5,000 customers. We promptly notified law enforcement authorities as well as each of the customers whose information may have been compromised. We conducted a forensic examination of the incident and took a number of steps to both remediate the underlying cause and strengthen our internal security system, including enhancing our internal information technology security department and redesigning our network architecture.

In early January 2006, the Federal Trade Commission (the “FTC”) commenced an inquiry into the December 2005 security breach. On September 20, 2006, we executed a consent decree proposed by the FTC that includes no monetary penalties. The consent decree finds that we failed to implement proper security measures to protect consumers’ data, and requires us to provide the FTC with initial and biennial third party assessments of our IT security for a period of 10 years. Additionally, the consent decree requires us to maintain a comprehensive IT security program, retain documentation of such program and provide notice of the consent decree to our executives and employees for a period of 20 years. The FTC formally approved the consent decree on November 15, 2006 and subsequently issued a press release announcing the investigation and its conclusion. Following the FTC press release, there commenced a public comment period of 30 days. On March 30, 2007, we received final notification from the FTC that the decree has become effective and the matter is formally concluded.

In addition, several customers who were notified have sought compensation, which in each case has been satisfied by payment of amounts which are not material to us. One customer has commenced litigation against us, which was dismissed by a federal court but may be refiled in state court. In connection with this breach, we have paid $11,500 in fines to credit card processing

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companies. However, we may still face additional legal and administrative action with respect to the incident. In addition, the incident received publicity and could adversely affect our ability to retain and attract customers. Given the incident, any subsequent breach of our security could be especially damaging to our reputation and business and may result in monetary penalties if the FTC were to find that the circumstances that lead to the breach constituted a violation of our obligations under the consent decree.

In addition, from time to time we may be targets of computer hackers who, among other things, create viruses to sabotage or otherwise attack companies’ networks, products and services. For example, there was recently a spread of viruses, or worms, that intentionally deleted anti-virus and firewall software. Our products, networks, websites and systems, may be the target of attacks by hackers. If successful, any of these events could damage our computer systems, force us to incur substantial costs to fix technical problems or result in hackers gaining access to our technical and other proprietary information, which could harm our business and results of operations.

If we fail to develop or maintain an effective system of internal controls, we may not be able to accurately or timely report our financial results or prevent fraud. As a result, current and potential stockholders could lose confidence in our financial reporting, which would harm our business and the trading price of our common stock.

Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud and to operate successfully as a public company. If we cannot provide reliable financial reports or prevent fraud, our reputation and operating results would be harmed. We have in the past discovered, and may in the future discover, areas of our internal controls that need improvement.

In November 2006, in conjunction with the audit of our financial statements for the nine months ended September 30, 2006, our independent registered public accounting firm reported to our audit committee “material weaknesses” in our internal controls of financial reporting. In addition, in connection with the audit of our financial statements for the year ended December 31, 2005, in July 2006, our independent registered public accounting firm reported to our audit committee several matters that are “material weaknesses” in our internal controls over financial reporting. A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

The material weaknesses reported by our independent registered public accounting firm in connection with their audit of our financial statements for the nine months ended September 30, 2006, are summarized below:

• We did not have adequate controls to provide reasonable assurance that revenue was being recorded in accordance with generally accepted accounting principles. The inadequate controls resulted in the premature recognition of revenue that should have been deferred to a later period, in accordance with AICPA Statement of Position 97-2, Software Revenue Recognition (“SOP 97-2”) and AICPA Technical Practice Aid, TIS Section 5100.69. Specifically, in the third quarter of 2005, we improperly recognized revenue in the amount of $244,000 prior to delivery of the related products. As a result of this error, an adjustment was recorded to our books and records and financial statements to defer revenue previously recorded during the quarter ended September 30, 2005 until the quarter ended December 31, 2005. The error resulted in a restatement of the previously reported quarterly results. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Accounting Restatements.”

• We did not have adequate controls and procedures to assure proper accounts payable accruals for services rendered and billed but not yet paid, and, as a result, we recorded post-closing adjustments to our books and records and financial statements for the nine months ended September 30, 2006.

In conjunction with the audit of our financial statements for the twelve months ended December 31, 2006 our independent registered public accounting firm noted that the internal controls put in place had not yet remediated the above material weakness.

The material weaknesses reported by our independent registered public accounting firm in connection with their audit of our financial statements for the year ended December 31, 2005, are summarized below:

• We did not have personnel within our accounting function that possessed an appropriate level of experience in the selection and application of GAAP to provide reasonable assurance that transactions were being appropriately recorded. Additionally, the training of employees and written communication regarding duties and control responsibilities was inadequate to ensure that processes and control activities were being carried out effectively.

• We did not have adequate controls to provide reasonable assurance that all elements of contractual arrangements with customers were being recorded in accordance with GAAP. Specifically, we did not have adequate controls to properly

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determine the frequency of upgrades and enhancements. Significant errors involved customer contracts consisting of multiple elements, such as license, professional services and maintenance fees. Errors in allocating revenue among these elements resulted in the premature recognition of revenue that should have been deferred to later periods, in accordance with SOP 97-2 and related interpretations. As a result of these identified deficiencies, material revenue-related post-closing adjustments were recorded to our financial statements to defer revenue from the periods in which they were originally recorded until such time as the appropriate revenue recognition criteria were met. In addition, other revenue recognition related errors were identified resulting primarily from a lack of secondary review over the application of accounting principles to specific contract terms as well as the analysis and estimates supporting the amounts recorded. These errors resulted from the lack of a systematic process for accumulating information underlying recorded revenue as well as the lack of appropriate levels of review.

• We did not have adequate controls and procedures with respect to the reconciliation of general ledger account balances to supporting detail; recording and analysis of certain accounts, including capitalized software development costs, lease transactions, accounts payable, stock compensation, asset disposals; and documentation of non-routine transactions. As a result of these material weaknesses, we recorded material post-closing adjustments to our financial statements.

In 2006, we began our remediation efforts and we believe that our actions in this regard have strengthened our internal controls over financial reporting. Although initiated, our plan to improve the effectiveness of our internal controls and processes is not complete. It will take some time to put in place the rigorous disclosure controls and procedures desired by our management and our board of directors. While we expect to complete this remediation process as quickly as possible, doing so depends on several factors beyond our control, including the hiring of additional qualified personnel and, as a result, we cannot at this time estimate how long it will take to complete the steps identified above. Our management will continue to evaluate the effectiveness of the control environment and will continue to refine existing controls. We cannot make assurances that the measures we have taken to date or any future measures will remediate the material weaknesses reported by our independent registered public accounting firms. Additional deficiencies in our internal controls may be discovered in the future. Any failure to develop or maintain effective controls, or any difficulties encountered in their implementation or improvement, could harm our operating results or cause us to fail to meet our reporting obligations and may result in a restatement of our prior period financial statements. Ineffective internal controls could also cause investors to lose confidence in our reported financial information, which would likely have a negative effect on the trading price of our common stock.

We also have not yet implemented a complete disaster recovery plan or business continuity plan for our accounting and related information technology systems. Any disaster could therefore materially impair our ability to maintain timely accounting and reporting.

We face risks related to our accounting restatements, including negative publicity, which could harm our business and reputation and cause the value of our common stock to decline.

In connection with the audit of our financial statements for the period ended September 30, 2006, we discovered that we had not properly applied certain accounting guidance contained in American Institute of Certified Public Accountants Statement of Position (SOP) 97-2, Software Revenue Recognition. Specifically, we had improperly recognized revenue prior to delivery of the related products in the third quarter of 2005. We restated the unaudited quarterly data for the three months ended September 30, 2005 and December 31, 2005, presented in Note 17 to the consolidated financial statements filed in conjunction with our Registration Statement on Form S-1, to correctly recognize revenue upon delivery (the “2005 Restatement”). The 2005 Restatement resulted in a decrease to revenue and net income for the three months ended September 30, 2005 and a corresponding increase to revenue and net income for the three months ended December 31, 2005.

In connection with the audit of our 2005 financial statements and the identification of material weaknesses previously described above, we discovered accounting inaccuracies in our previously audited financial statements and accordingly restated our results with regard to the year ended December 31, 2004 and prior years. We determined that we had not properly applied certain accounting guidance contained in Statement of Position (“SOP”) 97-2 “Software Revenue Recognition” and related interpretations. The improper application of these principles resulted in the premature recognition of revenue that should have been deferred to later periods.

In addition, during 2004, we incorrectly applied the provisions of Statements of Financial Accounting Standards (“SFAS”) No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed.” Specifically, we capitalized software development costs that should have been expensed. Our restated 2004 consolidated financial statements reflect additional research and development expense which had previously been capitalized.

If we are required to restate our financial statements in the future, we may be the subject of negative publicity focusing on the financial statement inaccuracies and resulting restatement. In addition, our financial results as restated may be more adverse than

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originally reported. In the past, certain publicly traded companies that have restated their financial statements have been subject to shareholder actions. The occurrence of any of the foregoing could harm our business and reputation and cause the price of our common stock to decline after this offering.

Our operating results and business would be seriously impaired if our revenues from our EnCase^® Enterprise product were to decline.

Historically, we have derived substantially all of our license revenues from sales of our EnCase^® Forensic and EnCase^® Enterprise product offerings. Although we have introduced new software modules, we expect that our EnCase^® Enterprise product offering will account for the largest portion of our software product for the foreseeable future. Although we have no reason to believe that sales of EnCase^® Forensic will decline in future periods, we believe that the degree of penetration for our EnCase^® Forensic product in the law enforcement market makes it unlikely that revenue from sales of EnCase^® Forensic will contribute dramatically to future revenue growth. For this reason, we are dependent on increased sales of EnCase^® Enterprise to drive future growth.

As a result, if for any reason revenue from our EnCase^® Enterprise product offerings declines or does not increase as rapidly as we anticipate, our operating results and our prospects for growth will be significantly impaired. Further, if these products fail to meet the needs of our existing and target customers, or if they do not compare favorably in price and performance to competing products, our business will be adversely affected.

We may be limited in our ability to utilize indirect sales channels, such as value-added resellers, corporate resellers, professional services firms and other third-party distributors for the sale and distribution of our products, which may limit our ability to expand our customer base and our revenues.

We may be limited in our ability to market and distribute our products through value-added resellers, corporate resellers, professional services firms and other third-party distributors, which we collectively refer to as third-party resellers, due to various factors. Due to the complex nature of our products, sales professionals generally require a significant amount of time and effort to become sufficiently familiar with our products in order to be able to market them effectively, which makes our products unattractive to third-party resellers. In addition, our competitors include professional services organizations, such as accounting, consulting and law firms, that would otherwise serve as a natural distribution channel for our products and related services.

Moreover, there is significant competition in our industry for qualified third-party resellers. Even if we were to succeed in attracting qualified and capable third-party resellers, we would likely have relatively short-term contracts and no minimum purchase commitments with any existing and future third-party resellers. In addition, agreements with such third-party resellers are generally renewable annually, not exclusive and may be terminated by either party within 30 days after the initial six-month period of the agreement, and with 30 days notice after the initial one-year period. If we are not able to recruit new qualified third-party resellers, our sales growth may be constrained and our results of operations would suffer.

Our intellectual property rights are valuable, and if we are unable to protect our proprietary technologies and defend infringement claims, we could lose our competitive advantage and our business could be adversely affected.

Our success depends in part on our ability to protect our proprietary products and services and to defend against infringement claims. If we are unable to do so, our business and financial results may be adversely affected. To protect our proprietary technology, we rely upon a combination of copyright, patent, trademark and trade secret law, confidentiality restrictions in contracts with employees, customers and other third parties, software security measures, and registered copyrights, trademarks and patents. If we fail to protect our intellectual property rights adequately, our competitors may gain access to our technology, and our business may be harmed. Any of our patents, trademarks, copyrights or other intellectual property rights may be challenged by others or invalidated through administrative process or litigation proceedings. In addition, we may be unable to obtain patent, copyright or trademark protection on products that we spend significant time and expense to develop in the future. Despite our efforts to protect our proprietary technology, unauthorized persons may be able to copy, reverse engineer or otherwise use some of our proprietary technology. Furthermore, existing patent and copyright laws may afford only limited protection, and the laws of certain countries in which we operate do not protect proprietary technology as well as established law in the United States. For these reasons, we may have difficulty protecting our proprietary technology against unauthorized copying or use. If any of these events happen, there could be a material adverse effect on the value of our proprietary technology and on our business and financial results. In addition, litigation may be necessary to protect our proprietary technology. This type of litigation is often costly and time-consuming, with no assurance of success.

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Claims that we misuse the intellectual property of others could subject us to significant legal liability and disrupt our business, which could have a material adverse effect on our financial condition and results of operations.

Because of the nature of our business, we may become subject to material claims of infringement by competitors and other third parties with respect to our current or future software applications, trademarks or other proprietary rights. The legal framework for software patents is rapidly evolving and we expect that software developers will increasingly be subject to infringement claims as the number of software applications and competitors in our industry segment grows. In certain circumstances, the owners of proprietary software could make copyright and/or patent infringement claims against us in connection with such activity. Any such claims, whether meritorious or not, could be time consuming and difficult to defend against, result in costly litigation, cause shipment delays or require us to enter into royalty or licensing agreements with third parties, which may not be available on terms that we deem acceptable, if at all. Any of these claims could disrupt our business, make it difficult to add or retain important features in our products and have a material adverse effect on our financial condition and results of operations.

If we are unable to continue to obtain government licenses, approvals or authorizations regarding the export of our products abroad, or if current or future export laws limit or otherwise restrict our business, we could be prohibited from shipping our products to certain countries, which could negatively impact our business, financial condition and results of operations.

We must comply with United States laws regulating the export of our products to other countries. Our products contain encryption and decryption technologies that require us to obtain certain licenses from the United States government in order to export certain of our products abroad. In addition, we are required to obtain licenses from foreign governments in order to import our products into these countries. We cannot assure you that we will be successful in obtaining such licenses, approvals and other authorizations required from applicable governmental authorities to export our products. The export regimes and the governing policies applicable to our business are subject to change, and we cannot assure you that such export approvals or authorizations will be available to us or for our products in the future. Our failure to receive any required export license, approval or authorization would hinder our ability to sell our products and could negatively impact our business, financial condition and results of operations.

We have grown rapidly, and if we are not able to effectively manage and support our growth or retain and attract highly skilled employees, our business strategy might not succeed.

In the past we have grown rapidly and we will need to continue to grow in all areas of our operations to execute our business strategy. Managing and sustaining our growth will place significant demands on management as well as on our administrative, operational, technical and financial systems and controls and other resources. We may not be able to expand our product offerings, our customer base and markets, or implement other features of our business strategy at the rate or to the extent presently planned. In addition, our traditionally high level of customer service may suffer as we grow, which could cause our software sales to suffer. If we are unable to successfully manage or support our future growth, we may not be able to maximize revenues or profitability.

In addition, in order to be able to effectively execute our rapid growth plan, we must attract and retain highly qualified personnel. We will need to hire additional personnel in virtually all operational areas, including selling and marketing, research and development, professional services, training, customer service and administration. Competition in our industry for experienced and qualified personnel in these areas is extremely intense, especially for software developers with high levels of experience in designing and developing software products and sophisticated technical sales people experienced in selling our complex type of software product and selling into government agencies. In order to expand sales of EnCase^® Enterprise, we must continue to hire highly qualified commissioned sales personnel to directly target potential EnCase^® Enterprise customers. These new commissioned sales personnel require several quarters of training and experience before being able to effectively market EnCase^® Enterprise, and, as a result of these hires, our sales and marketing expense will increase at a greater rate than our revenue, at least in the short term. The expense of hiring and training these commissioned sales personnel may never generate a corresponding increase in revenue. We may not be successful in attracting and retaining the necessary qualified personnel that our growth plan requires. We have from time to time in the past experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. Many of the companies with which we compete for experienced personnel have greater resources than we have. If we fail to attract new personnel or retain and motivate our current personnel, our business and future growth prospects could be severely harmed.

We also believe that a critical contribution to our successful rapid growth has been our corporate culture which fosters innovation, teamwork and excellence. As our organization grows and we are required to implement more complex organizational structures and institutional programs, we may find it difficult to maintain the beneficial aspects of our corporate culture, which could negatively affect our ability to attract and retain qualified and experienced personnel and therefore our future success in continuing to maintain our rapid growth.

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Our failure to offer high quality training and to attract and retain high quality training personnel could have a material adverse effect on our sales of software applications and therefore have a negative impact on our business, financial condition and results of operations.

Our services offerings include training programs designed to instruct current and potential customers on the proper process of conducting a competent digital investigation and the most efficient operation of our products. To a significant degree, the pool of potential users of our products is created by the training services we and our partners provide. A high level of training is critical for the successful marketing, sale and implementation of our software products. Finding qualified third-party providers of training services for our complex software products is difficult and time-consuming, and to date we have approved only five such providers. If we or our partners do not effectively train our customers to properly use our software applications, or succeed in helping our customers quickly resolve post-deployment issues, it would adversely affect our ability to sell additional software products to existing customers in the future and could harm our reputation with potential customers of software products. As a result, our failure to attract and maintain high quality training representatives and personnel would have a material adverse effect on our sales of software applications and therefore negatively impact our business, financial condition and results of operations.

Our software applications may be perceived as, or determined by the courts to be, a violation of privacy rights. Any such perception or determination could adversely affect our revenues and results of operations.

Because of the nature of digital investigations, our potential customers and purchasers of our products or the public in general may perceive that use of our products for these investigations result in violations of individual privacy rights. In addition, certain courts, legislative and regulatory authorities could determine that the use of our software solutions or similar products are a violation of privacy rights, particularly in jurisdictions outside of the United States. Any such determination or perception by potential customers, the general public, government entities or the judicial system could harm our reputation and adversely affect the sales of our products and our results of operations.

Our business could be adversely affected based on the fact we have chosen to enter into United States General Services Administration (GSA) contracts as a procurement vehicle for federal government agencies that purchase certain of our products and services. These GSA contracts require that we provide our best corporate prices to the government agencies and give the government agencies the right to conduct administrative audits of our performance under such GSA contracts. If we have an unfavorable administrative audit we may be required to reimburse the United States government for costs that they have expended under such contracts and our ability to bid and compete for future contracts with government agencies may be materially impaired.

We have chosen to enter into GSA contracts in connection with the sale of certain of our products and services. These GSA contracts are intended to facilitate efficient sales to government agencies and provide the government agencies with “most-favored nation” type pricing for the respective products and services on a comparable basis with sales to other third parties. In addition, the GSA and government agencies which purchase our products and services pursuant to GSA contracts are permitted to conduct administrative audits of us as part of their routine audits and investigations of government contracts. For example, the GSA conducted an audit of Guidance for 2005 and issued to us an administrative report card with a rating of “successful.” In addition, the GSA has provided notice that it will conduct an administrative audit for 2006. As part of the audit process, the GSA or a government agency may review our performance under the contract, cost structure, including the cost of comparable products and services to third parties, and compliance with applicable laws, regulations and standards. The GSA or a government agency may also review the adequacy of, and our compliance with, our internal controls systems and policies, including our purchasing, property, estimating, compensation and management information systems. If any of our pricing is found to be improperly discounted to a specific contract, the revenue received by us may have to be refunded and an additional penalty may have to be paid by us.

A future audit with unfavorable results could materially affect our competitive position and result in a material adjustment to our financial results. In addition, if a GSA or government agency audit uncovers improper or illegal activities on our part, we may be subject to civil and criminal penalties and administrative sanctions, including, but not limited to, termination of existing contracts, forfeiture or disgorgement of profits, suspension of future payments owed, fines and suspension from doing future business with the federal government through the GSA. Furthermore, our reputation could suffer serious or irreparable harm if allegations of impropriety were levied against us. If we were suspended from contracting through the GSA, our reputation or relationships with federal government agencies were impaired, or the GSA or these agencies otherwise ceased doing business with us or significantly decreased the amount of business they do with us, our revenues and prospects would be materially harmed.

In December, 2006, the Company entered into a Government Reseller Agreement with immixTechnology, to sell the Company’s products via the immixTechnology General Services Administration (GSA) contract to government customers. The Company expects that the use of the immixTechnology GSA contract will facilitate future business and enable the Company to benefit from industry best practices of selling to the government.

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Our business could be adversely affected based on the fact that we are subject to the compliance requirements of various government agencies that perform periodic audits. These audits require the Company to disclose its business practices as they relate to the respective government regulations. Adverse audit result by a government agency may damage our reputation and require the Company to pay penalties or fines.

We conduct our business under the rules and regulations of various government agencies. From time to time, these agencies perform audits to determine whether or not we are in compliance with their specific rules or regulations. An adverse audit result from one of these agencies may damage our reputation. In addition, fines, penalties, or lawsuits resulting from an adverse audit result could cause our expenses to increase.

For example, during April 2007, the Office of Federal Contract Compliance Programs Office of Federal Contract Compliance Programs (“OFCCP”) notified the Company that its Pasadena location had been selected for a compliance review. In addition to possible technical violations that carry no monetary exposure, if the Company were unable to successfully defend its selection or compensation decisions, certain applicants or employees could be entitled to make-whole relief, including back pay and offers of employment. The Company is currently in the process of preparing its plan for submission in regard to this audit. As the audit is in its initial stage, the outcome of this matter is not known, however, management does not believe its resolution will have a material, adverse effect on the Company’s financial condition.

Our business depends, in part, on sales to governments and governmental entities and significant changes in the contracting or fiscal policies of governments and governmental entities could have a material adverse effect on our business.

We derive a portion of our revenues from contracts with federal, state, local and foreign governments and government agencies, and we believe that the success and growth of our business will continue to depend on our successful procurement of government contracts. Accordingly, changes in government contracting policies or government budgetary constraints could directly affect our business, financial condition and results of operations. Among the factors that could adversely affect our business, financial condition or results of operations are:

• changes in fiscal policies or decreases in available government funding;

• changes in government programs or applicable requirements;

• the adoption of new laws or regulations or changes to existing laws or regulations;

• changes in political or social attitudes with respect to security issues, computer crimes, discovery of computer files and digital investigations;

• potential delays or changes in the government appropriations process; and

• delays in the payment of our invoices by government payment offices.

These and other factors could cause governments and governmental agencies to refrain from purchasing the products and services that we offer in the future, the result of which could have an adverse effect on our business, financial condition and results of operations. In addition, many of our government customers are subject to stringent budgetary constraints. The award of additional contracts from government agencies could be adversely affected by spending reductions or budget cutbacks at government agencies that currently use or are likely to utilize our products and services.

Because we offer our EnScript^® programming language for customization of and the creation of add-ons for our EnCase^® software, customers or third-party programmers may be able to develop products which compete with our products or reduce the marketability or value of our products.

We have developed many of our major products, including our EnCase^® eDiscovery Suite and our Automated Incident Response Suite, to function as applications running on the EnCase^® Enterprise platform. We created these applications using the EnScript^® programming language. In order to enhance the attractiveness of our EnCase^® software to potential customers and position EnCase^® software as a standard software for digital investigations, we have made available without charge the EnScript^® programming language, which permits users of EnCase^® software to develop customized add-on features for their own or others’ use, and we have trained our customers on how to write add-on programs using the EnScript^® programming language, which is similar to C++. As part of this strategy, we have encouraged the development of an active community of EnScript^® programmers similar to those which have emerged for other software products. While we believe widespread use of our EnScript^® programming language will ultimately create demand for our products, customers in the past have developed, and may in the future develop, software for use with EnCase^® software using the EnScript^® programming language, rather than purchasing certain of our product offerings. Losses of sales to potential customers could have a material adverse impact on our revenues and results of operations.

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Our success depends in part upon our ability to develop new products and enhance our existing products. Failure to successfully introduce new or enhanced products to the market may adversely affect our business, financial condition and results of operations.

Our future success depends in part on our ability to develop enhancements to our existing products and to introduce new products that keep pace with rapid technological developments and changes in customers’ needs. Although our products are designed to operate on a variety of network hardware and software platforms, we must continue to modify and enhance our products to keep pace with changes in network platforms, operating systems, software technology and changing customer demands. We may not be successful in developing and documenting these modifications and enhancements or in bringing them to market in a timely manner. Any failure of our products to operate effectively with future network platforms and technologies could reduce the demand for our products and result in customer dissatisfaction. In addition, the next version of our products will incorporate document viewer technology that we license from Stellent, Inc. Our license agreement with Stellent expires on December 15, 2008, and may be renewed by us for an additional two-year period at a higher price. In addition, Stellent may terminate this license agreement prior to the expiration of its term if we fail to make timely payments or fail to comply with any other material term of the license agreement. We may be unable to replace this technology if Stellent terminates this license agreement or it expires, or if the Stellent technology becomes obsolete or incompatible with our products.

Furthermore, any new products that we develop may not be released in a timely manner and may not achieve the market acceptance necessary to generate significant sales revenues. As a result, we may expend significant time and expense towards research and development for new or enhanced products, which may not gain market acceptance or generate sufficient sales to offset the costs of research and development. If we are unable to successfully develop new products or enhance and improve our existing products, or if we fail to position or price our products to meet market demand, our business, financial condition and results of operations will be adversely affected.

Errors in our products could adversely affect our reputation, result in significant costs to us, impair our ability to market our products and expose us to legal liability, any of which may adversely affect our operating results.

Products as complex as ours can contain undetected errors or failures. Despite extensive testing by us and by our customers, we have in the past discovered errors in our software applications and will likely continue to do so in the future. As a result of past discovered errors, we experienced delays and lost revenues while we corrected the problems in those software applications. In addition, customers in the past have brought to our attention “bugs” in our software exposed by the customers’ unique operating environments. Although we have been able to fix these software bugs in the past, we may not always be able to do so in the future. In addition, our products may also be subject to intentional attacks by viruses that seek to take advantage of these bugs, errors or other weaknesses. Any of these events may result in the loss of, or delay in, market acceptance of our products and services, which would seriously harm our sales, financial condition and results of operations.

Furthermore, we believe that our reputation and name recognition are critical factors in our ability to compete and generate additional sales of our products and services. Promotion and enhancement of our brand name will depend largely on our success in continuing to provide effective software applications and services. The occurrence of errors in our software applications or the detection of bugs by our customers may damage our reputation in the market as well as our relationships with existing customers, which may result in our inability to attract or retain customers.

In addition, because our products are used in security and forensic functions that are often critical to our customers, the licensing and support of our products makes us potentially subject to product liability claims. Any product liability insurance we carry may not be sufficient to cover our losses resulting from any such product liability claims. The successful assertion of one or more large product liability claims against us could have a material adverse effect on our financial condition.

Incorrect or improper use of our products, our failure to properly train customers on how to utilize our software products or our failure to properly provide consulting and implementation services could result in negative publicity and legal liability.

Our products are complex and are deployed in a wide variety of network environments. The proper use of our software requires extensive training by the end user and, if our software products are not used correctly or as intended, inaccurate results may be produced. Our customers or our professional services personnel may incorrectly implement or use our products. Our products may also be intentionally misused or abused by customers or non-customer third parties who obtain access and use of our products. Because our customers rely on our product and service offerings to manage a wide range of sensitive investigations and security functions, the incorrect or improper use of our products, our failure to properly train customers on how to efficiently and effectively use our products or our failure to properly provide consulting and implementation services to our customers may result in negative publicity or legal claims against us.

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We cannot predict our future capital needs and we may be unable to obtain additional financing to develop new products, enhance existing products, offer additional services or fund strategic acquisitions, the failure of which could have a material adverse effect on our business, financial condition and results of operations.

We may need to raise additional funds in the future in order to develop new products, enhance existing products, offer additional services or make strategic acquisitions of complementary businesses, technologies, products or services. Any required additional financing may not be available on terms acceptable to us, or at all. If we raise additional funds by issuing equity securities, you will experience dilution of your ownership interest, which could be significant, and the newly-issued securities may have rights senior to those of the holders of our common stock. If we raise additional funds by obtaining loans from third parties, the terms of those financing arrangements may include negative covenants or other restrictions on our business that could impair our operational and financial flexibility and would also require us to incur additional interest expense. If additional financing is not available when required or is not available on acceptable terms, we may be unable to successfully develop or enhance our software products and services through internal research and development or acquisitions in order to take advantage of business opportunities or respond to competitive pressures, which could negatively impact our software products and services offerings and sales revenues, the failure of which could have a material adverse effect on our business, financial condition and results of operations.

Acquisitions that we may undertake in the future involve risks that could adversely affect our business, financial condition and results of operations.

We may pursue strategic acquisitions of businesses, technologies, products or services that we believe complement or expand our existing business, products and services. Acquisitions involve numerous risks, including, but not limited to, the following:

• diversion of management’s attention during the acquisition and integration process;

• costs, delays and difficulties of integrating the acquired company’s operations, technologies and personnel into our existing operations and organization;

• adverse impact on earnings as a result of amortizing the acquired company’s intangible assets or impairment charges related to write-downs of goodwill related to any acquisition;

• issuance of equity securities to pay for acquisitions, which may be dilutive to existing stockholders;

• potential loss of customers or key employees of acquired companies;

• impact on our financial condition due to the timing of the acquisition or our failure to meet operating or synergy expectations for any acquired business; and

• assumption of unknown liabilities of the acquired company.

To date, we have not completed an acquisition. Any acquisitions of businesses, technologies, products or services that we may undertake in the future may not generate sufficient revenues or cost-saving synergies necessary to offset the associated costs of the acquisitions or may result in other material adverse effects.

Our international sales and operations are subject to factors that could have an adverse effect on our business, financial condition and results of operations.

We have significant sales and services operations outside the United States, and derive a substantial portion of our revenues from these operations. We also plan to expand our international operations in the future. For the three months ended March 31, 2007, we derived approximately 23.6% of our revenues from sales of products and services outside the United States.

Our international operations are subject to risks related to the differing legal, political, social and regulatory requirements and economic conditions of many countries, which risks include, but are not limited to:

• difficulties in staffing and managing our international operations;

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• the fact that foreign countries may impose additional withholding taxes or otherwise tax our foreign income, impose tariffs or adopt other restrictions on foreign trade or investment, including currency exchange controls;

• the general economic conditions in the countries in which we operate could have an adverse effect on our earnings from operations in those countries;

• the imposition of, or unexpected adverse changes in, foreign laws or regulatory requirements, including those pertaining to export duties and quotas, trade and employment restrictions;

• longer payment cycles for sales in foreign countries and difficulties in collecting accounts receivable;

• U.S. and foreign import and export laws;

• fluctuations in currency exchange rates;

• compliance with multiple, conflicting and changing governmental laws and regulations, including tax, privacy and data protection laws and regulations;

• costs and delays associated with developing software, documentation and training materials in multiple languages; and

• political unrest, war or acts of terrorism occurring in the foreign countries in which we currently operate or intend to operate in the future.

We may not continue to succeed in developing and implementing policies and strategies that will be effective in each location where we currently do business or intend to do business in the future. Furthermore, the occurrence of any of the foregoing factors may have a material adverse effect on our business, financial condition and results of operations.

Insiders control a majority of our outstanding stock, and this may delay or prevent a change of control of our company or adversely affect our stock price.

Our executive officers, directors and affiliated entities beneficially own more than 51% of the outstanding common stock. As a result, these stockholders will have control over matters that require approval by our stockholders, including the election of directors and approval of significant corporate transactions. Corporate actions favored by these stockholders might be taken even if other stockholders, including those who purchase shares in this offering, oppose them. This concentration of ownership might also have the effect of delaying or preventing a change of control that other stockholders may view as beneficial.

Our charter documents and Delaware law may deter potential acquirers of our business and may thus depress our stock price.

Our amended and restated certificate of incorporation and our bylaws contain provisions that could delay or prevent a change of control of our company that our stockholders might consider favorable. In addition, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which may discourage, delay or prevent certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our charter documents may make it more difficult for stockholders or potential acquirers to initiate actions that are opposed by the then-current board of directors, including delaying or impeding a merger, tender offer, or proxy contest or other change of control transaction involving our company. Any delay or prevention of a change of control transaction could cause stockholders to lose a substantial premium over the then current market price of their shares.

The trading price of our common stock is volatile.

The trading prices of the securities of technology companies have historically been highly volatile. Accordingly, the trading price of our common stock is likely to be subject to wide fluctuations. Factors affecting the trading price of our common stock may include:

• variations in our financial results;

• announcements of technological innovations, new solutions, strategic alliances or significant agreements by us or by our competitors;

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• recruitment or departure of key personnel;

• changes in the estimates of our financial results or changes in the recommendations of any securities analysts that elect to follow our common stock; and

• market conditions in our industry, the industries of our customers and the economy as a whole.

In addition, if the market for software or other technology stocks or the stock market in general experiences continued or greater loss of investor confidence, the trading price of our common stock could decline for reasons unrelated to our business or financial results. The trading price of our common stock might also decline in reaction to events that affect other companies in our industry even if these events do not directly affect us.

Future sales of shares by existing stockholders could cause our stock price to decline.

All of our outstanding shares are eligible for sale in the public market, subject in certain cases to volume limitations under Rule 144 of the Securities Act of 1933, as amended. Also, shares subject to outstanding options and rights under our First Amended and Restated 2004 Equity Incentive Plan are eligible for sale in the public market to the extent permitted by the provisions of various vesting agreements and Rules 144 and 701 under the Securities Act. If these shares are sold, or if it is perceived that they will be sold in the public market, the trading price of our common stock could decline.

In addition, our founder, Shawn McCreight, and his wife, continue to hold a substantial number of shares of our common stock. Sales by Mr. McCreight or his wife of a substantial number of shares, or the expectation that such sales may occur, could significantly reduce the market price of our common stock.

If our prior S Corporation election was not properly made and maintained, we would be liable for federal and certain state income taxes

In October 1998, we elected to be treated for federal income tax purposes as an “S Corporation” under Subchapter S of the Internal Revenue Code. In addition, we elected or were otherwise treated as an S Corporation for certain state tax purposes. As an S Corporation, our earnings were included in the income of our stockholders for federal and certain state income tax purposes. We filed an election to revoke our S Corporation status on December 11, 2006. If your S Corporation election was not properly made and maintained prior to its revocation, we would be liable for federal and certain state income taxes during prior open periods, together with interest thereon and, possibly, penalties. Such taxes and penalties may be material to our operating results.

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

No matters were submitted to a vote of security holders during the three month period ended March 31, 2007.

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Item 6. Exhibits

Exhibit Number	Description of Documents
31.1	Certification of Chief Executive Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934
31.2	Certification of Chief Financial Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934
32.1†	Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2†	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

† These certifications are being furnished solely to accompany this annual report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934 and are not to be incorporated by reference into any filing of Guidance Software, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing.

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