SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended June 30, 2005


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

For the transition period from to

Commission File Number 000-30277

Knova Software, Inc.

(Exact Name of Registrant as Specified in Its Charter)


Delaware (State or Other Jurisdiction of Incorporation or Organization)		25-1647861 (I.R.S. Employer Identification No.)

10201 Torre Avenue, Suite 350 Cupertino, CA		95014

(Address of Principal Executive Offices)		(Zip Code)

Registrant’s Telephone Number, Including Area Code: (408) 863-5800

ServiceWare Technologies, Inc.

(Former name, former address and former fiscal year if changed since last report)

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 þ No o

Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Exchange Act. Yes o No þ

The number of shares of the registrant’s common stock outstanding as of the close of business on August 1, 2005 was 8,743,116.

Knova Software, Inc.

Form 10-Q
June 30, 2005
INDEX


	Page No.
PART I. FINANCIAL INFORMATION

ITEM 1. Unaudited Consolidated Financial Statements

Consolidated Balance Sheets as of June 30, 2005 (unaudited) and December 31, 2004		3

Consolidated Statements of Operations for the three and six months ended June 30, 2005 and 2004 (unaudited)		4

Consolidated Statements of Stockholders’ Equity for the six months ended June 30, 2005 and 2004 (unaudited)		5

Consolidated Statements of Cash Flows for the six months ended June 30, 2005 and 2004 (unaudited)		6

Notes to Unaudited Consolidated Financial Statements		7

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		14

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk		27

ITEM 4. Controls and Procedures		28

PART II. OTHER INFORMATION

ITEM 4. Submission of Matters to a Vote of Security Holders		29

ITEM 6. Exhibits		29
EX-3.3
EX-10.1
EX-10.2
EX-31.1
EX-31.2
EX-32

PART I. FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

Knova Software, Inc.

CONSOLIDATED BALANCE SHEETS
Amounts in thousands, except per share amounts


	June 30,			December 31,
	2005			2004
	(Unaudited)
Assets
Current assets
Cash and cash equivalents	$	1,996		$	1,672
Marketable securities		6,350			9,266
Accounts receivable, less allowance for doubtful accounts of $150 as of June 30, 2005 and $95 as of December 31, 2004		7,678			2,529
Prepaid expenses and other current assets		437			513

Total current assets		16,461			13,980
Non current assets
Property and equipment
Office furniture, equipment, and leasehold improvements		1,515			1,511
Computer equipment		4,957			4,830

Total property and equipment		6,472			6,341
Less accumulated depreciation		(6,100	)		(5,890	)

Property and equipment, net		372			451
Intangible assets, net of amortization of $354 as of June 30, 2005		5,028			—
Goodwill		14,485			2,324
Other non current assets		61			198

Total non current assets		19,946			2,973

Total assets	$	36,407		$	16,953

Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable		2,128			1,693
Accrued compensation and benefits		1,192			407
Deferred revenue — licenses		382			379
Deferred revenue — services		4,482			2,720
Accrued restructuring charges		505			—
Current portion of capital lease obligations		47			34
Other current liabilities		1,126			572

Total current liabilities		9,862			5,805
Non current deferred revenue		226			323
Capital lease obligations		80			61

Total liabilities		10,168			6,189
Commitments and Contingencies
Stockholders’ equity
Common stock, $0.01 par; 50,000 shares authorized, 8,757 and 5,269 shares issued and 8,742 and 5,252 shares outstanding as of June 30, 2005 and December 31, 2004, respectively		88			53
Additional paid in capital		101,472			83,835
Treasury stock, 28 and 17 shares as of June 30, 2005 and December 31, 2004, respectively		(155	)		(62	)
Deferred compensation		(53	)		(162	)
Warrants		6,524			4,765
Accumulated other comprehensive income (loss)		(14	)		514
Accumulated deficit		(81,623	)		(78,179	)

Total stockholders’ equity		26,239			10,764

Total liabilities and stockholders’ equity	$	36,407		$	16,953

See accompanying notes to the financial statements.

Knova Software, Inc.

CONSOLIDATED STATEMENTS OF OPERATIONS

Amounts in thousands, except per share amounts
(Unaudited)


	Three months ended June 30,						Six months ended June 30,
	2005			2004			2005			2004
Revenues
Licenses	$	2,824		$	2,309		$	4,201		$	2,540
Services		4,518			1,578			6,840			3,184

Total revenues		7,342			3,887			11,041			5,724
Cost of revenues
Cost of licenses		257			80			420			144
Cost of services		2,220			927			3,848			1,699

Total cost of revenues		2,477			1,007			4,268			1,843

Gross margin		4,865			2,880			6,773			3,881
Operating expenses
Sales and marketing		2,042			1,539			3,705			2,541
Research and development		1,317			633			2,840			1,228
General and administrative		1,420			557			2,399			1,409
Intangible assets amortization		70			—			117			—
Restructuring charges		—			—			1,355			—

Total operating expenses		4,849			2,729			10,416			5,178

Income (loss) from operations		16			151			(3,643	)		(1,297	)
Other income (expense)
Interest expense		(2	)		(4	)		(3	)		(1,275	)
Other (net)		50			16			202			25

Other income (expense), net		48			12			199			(1,250	)

Net income (loss)	$	64		$	163			($3,444	)		($2,547	)


Net income (loss) per common share, basic:	$	0.01		$	0.03			($0.43	)		($0.50	)
Net income (loss) per common share, diluted:	$	0.01		$	0.03			($0.43	)		($0.50	)

Shares used in computing per share amounts, basic		8,723			5,217			7,953			5,061

Shares used in computing per share amounts, diluted		8,776			5,419			7,953			5,061

See accompanying notes to the financial statements.

Knova Software, Inc.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

Amounts in thousands, except per share amounts
(Unaudited)


																					Accumulated
																					other						Total
	Common stock					Additional			Treasury stock							Deferred					comprehensive			Accumulated			Stockholders'
	Shares			Amount		paid in capital			Shares				Amount			Compensation			Warrants		(loss) gain			Deficit			Equity
Balance at December 31, 2004		5,252		$	53	$	83,835			17			$	(62	)	$	(162	)	$	4,765	$	514		$	(78,179	)	$	10,764
Exercise of stock options		1					(2	)		(1	)			6														4
Issuance of common stock for merger		3,501			35		17,262																					17,297
Issuance of warrants for merger																				1,759								1,759

Stock based compensation expense							382										74											456

Issuance of stock under Employee Stock Purchase Plan		2					(5	)		(2	)			11														6
Forfeiture of restricted stock		(14	)							14				(110	)		35											(75	)
Comprehensive loss:																												—
Unrealized loss on short term investments																						(14	)					(14	)
Reclassification adjustment for gains realized in net loss																						(514	)					(514	)
Net loss																									(3,444	)		(3,444	)

Total comprehensive loss																												(3,958	)

Balance at June 30, 2005		8,742		$	88	$	101,472			28			$	(155	)	$	(53	)	$	6,524	$	(14	)	$	(81,623	)	$	26,239


Balance at December 31, 2003		2,433		$	247	$	76,433			36			$	(134	)	$	—		$	46	$	—		$	(76,485	)	$	107
Exercise of warrants and stock options		18					32			(16	)			60														92
Beneficial conversion feature of convertible notes							233																					233
Issuance of common stock and warrants, net of $574 of issuance costs		1,231			123		2,681													4,614								7,418
Issuance of warrants for settlement of lawsuit																				105								105
Issuance of common stock related to note conversion		1,535			154		3,685																					3,839

Stock based compensation expense		32			2		295										(236	)										61
Issuance of stock under Employee Stock Purchase Plan							2							6														8
Comprehensive (loss) gain:																												—
Unrealized loss on short term investments																						(8	)					(8	)
Net loss																									(2,547	)		(2,547	)


Total comprehensive (loss) gain																												(2,555	)

Balance at June 30, 2004		5,249		$	526	$	83,361			20		$		(68	)	$	(236	)	$	4,765	$	(8	)	$	(79,032	)	$	9,308

See accompanying notes to the financial statements

Knova Software, Inc.

CONSOLIDATED STATEMENTS OF CASH FLOWS

Amounts in thousands, except per share amounts

(Unaudited)


	Six months ended June 30,
	2005			2004
Cash flows from operating activities	($	3,444	)	($	2,547	)
Net loss
Adjustments to reconcile net loss to net cash used in operations:
Non cash items:
Depreciation		216			167
Amortization of intangible assets		354			25
Cost of warrants in connection with lease settlement		—			105
Amortization of beneficial conversion feature related to convertible notes		—			1,162
Amortization of discount on convertible notes		—			50
Interest expense paid by issuing common stock		—			107
Stock based compensation		456			61
Forfeiture of restricted stock		(75	)
Acquired in-process research and development		421			—
Loss (gain) on disposal of equipment		4			(7	)
Other non cash items		—			(8	)
Gain on sale of investments		(284	)		—
Changes in operating assets and liabilities, net of assets and liabilities acquired:
Increase in accounts receivable		(3,117	)		(1,321	)
Decrease in other assets		577			105
Decrease in accounts payable		(709	)		(26	)
Increase in accrued compensation		170			175
Increase in accrued restructuring charges		505			—
(Decrease) increase in deferred revenue		(208	)		477
(Decrease) increase in other liabilities		(368	)		387

Net cash used in operating activities		(5,502	)		(1,088	)

Cash flows from investing activities
Purchases of marketable securities		(4,898	)		(9,073	)
Proceeds from sale of marketable securities		7,570			2,000
Proceeds from sale of assets		1			1
Acquisition costs for Kanisa merger		(561	)		—
Cash acquired from Kanisa merger		3,779			—
Property and equipment acquisitions		(55	)		(112	)

Net cash provided by (used in) investing activities		5,836			(7,184	)

Cash flows from financing activities
Repayments of principal of capital lease obligations		(20	)		(16	)
Repayments of principal of revolving line of credit		—			(250	)
Proceeds from equity funding, net of debt issuance costs		—			7,418
Proceeds from stock option exercises and employee stock purchase plan issuances		10			76

Net cash provided by financing activities		(10	)		7,228

Increase (decrease) in cash and cash equivalents		324			(1,044	)
Cash and cash equivalents at beginning of period		1,672			1,438

Cash and cash equivalents at end of period	$	1,996		$	394


Supplemental disclosures of cash flow information:
Cash paid for interest	$	3		$	6

Supplemental disclosures of non-cash investing and financing activities:
Conversion of convertible debt and accrued interest to common stock		—			3,839
Adjustment to beneficial conversion feature for convertible notes		—			233
Exercise of warrants by bank		—			23
Issuance of warrants		1,759			5,134
Assets acquired under capital lease obligations		—			32
Unrealized loss on investments		(14	)		—
Kanisa acquisition (note 10)

See accompanying notes to the financial statements.

Knova Software, Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2005
(Unaudited)

Note 1. Organization of the Company

Knova Software, Inc. (the “Company) is a provider of customer relationship management (CRM) software applications, specifically applications that enable customer service organizations to more effectively resolve service requests and answer questions. Built on knowledge management and search technologies, the Company’s service resolution management (SRM) applications optimize the resolution process across multiple service channels, including contact centers, self-service websites, help desk, email and chat. The Company’s SRM applications complements, integrates with, and enhances traditional CRM, contact center, and help desk applications by providing patented knowledge management solutions that improve service delivery. The Company’s customers include some of the largest companies in the world and the Company’s products enable them to reduce operating and service delivery costs, improve customer satisfaction, and thereby increase revenues.

The Company is principally engaged in the design, development, marketing and support of software applications and services. Substantially all of the Company’s revenues are derived from a perpetual license of software products, the related professional services and the related customer support, otherwise known as maintenance. The Company licenses software in arrangements in which the customer purchases a combination of software, maintenance and/or professional services, such as training and implementation services. Maintenance, which includes technical support and product updates, is typically sold with the related software license and is renewable at the option of the customer on an annual basis after the first year. The Company’s professional services and technical support organizations provide a broad range of implementation services, training, and technical support to customers and implementation partners. The Company’s service organization has significant product and implementation expertise and is committed to supporting customers and partners throughout every phase of their adoption and use of the Company’s solutions.

The accompanying financial statements have been prepared on a basis, which assumes that the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. The Company incurred a net loss of $3, 444,000 and used $5,502,000 for operations for the six months ended June 30, 2005, and may incur additional losses throughout the remainder of 2005. The ability of the Company to continue in its present form is largely dependent on its ability to generate additional revenues, achieve profitability and positive cash flows or to obtain additional debt or equity financing. Management believes that the Company has the ability to do so and plans to fund 2005 operations through cash the Company expects to generate from operations and current cash balances. There is no assurance that the Company will be successful in obtaining sufficient license and service fees from its products or alternatively, to obtain additional financing on terms acceptable to the Company.

Note 2. Unaudited Interim Financial Information

The accompanying unaudited balance sheet as of June 30, 2005 and related unaudited consolidated statements of operations for the three and six months ended June 30, 2005 and 2004, unaudited consolidated statements of cash flows and the unaudited consolidated statements of stockholders’ equity for the six months ended June 30, 2005 and 2004 have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. As discussed in Note 10, the accounts of Kanisa Inc. (“Kanisa”) are included from the date of acquisition, February 8, 2005.

Management believes that the interim financial statements include all adjustments, consisting of normal recurring accruals, considered necessary for a fair statement of the results of interim periods. Operating results for any quarter are not necessarily indicative of the results that may be expected for the full year and particularly with respect to the operating results for the six months ended June 30, 2005, which include Kanisa results only from February 8, 2005. These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s 2004 Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Note 3. Significant Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries after elimination of all significant intercompany accounts and transactions.

Marketable Securities

The Company considers all marketable securities as available-for-sale. Accordingly, these securities are carried at fair value and unrealized holding gains and losses, net of the related tax effect, are excluded from earnings and are reported as a separate component of other comprehensive income (loss) until realized. Realized gains and losses from the sale of available-for-sale securities are determined on a specific identification basis. The securities consist of corporate bonds, government bonds and auction rate preferred securities.

The majority of the Company’s investments are held in an account with an investment firm of which a Director of the Company is an affiliate.

Stock Based Compensation

The Company has adopted the disclosure only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). SFAS No. 123, as amended by SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” permits the Company to continue accounting for stock-based compensation as set forth in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB Opinion No. 25”), provided the Company discloses the pro forma effect on net income and earnings per share of adopting the full provisions of SFAS No. 123. Accordingly, the Company continues to account for stock-based compensation under APB Opinion No. 25.

The following pro forma disclosure presents the Company’s net loss and loss per share had compensation cost for the Company’s stock option plans been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS No. 123.


	For the three months ended						For the six months ended
	June 30,						June 30,
	2005			2004			2005			2004
	(in thousands, except per share amounts)
Net income (loss) from continuing operations, as reported	$	64		$	163		($	3,444	)	($	2,547	)
Add: stock based compensation expense included in reported net loss		102			37			381			129
Less: total stock based compensation expense under SFAS No. 123		(825	)		(201	)		(1,885	)		(368	)

Adjusted net loss	($	659	)	($	1	)	($	4,948	)	($	2,786	)


Weighted average shares used to calculate basic and diluted loss per share		8,723			5,217			7,953			5,061
Net loss per share, basic and diluted	($	0.06	)	($	0.00	)	($	0.62	)	($	0.55	)

The average fair value of the options granted is estimated at $4.72 during first six months of 2005 and $5.80 during first six months of 2004, on the date of grant using the Black-Scholes pricing model.

The effects of applying SFAS 123 in this pro forma disclosure are not likely to be representative of the effects on reported net income for future years.

Impact of Recently Issued Accounting Standards

In December 2004, the FASB issued SFAS No. 123(R) “Share-Based Payment” (“SFAS 123R”), a revision to SFAS 123. SFAS 123R addresses all forms of share-based payment (“SBP”) awards, including shares issued under the Company’s Employee Stock Purchase Plan, stock options, restricted stock, restricted stock units and stock appreciation rights. SFAS 123R will require the Company to record compensation expense for SBP awards based on the fair value of the SBP awards. Under SFAS 123R, restricted

stock and restricted stock units will generally be valued by reference to the market value of freely tradable shares of the Company’s common stock. Stock options, stock appreciation rights and shares issued under the Employee Stock Purchase Plan will generally be valued at fair value determined through an option valuation model, such as a lattice model or the Black-Scholes model (the model that the Company currently uses for its footnote disclosure). In April 2005, the SEC approved a rule that delayed the effective date of SFAS 123R. SFAS 123R will now be effective for public companies for annual periods that begin after June 15, 2005. The Company is currently evaluating the impact of the adoption of SFAS 123R.

In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107, “Share-Based Payment” (“SAB 107”), which provides interpretive guidance related to the interaction between SFAS 123R and certain SEC rules and regulations, as well as provides the SEC staff’s views regarding the valuation of share-based payment arrangements. The Company is currently assessing the impact of SAB 107 on its implementation and adoption of SFAS 123R.

In May 2005, the FASB issued SFAS No. 154 “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3” (SFAS No. 154). SFAS No. 154 requires that all voluntary changes in accounting principles be recognized as a retroactive restatement of all periods presented except when retroactive restatement is impracticable. In addition, SFAS No. 154 also requires that a change in depreciation method be accounted for as a change in accounting estimate that is affected by a change in accounting principle, which would be accounted for in the period of change, if the change affects that period and also in future periods if the change affects both the period of change and future periods. SFAS No. 154 further eliminates paragraph 4 of APB 20, which specifies that APB 20 does not apply to changes made to comply with new pronouncements. This Statement will require that any change in an accounting principle made as a result of adopting a new pronouncement be reported following the same guidance as that for voluntary changes in accounting principles unless the new pronouncement’s transition provisions require another method. SFAS No. 154 is effective for years beginning after December 15, 2005.

Reclassification

Certain prior year amounts have been reclassified to conform to the current year’s presentation.

Revision in the Classification of Certain Securities

During the first quarter 2005, the Company concluded that it was appropriate to classify all auction rate preferred stock as marketable securities. Previously, a portion of such investments had been classified as cash and cash equivalents. Accordingly, the Company revised the classification to report these securities totaling $850,000 as marketable securities on the previously reported Consolidated Balance Sheet as of December 31, 2004. The Company has also made corresponding adjustments to the previously reported Consolidated Statement of Cash Flows for the six months ended June 30, 2004 to reflect the net cash used in investing activities of $6,006,000 related to the gross purchases and sales of these securities rather than as a component of cash and cash equivalents. This change in classification does not affect previously reported cash flows from operations or from financing activities in the Company’s previously reported Consolidated Statements of Cash Flows, or the previously reported Consolidated Statements of Operations for any period.

For the year ended December 31, 2004, now included in cash used in investing activities in our consolidated statements of cash flows is purchases of approximately $13.2 million and sales of approximately $5.3 million of marketable securities, which were previously classified as cash and cash equivalents.

For the six months ended June 30, 2005, now included in cash used in investing activities in our consolidated statements of cash flows is purchases of approximately $4.1 million and sales of approximately $2.3 million of marketable securities, which were previously classified as cash and cash equivalents.

Note 4. Debt

Convertible Notes

In second quarter 2002, the Company issued $3,250,000 of convertible notes, with proceeds of $2,975,000, net of transaction costs of $275,000. The convertible notes were originally to mature 18 months from the closing date, bore interest at 10% per annum, and were originally convertible at any time at the option of the holder, into shares of the Company’s common stock at a conversion price of $3.00 per share. Interest was payable in cash or additional convertible notes, at the option of the Company.

On March 31, 2003, the noteholders agreed to an amendment to the original notes. The amendment reduced the conversion price from $3.00 per share to $2.50 per share and extended the term of the notes until July 15, 2004.

In accordance with EITF 00-27, “Application of EITF Issue No. 98-5, ‘Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,’ to Certain Convertible Instruments,” the Company recognized an additional beneficial conversion feature (“BCF”) of $232,672 in 2004 as a result of the payment of interest with additional convertible notes, which was being amortized over the amended term of the convertible notes.

On February 10, 2004, the notes were converted into common stock as part of the terms of an equity funding as discussed in Note 7. Additional interest of $105,760 was paid in shares of stock in connection with the conversion.

Note 5. Net Loss Per Share

The following table sets forth the computation of basic and diluted loss per share:


	For the three months ended				For the six months ended
	June 30,				June 30,
	2005		2004		2005			2004
	(in thousands, except per share amounts)
Numerator:
Net income (loss )	$	64	$	163	($	3,444	)	($	2,547	)

Denominator:
Denominator for basic earnings per share — weighted average shares		8,723		5,217		7,953			5,061

Denominator for diluted earnings per share — weighted average shares		8,776		5,419		7,953			5,061

Net income (loss) per share, basic	$	0.01	$	0.03	($	0.43	)	($	0.50	)

Net income (loss) per share, diluted	$	0.01	$	0.03	($	0.43	)	($	0.50	)

Dilutive securities include convertible notes, options and warrants, as if converted. Potentially dilutive securities totaling 3,025,465 and 1,588,714 shares for the six month period ended June 30, 2005 and 2004, respectively, were excluded from historical basic and diluted loss per share because of their antidilutive effect. The number of outstanding options to purchase common stock for which the option exercise price exceeded the average market price of the Company’s common stock aggregated 1,762,022 and 685,270 for the six months ended June 30, 2005 and 2004, respectively.

Note 6. Segment Information

The Company has one business segment.


	For the three months ended				For the six months ended
	June 30,				June 30,
	2005		2004		2005		2004
	(in thousands, except per share amounts)
Revenues (a)
United States	$	7,140	$	3,675	$	10,520	$	5,406
International		202		212		521		318

Total	$	7,342	$	3,887	$	11,041	$	5,724


(a)		Revenues are attributed to the United States and International based on customer location.

Note 7. Capital Stock

On January 30, 2004, the Company secured an additional $7.4 million, net of expenses, in funding to finance its operations and the development of its business. The funding was raised through a private placement of equity securities consisting of 1,230,769 shares of common stock and five-year warrants to purchase 615,385 shares of common stock at $7.20 per share.

At the Company’s 2004 annual meeting of stockholders on December 7, 2004, the stockholders approved an amendment to the Company’s Certificate of Incorporation to effect a reverse stock split of its common stock and to grant its board of directors the authority until June 30, 2006 to set the ratio for the reverse split or to not complete the reverse split. The board subsequently approved a 1 for 10 reverse stock split to become effective February 4, 2005. The split is reflected in all share and per share information found throughout the consolidated financial statements. In addition, on February 4, 2005, the number of authorized shares of common stock was decreased to 50,000,000 shares upon completion of the reverse stock split.

See Note 10 for a discussion of stock and warrants issued to Kanisa stockholders in the business combination effected on February 8, 2005.

Note 8. Stock Option Plan

The following table summarizes option activity for the six months ended June 30, 2005:


	Options			Option Price		Weighted Average
	Outstanding			Range per Share		Exercise Price

Options outstanding, December 31, 2004		867,049		$	2.50-$70.00	$	5.0950
Options granted		1,290,100		$	3.70-$4.60	$	4.1947
Options exercised		(1,140	)	$	2.60-$3.80	$	3.6526
Options forfeited		(190,349	)	$	2.60-$25.00	$	5.2988

Options outstanding, June 30, 2005		1,965,660


Options exercisable, June 30, 2005		741,790		$	2.50-$70.00	$	4.8800

The following table summarizes option activity for the six months ended June 30, 2004:


	Options			Option Price		Weighted Average
	Outstanding			Range per Share		Exercise Price

Options outstanding, December 31, 2003		576,771		$	2.50-$70.00	$	4.7100
Options granted		349,796		$	5.40-$8.19	$	5.8256
Options exercised		(16,150	)	$	2.60-$4.50	$	4.2814
Options forfeited		(15,958	)	$	2.60-$50.99	$	5.1405

Options outstanding, June 30, 2004		894,459


Options exercisable, June 30, 2004		470,413		$	2.50-$70.00	$	4.7868

At the annual stockholders meeting held on May 24, 2005, the stockholders approved an amendment to the Company’s stock option plan to increase the number of shares available for issuance under the plan to 2,453,387 (subject to additional annual increases in accordance with the terms of the plan).

In February 2005, in accordance with an agreement entered into with an executive, who terminated active employment with the Company, the Company accelerated the vesting and extended the exercise period for options held by the executive. Accordingly, approximately $242,000 in stock based compensation was recorded in the three months ended March 31, 2005, as a result of this agreement.

In June 2005, in accordance with an agreement entered into with an executive, who terminated active employment with the Company, the Company accelerated the vesting and extended the exercise period for options held by the executive. Accordingly, approximately $140,000 in stock based compensation was recorded in the three months ended June 30, 2005. The stock based compensation was offset by the reversal of expense previously recognized in connection with a restricted stock grant since the restricted stock was forfeited upon the termination of employment. Approximately $75,000 in stock based compensation was reversed in the three months ended June 30, 2005, as a result of this agreement.

Note 9. Contingencies

On January 16, 2004, the Company entered into a release agreement with its prior landlord, Sibro Enterprises, LP (“Sibro”), pursuant to which the Company settled all outstanding disputes under the lawsuit Sibro had filed in the Court of Common Pleas of Allegheny County, Pennsylvania. Pursuant to the release agreement, the Company paid Sibro Enterprises an agreed upon amount representing rent due through December 31, 2003, which was recorded in its 2003 consolidated financial statements and issued Sibro Enterprises a warrant to purchase 12,500 shares of common stock at a purchase price of $8.40 per share. The warrant was valued and recorded at approximately $105,000. In exchange, the parties mutually agreed to terminate the lease as of December 31, 2003, dismiss the lawsuit with prejudice, and release each other from any and all claims as of the date of the release agreement.

Note 10. Acquisition

On December 22, 2004, the Company entered into a business combination agreement with Kanisa Inc. under which Kanisa became a wholly-owned subsidiary of the Company through a merger with a newly created wholly-owned subsidiary of the Company. The merger was completed on February 8, 2005 pursuant to an Amended Merger Agreement. Bruce Armstrong, CEO of Kanisa, became CEO of the Company. The corporate headquarters of the Company following consummation of the merger is Cupertino, California.

In pursuing this merger, the Company determined that combining the technology, research and development resources, customer relationship and sales and marketing capabilities of the two companies would create a stronger and more competitive company, with the breadth and scale that the Company’s market demands.

Pursuant to the Merger, the Kanisa stockholders received a total of 3,501,400 shares of $.01 par value common stock of the Company, which represents 40% of post-merger common stock outstanding. Warrants to purchase an additional 423,923 shares of common stock at an exercise price of $7.20 per share were issued to the Kanisa stockholders. These warrants will expire in January 2009. The fair value of each warrant was estimated using the Black-Scholes option-pricing model with the following weighted average assumptions:


Volatility		142.67	%
Risk-free interest rate		3.4	%
Dividend yield		—
Expected life	4 years

Based on this methodology, the warrants were valued at approximately $4.15 each, resulting in a total value of approximately $1.8 million.

The results of operations of Kanisa have been included in the Company’s consolidated results from the date of acquisition, February 8, 2005.

The following table summarizes the allocation of the total purchase price (consisting of $17,297,000 for the common stock issued to Kanisa stockholders, $1,759,000 for the warrants issued to the Kanisa stockholders and acquisition costs of $561,000) to the fair values of the assets acquired and liabilities assumed as of the date of the acquisition (in thousands):


Cash and cash equivalents	$	3,779
Accounts receivable		2,032
Prepaid expenses and other current assets		364
Equipment		87
Intangible assets:
Core and developed technologies		3,981
Acquired in-process research and development		421
Customer contracts/customer relations		1,401
Goodwill		12,161
Accounts payable		(1,144	)
Accrued compensation and benefits		(614	)
Other current liabilities		(913	)
Deferred revenues		(1,876	)
Capital lease obligations		(62	)

Net assets acquired	$	19,617

The Company expensed the acquired in-process research and development in first quarter 2005. The core and developed technologies of $4.0 million were assigned a useful life of 7 years and the customer contracts/customer relations of $1.4 million were assigned a useful life of 5 years. The intangible assets are being amortized using the straight-line method over their estimated useful lives.

An investment firm, of which a Director of the Company is an affiliate, received $350,000 in consulting fees for assistance with the acquisition. These fees are included in the acquisition costs.

The merger contemplated a name change for the Company. Effective as of May 27, 2005, the Company’s name was changed to “Knova Software, Inc.”.

Pro forma results

The following pro forma results of operations reflect the combined results of the Company and Kanisa as if the combination occurred at the beginning of each of the applicable periods. The information used for this pro forma disclosure was obtained from internal financial reports prepared by Kanisa for the periods January 1, 2005 through February 7, 2005 and January 1, 2004 through June 30, 2004.


	For the three months ended						For the six months ended
	June 30,						June 30,
	2005			2004			2005			2004
	(in thousands, except per share amounts)
Revenues	$	7,342		$	6,593		$	11,447		$	10,592
Net loss	($	357	)	($	2,377	)	($	4,368	)	($	8,942	)
Net loss per share	($	0.04	)		(0.27	)	($	0.55	)		(1.04	)
Shares used in per share calculation		8,723			8,718			7,953			8,562

The pro forma results are not necessarily indicative of what would have occurred if the acquisition had actually been completed as of the assumed dates and periods presented. The actual results for the six months ended June 30, 2005 include the results for Kanisa from February 8, 2005 through June 30, 2005.

Note 11. Restructuring Charges

During the first quarter 2005, in connection with the integration of its acquisition of Kanisa, the Company approved a plan to streamline its operations. The workforce reduction of 21 employees consisted of one executive, three from general and administrative, nine from research and development, three from professional services and five from sales. During the quarter ended March 31, 2005, the Company recorded restructuring charges of approximately $1.4 million, including stock based compensation of $242,000 for an executive discussed in Note 8. As of June 30, 2005, $505,000 in severance costs remain to be paid to terminated employees over the next year.


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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes contained in this Quarterly Report on Form 10-Q (“Form 10-Q”).

Certain statements contained in this Form 10-Q that are not historical facts, including those statements that refer to our plans, prospects, expectations, strategies, intentions, hopes and beliefs, constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any expressed or implied by these forward-looking statements. We assume no obligation to update these forward-looking statements as circumstances change in the future. In some cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “expects”, “intends”, “plans”, “anticipates”, “believes”, “estimates”, “predicts”, “potential”, “continue”, or the negative of these terms or other comparable terminology. For a description of some of the risk factors that could cause our results to differ materially from our forward looking statements, please refer to the risk factors set forth in the section entitled “Additional Factors that May Affect Future Results” beginning on page 19 of this Form 10-Q, as well as to our other filings with the Securities and Exchange Commission and to other factors discussed elsewhere in this Form 10-Q.

Overview

We are a provider of customer relationship management (CRM) software applications, specifically applications that enable customer service organizations to more effectively resolve service requests and answer questions. Built on knowledge management and search technologies, our service resolution management (SRM) applications optimize the resolution process across multiple service channels, including contact centers, self-service websites, help desk, email and chat. Our SRM applications complement, integrate with, and enhance traditional CRM, contact center, and help desk applications by providing patented knowledge management solutions that improve service delivery. Our customers include some of the largest companies in the world and our products enable them to reduce operating and service delivery costs, improve customer satisfaction, and thereby increase revenues.

We are principally engaged in the design, development, marketing and support of software applications and services. Substantially all of our revenues are derived from a perpetual license of our software products, the related professional services and the related customer support, otherwise known as maintenance. We license our software in arrangements in which the customer purchases a combination of software, maintenance and/or professional services, such as our training and implementation services. Maintenance, which includes technical support and product updates, is typically sold with the related software license and is renewable at the option of the customer on an annual basis after the first year. Our professional services and technical support organizations provide a broad range of implementation services, training, and technical support to our customers and implementation partners. Our service organization has significant product and implementation expertise and is committed to supporting customers and partners throughout every phase of their adoption and use of our solutions.

The Knova Application Suite is a suite of knowledge powered service resolution management applications designed to enable companies to better service and retain their customers and employees. Specifically, we believe our Knova Application Suite enables companies we service to improve employee productivity, improve customer service, and increase customer satisfaction and revenue.

The Knova Application Suite consists of the following business applications:

	•		Knova Contact Center is an assisted-service application for customer service and help desk agents that enables them to resolve customer issues and questions more effectively. Knova Contact Center integrates a sophisticated knowledge management system with additional features such as search, collaboration, interview scripting, email response, and knowledge authoring. Knova Contact Center features business process support integrated with customer relationship management systems that can tailor the resolution experience based on the customer’s or employee’s issue or question.

	•		Knova Self-Service is a self-service application that enables customers and employees to resolve their own issues and questions on an enterprise website. Knova Self-Service features business process support that can provide a personalized and guided resolution experience based on the issue or question the customer or employee has.

	•		Knova Forums is an application for online customer communities and forums that enables customers to discuss and collaborate on topics of interest, including an enterprise’s products and services. Knova Forums enables customers and employees to assist each other, reducing service delivery costs and providing valuable insight to the enterprise.

	•		Knova Service Desk is a packaged knowledge management solution for service desks to resolve questions, author knowledge, and manage repositories of intellectual capital. Knova Service Desk is integrated with traditional service and help desk applications from companies such as Remedy and Hewlett Packard (“HP”). It is based on a patented self-learning search technology that is designed to improve with usage. Knova Service Desk features application modules for different user types and functions.

Factors Affecting Future Operations

Our operating losses, as well as our negative operating cash flow, have been significant to date. We expect to have positive operating margins over time by increasing our customer base without significantly increasing related capital expenditures and other operating costs. We do not know if we will be able to achieve these objectives.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated 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 our estimates. 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. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements: (i) revenue recognition on license fees, (ii) estimates of doubtful accounts receivable, and (iii) the valuation of intangible assets and goodwill. For additional discussion of our critical accounting estimates, see our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K for the year ended December 31, 2004.

Description of Statement of Operations

Revenues

We market and sell our products primarily in North America through our direct sales force. Internationally, we market our products through value-added resellers, software vendors and system integrators as well as our direct sales force. International revenues were 5% of total revenues in the first six months of 2005 and 6% in the first six months of 2004. Revenues generated by resellers, including international resellers, were 4% in the first six months of 2005 and 12% in the first six months of 2004. We derive our revenues from licenses for software products and from providing related services, including installation, training, consulting, customer support and maintenance and hosting contracts. License revenues primarily represent fees for perpetual licenses. Service revenues contain variable fees for installation, training and consulting, hosting, reimbursements for travel expenses that are billed to customers, as well as fixed fees for customer support and maintenance contracts. Services revenues are generated primarily from time and materials contracts. Three customers accounted for 44% of our total revenues in the second quarter 2005.

Cost of Revenues

Cost of license revenues consists primarily of the expenses related to royalties, the cost of the media on which our product is delivered, product fulfillment costs and amortization of purchased technology. Cost of service revenues consists of the salaries, benefits, direct expenses and allocated overhead costs of customer support and services personnel, reimbursable expenses for travel that are billed to customers, and fees for sub-contractors.

Operating Costs

We classify our core operating costs into four general categories: sales and marketing, research and development, general and administrative, and intangible assets amortization based upon the nature of the costs. Restructuring charges are presented separately to enable the reader to determine core operating costs. We allocate the total costs for overhead and facilities, based upon headcount, to each of the functional areas that benefit from these services. Allocated charges include general overhead items such as building rent, equipment leasing costs, telecommunications charges and depreciation expense. Sales and marketing expenses consist primarily of employee compensation for direct sales and marketing personnel, travel, public relations, sales and other promotional materials, trade shows, advertising and other sales and marketing programs. Research and development expenses consist primarily of expenses related to the development and upgrade of our proprietary software and other technologies. These expenses include employee compensation for software developers and quality assurance personnel and third-party contract development costs. General and administrative expenses consist primarily of compensation for personnel and fees for outside professional advisors. Intangible assets amortization expense consists primarily of the amortization of intangible assets acquired through our acquisition of Kanisa. These assets (other than goodwill) are amortized on a straight line basis over their respective estimated useful lives. Restructuring charges consist of costs incurred in connection with streamlining our work force as a result of the combination with Kanisa.

Results of Operations

The following table sets forth the consolidated statement of operations data as a percentage of total revenues for each of the periods indicated:


	Three months ended June 30,						Six months ended June 30,
	2005			2004			2005			2004
Revenues
Licenses		38.5	%		59.4	%		38.0	%		44.4	%
Services		61.5	%		40.6	%		62.0	%		55.6	%

Total revenues		100.0	%		100.0	%		100.0	%		100.0	%

Cost of revenues
Cost of licenses		3.5	%		2.1	%		3.8	%		2.5	%
Cost of services		30.2	%		23.8	%		34.9	%		29.7	%

Total cost of revenues		33.7	%		25.9	%		38.7	%		32.2	%

Gross margin		66.3	%		74.1	%		61.3	%		67.8	%
Operating expenses
Sales and marketing		27.8	%		39.6	%		33.6	%		44.4	%
Research and development		17.9	%		16.3	%		25.7	%		21.5	%
General and administrative		19.3	%		14.3	%		21.7	%		24.6	%
Intangible assets amortization		1.0	%		0.0	%		1.1	%		0.0	%
Restructuring charges		0.0	%		0.0	%		12.3	%		0.0	%

Total operating expenses		66.0	%		70.2	%		94.3	%		90.5	%

Income (loss) from operations		0.2	%		3.9	%		(33.0	)%		(22.7	)%
Other income (expense), net		0.7	%		0.3	%		1.8	%		(21.8	)%

Net income (loss)		0.9	%		4.2	%		(31.2	)%		(44.5	)%

Three Months Ended June 30, 2005 and 2004

The comparison of our performance during the second quarter of 2005 to the second quarter of 2004 is significantly impacted as the Kanisa financial performance was not reflected in results prior to its acquisition on February 8, 2005.

Revenues

Total revenues increased 88.9% to $7.3 million in second quarter 2005 from $3.9 million in second quarter 2004. License revenues increased 22.3% to $2.8 million in second quarter 2005 from $2.3 million in second quarter 2004; the increase resulted primarily from an increase in the size of sales to new customers sold after the merger with Kanisa. The average license revenue recognized from sales to new customers was $816,000 up 436.8% from $152,000 in second quarter 2004, and the average license revenue from existing customers was $23,000 in second quarter 2005 down 81.8% from $126,000 in second quarter 2004. There were license sales to three new customers in second quarter 2005 compared to five in the second quarter 2004, and the number of sales of additional licenses to existing customers increased to five in second quarter 2005 from three in second quarter 2004.

Service revenues increased 186.3% to $4.5 million in second quarter 2005 from $1.6 million in second quarter 2004. The increase was due to an increased combined install base after the merger with Kanisa and one major services engagement for an existing customer, which accounted for 18.2% of services revenues in the second quarter 2005.

Cost of Revenues

Cost of revenues increased 146.1% to $2.5 million in second quarter 2005 from $1.0 million in second quarter 2004. The increase is primarily due to the costs associated with our merger with Kanisa, including the amortization of the core technology purchased and a 90.9% increase in employee headcount (allocable to cost of revenues) to 42 at the end of second quarter 2005 compared to 22 at the end of second quarter 2004.

Cost of license revenues increased to $257,000 in second quarter 2005 from $80,000 in second quarter 2004. Cost of license revenues as a percentage of revenues increased to 3.5% from 2.1%. The increase in the cost of license revenues was primarily attributable to the amortization of core technology acquired from Kanisa.

Cost of service revenues increased 139.6% to $2.2 million in second quarter 2005 from $0.9 million in second quarter 2004. The increase was primarily due to a 58.8% increase in employee headcount (allocable to cost of revenues) and the increased use of a third party implementation partner after the merger.

Operating Expenses

Sales and Marketing. Sales and marketing expenses increased 32.7% to $2.0 million, or 27.8% of revenues, in second quarter 2005 from $1.5 million, or 39.6% of revenues, in second quarter 2004. The increase is primarily attributable to costs associated with our merger with Kanisa, which includes a 57.1% increase in employee headcount (allocable to sales and marketing) to 33 at the end of second quarter 2005, of which 9 are quota carrying sales representatives, compared to 21 at the end of second quarter 2004. In addition, we increased our investment in discretionary marketing programs during the second quarter of 2005 in order to seek to strengthen our sales pipeline for future periods.

Research and Development. Research and development expenses increased 108.1% to $1.3 million in second quarter 2005 from $0.6 million in second quarter 2004. The increase was primarily due to the costs associated with our merger with Kanisa. In addition, the increase was a result of a 300% increase in employee headcount (allocable to research and development) to 20 at the end of second quarter 2005 compared to 5 at the end of second quarter 2004. Research and development expenses as a percentage of revenues increased to 17.9% from 16.3% as a consequence of the merger with Kanisa.

General and Administrative. General and administrative expenses increased 154.8% to $1.4 million, or 19.3% of revenues in second quarter 2005 from $0.6 million, or 14.3% of revenues in second quarter 2004. The increase resulted from costs associated with our merger with Kanisa, including increases in facility costs to maintain two locations, costs of contractors associated with integration of the two companies, legal and accounting fees relating to public filings, and recruiting fees associated with the hiring of the new chief financial officer. In addition, stock based compensation costs increased 173.9% in second quarter 2005, as we recorded $140,000 to reflect compensation relating to the acceleration of a terminated executive’s stock options.

Intangible Assets Amortization. Intangible assets amortization of $70,000 recorded in second quarter 2005 was a result of intangible assets acquired through our acquisition of Kanisa. There was no intangible assets amortization in second quarter 2004 as our intangible assets at that time had been fully amortized prior to 2004.

Other income (expense), net

Other income (expense), net consists primarily of interest income on short-term investments, offset by interest expense. Second quarter 2005 results reflect net other income of approximately $48,000 or 0.7% of revenues compared to $12,000 or 0.3% of revenues in second quarter 2004. With no current debt, we do not expect any significant amount of interest expense in the near future.

Six Months Ended June 30, 2005 and 2004

The comparison of our performance during the first six months of 2005 to the first six months of 2004 is skewed since Kanisa financial performance is included in the 2005 results from and after February 8, 2005, but is not reflected in the 2004 operating results.

Revenues

Total revenues increased 92.9% to $11.0 million in the first six months of 2005 from $5.7 million in the first six months of 2004. License revenues increased 65.4% to $4.2 million in the first six months of 2005 from $2.5 million in the first six months of 2004; the increase resulted primarily from an increase in the size of sales to new customers after the merger with Kanisa. The average license revenue recognized from sales to new customers was $245,000 up 63.3% from $150,000 in the first six months of 2004, and the average license revenue from existing customers was $72,000 in the first six months of 2005 down 25.0% from $96,000 in the first six months of 2004. There were six license sales to new customers in the first six months of 2005 and in the first six months of 2004. The number of sales of additional licenses to existing customers remained consistent at ten in the first six months of 2005 and in the first six months of 2004.

Service revenues increased 114.8% to $6.8 million in the first six months of 2005 from $3.2 million in the first six months of 2004. The increase was primarily due to an increased combined install base after the merger with Kanisa and one major services engagement for an existing customer, which accounted for 12.1% of services revenues in the first six months of 2005.

Cost of Revenues

Cost of revenues increased 134.2% to $4.3 million in the first six months of 2005 from $1.8 million in the first six months of 2004. The increase is primarily due to the costs associated with our merger with Kanisa, including the amortization of the core technology purchased and a 90.9% increase in employee headcount (allocable to cost of revenues) to 42 at June 30, 2005 compared to 22 at June 30, 2004.

Cost of license revenues increased to $420,000 in the first six months of 2005 from $144,000 in the first six months of 2004. Cost of license revenues as a percentage of revenues increased to 3.8% from 2.5%. The increase in the cost of license revenues was

primarily attributable to the amortization of core technology acquired from Kanisa.

Cost of service revenues increased 126.5% to $3.8 million in the first six months of 2005 from $1.7 million in the first six months of 2004. The increase was primarily due to a 100% increase in employee headcount (allocable to cost of revenues) and the increased use of a third party implementation partner after the merger.

Operating Expenses

Sales and Marketing. Sales and marketing expenses increased 45.8% to $3.7 million, or 33.6% of revenues, in the first six months of 2005 from $2.5 million, or 44.4% of revenues, in the first six months of 2004. The increase is primarily attributable to costs associated with our merger with Kanisa, which includes a 57.1% increase in employee headcount (allocable to sales and marketing) to 33 at the end of second quarter 2005 compared to 21 at the end of second quarter 2004. In addition, we increased our investment in discretionary marketing programs during the second quarter of 2005 in order to seek to strengthen our sales pipeline for future periods.

Research and Development. Research and development expenses increased 131.3% to $2.8 million in the first six months of 2005 from $1.2 million in the first six months of 2004. The increase was primarily due to the costs associated with our merger with Kanisa, which includes recognizing the expense for acquired in-process research and development of approximately $421,000. In addition, the increase was a result of a 300% increase in employee headcount (allocable to research and development) to 20 at June 30, 2005 compared to 5 at June 30, 2004. Research and development expenses as a percentage of revenues increased to 25.7% from 21.4% as a consequence of merger with Kanisa.

General and Administrative. General and administrative expenses increased 70.2% to $2.4 million, or 21.7% of revenues in the first six months of 2005 from $1.4 million, or 24.6% of revenues in the first six months of 2004. The increase resulted from costs associated with our merger with Kanisa, including increases in facility costs to maintain two locations, costs of contractors associated with integration of the two companies, legal and accounting fees relating to public filings, and recruiting fees associated with the hiring of the new chief financial officer. These additional costs were offset by savings of approximately $60,000 from integrating liability insurance policies.

Intangible Assets Amortization. Intangible assets amortization of $117,000 recorded in the first six months of 2005 was a result of intangible assets acquired through our acquisition of Kanisa. There was no intangible assets amortization in the first six months of 2004 as our intangible assets at that time had been fully amortized prior to 2004.

Restructuring. There was approximately $1.4 million in restructuring expense in the first six months of 2005 relating to severances paid to 21 employees in conjunction with layoffs that occurred as a result of the Kanisa acquisition. For further discussion refer to Note 11 to our consolidated financial statements.

Other income (expense), net

Other income (expense), net consists primarily of interest income on short-term investments, offset by interest expense and other fees related to our convertible notes which were outstanding during a portion of first quarter 2004. Results for the first six months of 2005 reflect net income of approximately $199,000 or 1.8% of revenues compared to a net expense of $1.2 million or 21.8% of revenues in the first six months of 2004. The interest expense in the first six months of 2004 primarily represents amortization of the beneficial conversion feature recognized in conjunction with the issuance and amendment of the convertible notes, in addition to the 10% interest and amortization of the debt discount and debt issue costs on the convertible notes. The beneficial conversion feature was fully amortized in first quarter 2004 as a result of the conversion of all of the notes into common stock in first quarter 2004. With no current debt, we do not expect any significant amount of interest expense in the near future.

Liquidity and Capital Resources

Historically, we have satisfied our cash requirements primarily through private placements of convertible preferred stock and common stock, our initial public offering, and incurrence of debt.

As of June 30, 2005, we had $8.3 million in cash, cash equivalents and marketable securities compared to $10.9 million as of December 31, 2004.

Our ability to continue as a business in our present form is largely dependent on our ability to generate additional revenues, reduce overall operating expenses, and achieve profitability and positive cash flows. We believe that we have the ability to do so and plan to fund the remainder of the 2005 operations through operating revenue and our cash balances.

If we require additional financing, there can be no assurance that additional capital will be available to us on reasonable terms, if at all, when needed or desired. If we raise additional funds through the issuance of equity, equity-related or debt securities, such

securities may have rights, preferences or privileges senior to those of the rights of our common stock. Our stockholders may suffer significant additional dilution in any such equity issuance. Further, the issuance of debt securities could increase the risk or perceived risk of our company.

We incurred a net loss of $3.4 million in first six months of 2005, as compared to a net loss of $2.5 million in the first six months of 2004. Over the past three years, we have taken substantial measures to streamline our costs and we believe that we have improved our chances of achieving profitability in 2005 if we are able to increase our revenues and maintain reasonable expense levels.

The net cash used for operating activities was $5.5 million and $1.1 million for the first six months of 2005 and 2004, respectively. Net cash used for operating activities in the first six months of 2005 and 2004 was principally the result of our net loss reduced by non-cash items, including $0.5 million of restructuring charges in the first six months of 2005 and $1.1 million of amortization of a beneficial conversion feature related to convertible notes in first quarter 2004.

Net cash provided by investing activities of $5.8 million in the first six months of 2005 is primarily due to the cash received from the acquisition of Kanisa and proceeds from the sale of marketable securities. Net cash used in investing activities of $5.9 million in the first six months of 2004 was principally due to the purchases of marketable securities.

Net cash used in financing activities during the first six months of 2005 was not significant. Net cash provided from financing activities of $7.2 million for the first six months of 2004 was principally due to the proceeds of an equity offering.

Contractual Obligations

As of June 30, 2005, we are obligated to make cash payments in connection with our capital leases, operating leases and restructuring charges. The effect of these obligations and commitments on our liquidity and cash flows in future periods is listed below. All of these arrangements require cash payments over varying periods of time. Some of these arrangements are cancelable on short notice and others require termination or severance payments as part of any early termination. Included in the table below are our contractual obligations as of June 30, 2005:


	Payments due by period (in thousands)
	Total		Less than 1 year		1-3 years		4-5 years

Capital lease obligations	$	116	$	51	$	51	$	14
Operating lease obligations		1,460		532		706		222
Restructuring charges		505		505		—		—

Total contractual obligations	$	2,081	$	1,088	$	757	$	236

Related Party Transactions

Our marketable securities are held in an account with an investment firm that is related to one of our directors and his affiliated entities, who collectively own more than 25% of our stock. Also, as investments are purchased and sold, this investment firm may hold a cash balance. At June 30, 2005, the cash balance with this investment firm was approximately $7,000. Cash is defined as cash and cash equivalents maturing within 30 days.

Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123(R) “Share-Based Payment” (“SFAS 123(R)”), a revision to SFAS 123. SFAS 123R addresses all forms of share-based payment (“SBP”) awards, including shares issued under our Employee Stock Purchase Plan, stock options, restricted stock, restricted stock units and stock appreciation rights. SFAS 123R will require us to record compensation expense for SBP awards based on the fair value of the SBP awards. Under SFAS 123R, restricted stock and restricted stock units will generally be valued by reference to the market value of freely tradable shares of our common stock. Stock options, stock appreciation rights and shares issued under our Employee Stock Purchase Plan will generally be valued at fair value determined through an option valuation model, such as a lattice model or the Black-Scholes model (the model that we currently use for our footnote disclosure). In April 2005, the SEC approved a rule that delayed the effective date of SFAS 123R. SFAS 123R will now be effective for public companies for annual periods that begin after June 15, 2005. We are currently evaluating the impact of the adoption of SFAS 123R.

In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107, “Share-Based Payment” (“SAB 107”), which provides interpretive guidance related to the interaction between SFAS 123R and certain SEC rules and regulations, as well as provides the SEC staff’s views regarding the valuation of share-based payment arrangements. We are currently assessing the impact of SAB 107 on our implementation and adoption of SFAS 123R.

Additional Factors That May Affect Future Results

Set forth below and elsewhere in this Form 10-Q and in other documents we file with the Securities and Exchange Commission are risks and uncertainties that could cause actual results to differ materially from the results contemplated by any forward-looking statements contained in this Form 10-Q or the results indicated or projected by our historical results.

We may not be able to reverse our history of losses.

As of June 30, 2005, we had an accumulated deficit of $81.6 million. Although we achieved profitability on a quarterly basis during four of the last five quarters, we incurred a net loss of $1.7 million for the year ended December 31, 2004, and a loss of $3.4 million for the first six months of 2005. Transition expenses to be incurred in connection with the combination of our operations with Kanisa will likely contribute to net losses in 2005. Thereafter, we will need to increase our revenues and control expenses to avoid continued losses. In addition, our history of losses may cause some of our potential customers to question our viability, which might hamper our ability to make sales.

We may need additional capital to fund continued business operations and we cannot be sure that additional financing will be available when and if needed.

Although we presently have adequate cash resources for our near term needs, our ability to continue as a business in our present form will ultimately depend on our ability to generate sufficient revenues or to obtain additional debt or equity financing. From time to time, we consider and discuss various financing alternatives and expect to continue such efforts to raise additional funds to support our operational plan as needed. However, we cannot be certain that additional financing will be available to us on favorable terms when required, or at all.

If we are not able to obtain capital when needed, we may need to dramatically change our business strategy and direction, including pursuing options to sell or merge our business.

In the past, we have funded our operating losses and capital expenditures through proceeds from equity offerings and debt. Changes in equity markets within the past several years have adversely affected our ability to raise equity financing and have adversely affected the markets for debt financing for companies with a history of losses such as ours. If we raise additional funds through the issuance of equity, equity-linked or debt securities, those securities may have rights, preferences or privileges senior to those of the rights of our common stock and, in light of our current market capitalization, our stockholders may experience substantial dilution. Further, the issuance of debt securities could increase the risk or perceived risk of our company. If we are not able to obtain necessary capital, we may need to dramatically change our business strategy and direction, including pursuing options to sell or merge our business.

Our cash flow may not be sufficient to permit repayment of any future debt when due.

Although we do not have any outstanding debt other than trade debt incurred in the ordinary course of business, we may need to, in the future, raise additional money through bank financing or debt instruments. Our ability to retire or to refinance any future indebtedness will depend on our ability to generate cash flow in the future. Our cash flow from operations may be insufficient to repay this indebtedness at scheduled maturity. If we are unable to repay or refinance our debt when due, we could be forced to dispose of assets under circumstances that might not be favorable to realizing the highest price for the assets or to default on our obligations with respect to this indebtedness.

Failure of our recent combination with Kanisa to achieve its potential benefits could harm our business and operating results.

We recently acquired Kanisa Inc. We will not achieve the anticipated benefits of this acquisition unless we are successful in combining our operations and integrating our products. Integration will be a complex, time consuming and expensive process and will result in disruption of our operations and revenues if not completed in a timely and efficient manner. We are in the process of combining various aspects of our organizations through the common use of:

	•		marketing, sales and service and support organizations;

	•		information and communications systems;

	•		operating procedures;

	•		accounting systems and financial controls; and

	•		human resource policies, procedures and practices, including benefit programs.

There may be substantial difficulties, costs and delays involved in integrating Kanisa into our business. These could include:

	•		problems with compatibility of business cultures;

	•		customer perception of an adverse change in service standards, business focus or product and service offerings;

	•		costs and inefficiencies in delivering products and services to our customers;

	•		problems in successfully coordinating our research and development efforts;

	•		difficulty in integrating sales, support and product marketing;

	•		costs and delays in implementing common systems and procedures, including financial accounting systems; and

	•		the inability to retain and integrate key management, research and development, technical sales and customer support personnel.

As we integrate the ServiceWare and Kanisa products into a single product platform, we will need to ultimately transition our customers onto the new platform. This transition could cause interruptions or inconvenience for our customers and potentially result in a loss of renewals and continuing revenues for us.

Further, we may not realize the anticipated benefits and synergies of the combination. Any one or all of the factors identified above could cause increased operating costs, lower than anticipated financial performance, or the loss of customers, employees or business partners. The failure to integrate Kanisa successfully would have a material adverse effect on our business, financial condition and results of operations.

Our change in management might not be successful.

Pursuant to the Merger Agreement entered into with Kanisa, Bruce Armstrong, the chief executive officer of Kanisa, has become our chief executive officer and Mark Angel, chief technology officer of Kanisa, has become our chief technology officer after the merger. In addition, we have recently hired a new chief financial officer and our headquarters were relocated to Kanisa’s offices in Cupertino, California, following the merger. We cannot assure you that our new senior officers will be effective in managing our company or will successfully work with our current organization, customers and business partners.

Failure to retain key employees could diminish the anticipated benefits of the merger.

The success of the merger will depend in part on the retention of personnel critical to the business and operations of the combined company due to, for example, their technical skills or management expertise. Some of our employees may not want to continue to work for the combined company. In addition, competitors may seek to recruit employees during the integration. If we are unable to retain personnel that are critical to our successful integration and future operation, we could face disruptions in our operations, loss of existing customers, loss of key information, expertise or know-how, and unanticipated additional recruitment and training costs. In addition, the loss of key personnel could diminish the anticipated benefits of the merger.

The market price of our common stock may decline as a result of the merger.

The market price of our common stock may decline as a result of the merger if:

	•		our integration with Kanisa is not as successful as anticipated

	•		we do not achieve or are perceived not to have achieved the expected benefits of the merger as rapidly or to the extent anticipated by financial or industry analysts or investors

	•		the effect of the merger on our financial results is not consistent with the expectations of financial or industry analysts or investors.

The market price of our common stock could also decline as a result of unforeseen factors related to the merger or other factors described in this section.

The substantial costs of our combination with Kanisa could harm our financial results.

In connection with our combination with Kanisa, we incurred substantial costs. These include fees to investment bankers, legal counsel, independent accountants and consultants, as well as costs associated with workforce reductions. If the benefits of the combination do not exceed the associated costs, including any dilution to our stockholders resulting from the issuance of shares of our

common stock in the transaction, our financial results, including earnings per share, could suffer, and the market price of our common stock could decline.

We may not succeed in attracting and retaining the personnel we need for our business.

Our business requires the employment of highly skilled personnel, especially experienced software developers. The inability to recruit and retain experienced software developers in the future could result in delays in developing new versions of our software products or could result in the release of deficient software products. Any such delays or defective products would likely result in lower sales. We may also experience difficulty in hiring and retaining sales personnel, product managers and professional services employees.

A third party performs a significant percentage of our product development internationally, the loss of which could substantially impair our product development efforts.

A significant percentage of our product development work, and some of our implementation services, is performed by a third-party development organization located in Minsk, Belarus. Unpredictable developments in the political, economic and social conditions in Belarus, or our failure to maintain or renew our business relationship with this organization on terms similar to those which exist currently, could reduce or eliminate product development and implementation services. If access to these services were to be unexpectedly eliminated or significantly reduced, our ability to meet development objectives vital to our ongoing strategy would be hindered or we may be required to incur significant costs to find suitable replacements, and our business could be seriously harmed.

It is difficult to draw conclusions about our future performance based on our past performance due to significant fluctuations in our quarterly operating results and the merger with Kanisa.

We seek to manage our expense levels based on our expectations regarding future revenues and our expenses are relatively fixed in the short term. Therefore, if revenue levels are below expectations in a particular quarter, operating results and net income are likely to be disproportionately adversely affected because our expenses are relatively fixed. In addition, a significant percentage of our revenues is typically derived from large orders from a limited number of customers, so it is difficult to estimate accurately the timing of future revenues. Our revenues are unpredictable and fluctuate up and down from quarter to quarter.

Our historical results may not be indicative of future performance as a result of the significant changes to our business that have resulted and will result from the merger with Kanisa.

Our quarterly results are also impacted by our revenue recognition policies. Because we generally recognize license revenues upon installation and training, sales orders from new customers in a quarter might not be recognized during that quarter. Delays in the implementation and installation of our software near the end of a quarter could also cause recognized quarterly revenues and, to a greater degree, results of operations to fall substantially short of anticipated levels. We often recognize revenues for existing customers in a shorter time frame because installation and training can generally be completed in significantly less time than for new customers. However, we may not be able to recognize expected revenues at the end of a quarter due to delays in the receipt of expected orders from existing customers.

Quarterly results may also be skewed in the near future as a result of the assimilation of the ServiceWare and Kanisa businesses.

Revenues in any given quarter are not indicative of revenues in any future period because of these and other factors and, accordingly, we believe that certain period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indicators of future performance.

The markets for knowledge management and service resolution management are evolving and, if they do not grow rapidly, our business will be adversely affected.

The markets for knowledge management and service resolution management solutions are emerging industries, and it is difficult to predict how large or how quickly they will grow, if at all. Customer service historically has been provided primarily in person or over the telephone with limited reference materials available for the customer service representative. Our business model assumes that companies which provide customer service over the telephone will find value in aggregating institutional knowledge by using our software and will be willing to access our content over the Internet. Our business model also assumes that companies will find value in providing some of their customer service over the Internet rather than by telephone. Our success will depend on the broad commercial acceptance of, and demand for, these knowledge management and service resolution management solutions.

We currently have one core product family. If the demand for this line of products declines, our business will be adversely affected.

Our knowledge powered service resolution management application, Knova Application Suite, includes our Knova Contact Center, Knova Self-Service, Knova Forums, and Knova Service Desk software products. Our past and expected future revenues consist primarily of license fees for these software solutions and fees for related services. Factors adversely affecting the demand for these products and our products in general, such as competition, pricing or technological change, could materially adversely affect our business, financial condition, operating results, and the value of our stock price. Our future financial performance will substantially depend on our ability to sell current versions of our entire suite of products and our ability to develop and sell enhanced versions of our products.

Due to the lengthy sales cycles of our products and services, the timing of our sales is difficult to predict and may cause us to miss our revenue expectations.

Our products and services are typically intended for use in applications that may be critical to a customer’s business. In certain instances, the purchase of our products and services involves a significant commitment of resources by prospective customers. As a result, our sales process is often subject to delays associated with lengthy approval processes that accompany the commitment of significant resources. For these and other reasons, the sales cycle associated with the licensing of our products and subscription for our services typically ranges between six and eighteen months and is subject to a number of significant delays over which we have little or no control. While our customers are evaluating whether our products and services suit their needs, we may incur substantial sales and marketing expenses and expend significant management effort. We may not realize forecasted revenues from a specific customer in the quarter in which we expend these significant resources, or at all, because of the lengthy sales cycle for our products and services.

We may not be able to expand our business internationally, and, if we do, we face risks relating to international operations.

Our business strategy includes efforts to attract more international customers. By doing business in international markets we face risks, such as unexpected changes in tariffs and other trade barriers, fluctuations in currency exchange rates, political instability, reduced protection for intellectual property rights in some countries, seasonal reductions in business activity during the summer months in Europe and certain other parts of the world, and potentially adverse tax consequences, any of which could adversely impact our international operations.

If we are not able to keep pace with rapid technological change, sales of our products may decrease.

The software industry is characterized by rapid technological change, including changes in customer requirements, frequent new product and service introductions and enhancements and evolving industry standards. If we fail to keep pace with the technological progress of our competitors, sales of our products may decrease.

We depend on technology licensed to us by third parties, and the loss of this technology could delay implementation of our products, injure our reputation or force us to pay higher royalties.

We rely, in part, on technology that we license from a small number of software providers for use with our products. After the expiration of these licenses, this technology may not continue to be available on commercially reasonable terms, if at all, and may be difficult to replace. The loss of any of these technology licenses could result in delays in introducing or maintaining our products until equivalent technology, if available, is identified, licensed and integrated. In addition, any defects in the technology we may license in the future could prevent the implementation or impair the functionality of our products, delay new product introductions or injure our reputation. If we are required to enter into license agreements with third parties for replacement technology, we could be subject to higher royalty payments.

Problems arising from the use of our products with other vendors’ products could cause us to incur significant costs, divert attention from our product development efforts and cause customer relations problems.

Our customers generally use our products together with products from other companies. As a result, when problems occur in a customer’s systems, it may be difficult to identify the source of the problem. Even when our products do not cause these problems, they may cause us to incur significant warranty and repair costs, divert the attention of our technical personnel from our product development efforts and cause significant customer relations problems.

If third parties cease to provide open program interfaces for their customer relationship management software, it will be difficult to integrate our software with theirs. This may decrease the attractiveness of our products.

Our ability to compete successfully also depends on the continued compatibility and interoperability of our products with products and systems sold by various third parties, specifically including CRM software sold by Siebel Systems, Amdocs, Peoplesoft/Oracle, SAP, Remedy, Hewlett Packard, and Peregrine. Currently, these vendors have open applications program interfaces, which facilitate our ability to integrate with their systems. If any one of them should close their programs’ interface or if they should acquire one of our competitors, our ability to provide a close integration of our products could become more difficult, or

impossible, and could delay or prevent our products’ integration with future systems. Inadequate integration with other vendors’ products could make our products less desirable and could lead to lower sales.

We face intense competition from both established and recently formed entities, and this competition may adversely affect our revenues and profitability because we compete in the emerging markets for knowledge management and service resolution management solutions.

We compete in the emerging markets for knowledge management and service resolution management solutions and changes in these markets could adversely affect our revenues and profitability. We face competition from many firms offering a variety of products and services. In the future, because there are relatively low barriers to entry in the software industry, we expect to experience additional competition from new entrants into the knowledge management and service resolution management solutions market. It is also possible that alliances or mergers may occur among our competitors and that these newly consolidated companies could rapidly acquire significant market share. Greater competition may result in price erosion for our products and services, which may significantly affect our future operating margins.

If our software products contain errors or failures, sales of these products could decrease.

Software products frequently contain errors or failures, especially when first introduced or when new versions are released. In the past, we have released products that contained defects, including software errors in certain new versions of existing products and in new products after their introduction. In the event that the information contained in our products is inaccurate or perceived to be incomplete or out-of-date, our customers could purchase our competitors’ products or decide they do not need knowledge management or service resolution management solutions at all. In either case, our sales would decrease. Our products are typically intended for use in applications that may be critical to a customer’s business. As a result, we believe that our customers and potential customers have a great sensitivity to product defects.

We could incur substantial costs as a result of product liability claims because our products are critical to the operations of our customers’ businesses.

Our products may be critical to the operations of our customers’ businesses. Any defects or alleged defects in our products entail the risk of product liability claims for substantial damages, regardless of our responsibility for the failure. Although our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims, these provisions may not be effective under the laws of some jurisdictions. In addition, product liability claims, even if unsuccessful, may be costly and divert management’s attention from our operations. Software defects and product liability claims may result in a loss of future revenue, a delay in market acceptance, the diversion of development resources, damage to our reputation or increased service and warranty costs.

If our customers’ system security is breached and confidential information is stolen, our business and reputation could suffer.

Users of our products transmit their and their customers’ confidential information, such as names, addresses, social security numbers and credit card information, over the Internet. In our license agreements with our customers, we typically disclaim responsibility for the security of confidential data and have contractual indemnities for any damages claimed against us. However, if unauthorized third parties are successful in illegally obtaining confidential information from users of our products, our reputation and business may be damaged, and if our contractual disclaimers and indemnities are not enforceable, we may be subject to liability.

We may acquire or make investments in companies or technologies that could hurt our business.

In addition to our recent combination with Kanisa, we may pursue mergers or acquisitions in the future to obtain complementary businesses, products, services or technologies. Entering into a merger or acquisition entails many risks, any of which could adversely affect our business, including:

	•		failure to integrate the acquired assets and/or companies with our current business;

	•		the price we pay may exceed the value we eventually realize;

	•		potential loss of share value to our existing stockholders as a result of issuing equity securities as part or all of the purchase price;

	•		potential loss of key employees from either our current business or the acquired business;

	•		entering into markets in which we have little or no prior experience;

	•		diversion of management’s attention from other business concerns;

	•		assumption of unanticipated liabilities related to the acquired assets; and

	•		the business or technologies we acquire or in which we invest may have limited operating histories and may be subject to many of the same risks we are.

Any of these outcomes could prevent us from realizing the anticipated benefits of any additional acquisitions. To pay for an acquisition, we might use stock or cash or, alternatively, borrow money from a bank or other lender. If we use our stock, our stockholders would experience dilution of their ownership interests. If we use cash or debt financing, our financial liquidity would be reduced. We may be required to capitalize a significant amount of intangibles, including goodwill, which may lead to significant amortization charges. In addition, we may incur significant, one-time write offs and amortization charges. These amortization charges and write offs could decrease our future earnings or increase our future losses.

We may not be able to protect our intellectual property rights, which may cause us to incur significant costs in litigation and erosion in the value of our brands and products.

Our business is dependent on proprietary technology and the value of our brands. We rely primarily on patent, copyright, trade secret and trademark laws to protect our technology and brands. Our patents may not survive a legal challenge to their validity or provide meaningful protection to us. Litigation to protect our patents could be expensive and the loss of our patents would decrease the value of our products. Defending against claims of patent infringement would also be expensive and, if unsuccessful, we could be forced to redesign our products, pay royalties, or cease selling them. In addition, effective trademark protection may be unavailable for our trademarks. The use by other parties of our trademarks would dilute the value of our brands.

Notwithstanding the precautions we have taken, a third party may copy or otherwise obtain and use our software or other proprietary information without authorization or may develop similar software independently. Policing unauthorized use of our technology is difficult, particularly because the global nature of the Internet makes it difficult to control the ultimate destination or security of software or other transmitted data. Further, we have granted certain third parties limited contractual rights to use proprietary information, which they may improperly use or disclose. The laws of other countries may afford us little or no effective protection of our intellectual property. The steps we have taken may not prevent misappropriation of our technology, and the agreements entered into for that purpose may not be enforceable. The unauthorized use of our proprietary technologies could also decrease the value of our products.

We may initiate lawsuits to protect or enforce our patents. Lawsuits may be expensive and, depending on the verdict, we may lose some, if not all, of our intellectual property rights, and this may impair our ability to compete in the market.

We believe that some companies, including direct and indirect competitors, may be infringing our patents. In order to protect or enforce our patent rights, we may decide to initiate patent litigation suits against third parties, such as infringement suits or interference proceedings. Lawsuits that we may file are likely to be expensive, may take significant time and could divert management’s attention from other business concerns. Litigation also places our patents at risk of being invalidated or interpreted narrowly. Lawsuits may also provoke these third parties to assert claims against us. Patent law relating to the scope of claims in the technology fields in which we operate is still evolving and, consequently, patent positions in our industry are generally uncertain. We may not prevail in any suits we may bring, the damages or other remedies that may be awarded to us may not be commercially valuable and we could be held liable for damages as a result of counterclaims.

The success of our software products depends on its adoption by our customers’ employees. If these employees do not accept the implementation of our products, our customers may fail to renew their service contracts and we may have difficulty attracting new customers.

The effectiveness of our products depends in part on widespread adoption and use of our software by our customers’ customer service personnel and on the quality of the solutions they generate. Resistance to our software by customer service personnel and an inadequate development and maintenance of the system’s knowledge resources, business rule, and other configurations may make it more difficult to attract new customers and retain old ones.

Some of our customers have found that customer service personnel productivity initially drops while customer service personnel become accustomed to using our software. If an enterprise deploying our software has not adequately planned for and communicated its expectations regarding that initial productivity decline, customer service personnel may resist adoption of our software.

We depend on increased business from our new customers and, if we fail to grow our customer base or generate repeat business, our operating results could be adversely affected.

Some of our customers initially make a limited purchase of our products and services for pilot programs. If these customers do not successfully develop and deploy such initial applications, they may choose not to purchase complete deployment or development licenses. Some of our customers who have made initial purchases of our software have deferred or suspended implementation of our products due to slower than expected rates of internal adoption by customer service personnel. If more customers decide to defer or

suspend implementation of our products in the future, we will be unable to increase our revenue from these customers from additional licenses or maintenance agreements, and our financial position will be seriously harmed.

In addition, as we introduce new versions of our products or new products, our current customers may not need our new products and may not ultimately license these products. Any downturn in our software licenses revenues would negatively impact our future service revenues because the total amount of maintenance and service fees we receive in any period depends in large part on the size and number of licenses that we have previously sold. In addition, if customers elect not to renew their maintenance agreements, our service revenues could be significantly adversely affected.

A decline in information technology spending could reduce the sale of our products.

The license fees for our products often represent a significant expenditure of information technology (“IT”) capital for our customers. Any slowdown in the national or global economy or increased uncertainty resulting from acts of terrorism or war could cause existing and potential customers to reduce or reassess their planned IT expenditures. Such reductions in or eliminations of IT spending could cause us to be unable to maintain or increase our sales volumes, and therefore, have a material adverse effect on our revenues, operating results, ability to generate positive cash flow and stock price.

Increasing government regulation of the Internet could harm our business.

As knowledge management, service resolution management, and the Internet continue to evolve, we expect that federal, state and foreign governments will adopt laws and regulations tailored to the Internet addressing issues like user privacy, taxation of goods and services provided over the Internet, pricing, content and quality of products and services. If enacted, these laws and regulations could limit the market for knowledge management and service resolution management services and, therefore, the market for our products and services. Additionally, Internet security issues could deter customers from using the Internet for certain transactions or from implementing customer support websites.

The Telecommunications Act of 1996 prohibits certain types of information and content from being transmitted over the Internet. The prohibition’s scope and the liability associated with a violation of the Telecommunications Act’s information and content provisions are currently unsettled. The imposition of potential liability upon us and other software and service providers for information carried on or disseminated through our applications could require us to implement measures to reduce our exposure to this liability. These measures could require us to expend substantial resources or discontinue certain services. In addition, although substantial portions of the Communications Decency Act, the act through which the Telecommunications Act of 1996 imposes criminal penalties, were held to be unconstitutional, similar legislation may be enacted and upheld in the future. It is possible that new legislation and the Communications Decency Act could expose companies involved in Internet services to liability, which could limit the growth of Internet usage and, therefore, the demand for knowledge management and service resolution management solutions. In addition, similar or more restrictive laws in other countries could have a similar effect and hamper our plans to expand overseas.

We may become involved in securities class action litigation, which could divert management’s attention and harm our business.

In recent years, the common stocks of technology companies have experienced significant price and volume fluctuations. These broad market fluctuations may cause the market price of our common stock to decline. In the past, following periods of volatility in the market price of a particular company’s securities, securities class action litigation has often been brought against that company. We may become involved in that type of litigation in the future. Litigation is often expensive and diverts management’s attention and resources, which could harm our business and operating results.

Our stock price may be adversely affected since our stock is not listed on an exchange or The Nasdaq Stock Market.

As our stock is traded on the OTC Bulletin Board, investors may find it more difficult to dispose of or obtain accurate quotations as to the market value of our securities. In addition, we are subject to a rule promulgated by the Securities and Exchange Commission that, if we fail to meet criteria set forth in such rule, various practice requirements are imposed on broker-dealers who sell securities governed by the rule to persons other than established customers and accredited investors. For these types of transactions, the broker-dealer must make a special suitability determination for the purchaser and have received the purchaser’s written consent to the transactions prior to purchase. Consequently, the rule may deter broker-dealers from recommending or purchasing our common stock, which may further affect the liquidity of our common stock.

Our failure to be listed on an exchange or Nasdaq makes trading our shares more difficult for investors. It may also make it more difficult for us to raise additional capital. Further, we may also incur additional costs under state blue sky laws in connection with any sales of our securities.

Shares available for future sale could adversely affect our stock price.

Future sales of a substantial number of shares of our common stock in the public market, or the perception that such sales may occur, could adversely affect trading prices of our common stock from time to time. As of the time of this filing, 8,743,116 shares of our common stock are outstanding. Virtually all of the shares outstanding prior to the Kanisa merger (approximately 5,252,245 shares) are freely tradable without restriction or further registration under the Securities Act, except for any shares which are owned by an affiliate of ours as that term is defined in Rule 144 under the Securities Act and that are not registered for resale under our currently effective prospectus. The shares of our common stock issued in the merger with Kanisa and the shares of our common stock owned by our affiliates and not registered for resale under our currently effective prospectus are restricted securities, as that term is defined in Rule 144, and may in the future be sold under the Securities Act to the extent permitted by Rule 144 or any applicable exemption under the Securities Act.

Our management owns a significant percentage of our company and will be able to exercise significant influence over our actions.

Our officers and directors and related entities, who in the aggregate directly or indirectly control more than 50% of our outstanding common stock and voting power, control us. These stockholders collectively will likely be able to control our management policy, decide all fundamental corporate actions, including mergers, substantial acquisitions and dispositions, and elect our board of directors.

Voting agreements in place assure election of our current directors for 2006.

Certain of our stockholders owning more than 50% of our voting stock have entered into voting agreements to vote in favor of the current board members up for election in 2006. This could negatively affect the ability of any third party to gain control of our company.

Terrorist attacks and other attacks or acts of war may adversely affect the markets on which our common stock trades, our financial condition and our results of operations.

Acts of terrorism in the United States or elsewhere could cause instability in the United States and other financial markets. Armed hostilities or further acts of terrorism could cause further instability in financial markets and could directly impact our financial condition and our results of operations.

The regulatory environment surrounding accounting and corporate governance subjects us to certain legal uncertainties in the operation of our business and may increase the cost of doing business.

We will face increased regulatory scrutiny associated with the highly publicized financial scandals and the various accounting and corporate governance rules promulgated under the Sarbanes-Oxley Act of 2002 and related regulations. Our management will review and will continue to monitor our accounting policies and practices, legal disclosure and corporate governance policies under the new legislation, including those related to relationships with our independent auditors, enhanced financial disclosures, internal controls, board and board committee practices, corporate responsibility and executive officer loan practices. We intend to fully comply with these laws. Nevertheless, the increased scrutiny and penalties involve risks to both us and our executive officers and directors in monitoring and ensuring compliance. A failure to properly navigate the legal disclosure environment and implement and enforce appropriate policies and procedures, if needed, could harm our business and prospects, including our ability to recruit and retain skilled officers and directors. In addition, we may be adversely affected as a result of new or revised legislation or regulations imposed by the Securities and Exchange Commission, other U.S. or foreign governmental regulatory authorities or self-regulatory organizations that supervise the financial markets. We also may be adversely affected by changes in the interpretation or enforcement of existing laws and rules by these governmental authorities and self-regulatory organizations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Nearly all of our revenues recognized to date have been denominated in United States dollars and are primarily from customers in the United States. We have a European distributor located in London, England. Revenues from international clients were 5% in the first six months of 2005 and 6% in the first six months of 2004, and nearly all of these revenues have been denominated in United States dollars. In the future, a portion of the revenues we derive from international operations may be denominated in foreign currencies. Furthermore, to the extent that we engage in international sales denominated in United States dollars, an increase in the value of the United States dollar relative to foreign currencies could make our services less competitive in international markets. Although currency fluctuations are currently not a material risk to our operating results, we will continue to monitor our exposure to currency fluctuations and when appropriate, consider the use of financial hedging techniques to minimize the effect of these fluctuations in the future. Exchange rate fluctuations may harm our business in the future. We do not currently utilize any derivative financial instruments or derivative commodity instruments.

Our interest income is sensitive to changes in the general level of United States interest rates, particularly because the majority of

our investments are in short-term instruments. Since we no longer have any debt, except capital leases, we are not currently subject to material interest rate risk.

Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures. As of the end of the period covered by this report, under the supervision and with the participation of our management, including our chief executive officer (“CEO”) and chief financial officer (“CFO”), we evaluated the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, or the “Exchange Act”). Based on this evaluation, our management, including our CEO and CFO, has concluded that our disclosure controls and procedures are designed, and are effective, to give reasonable assurance that the information we are required to disclose is recorded, processed, summarized and reported by our management on a timely basis in order to comply with our disclosure obligations under the Exchange Act and the SEC rules thereunder.

(b) Changes in internal controls. There were no changes in our internal control over financial reporting that occurred during our quarter ended June 30, 2005, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

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

We held our annual meeting of stockholders on May 24, 2005. The following matters were considered and voted upon at the Annual Meeting:

	•		the election of two persons to serve as Class II Directors for a three-year term

	•		the approval of an amendment to our Certificate of Incorporation to change our name to “Knova Software, Inc.”

	•		the approval of amendments to our 2000 Stock Incentive Plan (the “2000 Stock Plan”) to: (i) increase the maximum aggregate number of shares of common stock available for issuance thereunder from 1,240,817 to 2,453,387 shares and to reserve an additional 1,212,570 shares of our common stock for issuance in connection with awards granted or to be granted under the 2000 Stock Plan; (ii) to approve an increase in the grant limit under the 2000 Stock Plan from 100,000 to 500,000 shares per participant per fiscal year; and (iii) to make other changes to the 2000 Stock Plan.

The nominations of David Schwab and Timothy Wallace to serve as directors and the adoption of the other matters were approved. The terms of Bruce Armstrong, Kent Heyman, Thomas Shanahan and Thomas Unterberg as Directors of our company continued after the meeting. The votes on the matters presented to our Stockholders were as follows:


	Votes for		Votes against		Votes abstained
Election of David Schwab as a director		4,751,385		N/A		10,603

Election of Timothy Wallace as a director		4,751,385		N/A		49,603

Approval of an amendment to our Certificate of Incorporation to approve our name change		4,766,755		20,374		1,660

Approval of proposed amendments to our stock option plan		3,341,244		59,273		50

Item 6. Exhibits

2 .1 Amended Agreement and Plan of Merger, dated as of February 8, 2005, by and among the Company, Kanisa Inc. and SVCW Acquisition, Inc. (1)

3 .1 Amended and Restated Bylaws of the Company (1)

3 .2 Certificate of Amendment of Third Amended and Restated Certificate of Incorporation (reverse split) (2)

3.3 Certificate of Amendment of Third Amended and Restated Certificate of Incorporation (name change)

4 .1 Form of Warrant issued to Kanisa stockholders as of February 8, 2005 (2)

4 .2 Registration Rights Agreement, dated as of February 8, 2005, by and among the Company and stockholders of Kanisa Inc. (1)

10.1 Separation Agreement and General Release, effective June 30, 2005, by and between Knova Software, Inc. and Scott Schwartzman

10.2 Employment Agreement effective June 23, 2005, by and between Knova Software, Inc. and Thomas Muise

31.1 Rule 13a — 14(a) / 15d — 14(a) Certification of Principal Executive Officer

31.2 Rule 13a — 14(a) / 15d — 14(a) Certification of Principal Financial Officer

32. Section 1350 Certifications


(1)		Incorporated by reference to our Current Report on Form 8-K dated February 8, 2005.

(2)		Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2004.

SIGNATURES

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


	KNOVA SOFTWARE, INC.

Date: August 8, 2005		By:	/s/ THOMAS MUISE

		Thomas Muise
		Principal Financial Officer

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KNOVA SOFTWARE, INC. 10-Q