UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark one)

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

For the quarterly period ended September 30, 2003

¨	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 0-15454

TANGRAM ENTERPRISE SOLUTIONS, INC.

(Exact Name of Registrant as Specified in Its Charter)

Pennsylvania

23-2214726

(State or Other Jurisdiction of

Incorporation or Organization)

(I.R.S. Employer Identification No.)

11000 Regency Parkway, Suite 301

Cary, NC 27511

(Address of Principal Executive Offices) (Zip Code)

(919) 653-6000

(Registrant’s telephone number, including area code)

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

None

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

Common Stock, $0.01 par value

(Title of class)

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 ¨

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

The number of outstanding shares of Common Stock, $0.01 par value per share, as of November 14, 2003 was 19,802,439.

TANGRAM ENTERPRISE SOLUTIONS, INC.

INDEX

PART I. FINANCIAL INFORMATION

Item 1 - Financial Statements:

Balance Sheets – September 30, 2003 (Unaudited) and December 31, 2002		3

Statements of Operations – Three Months Ended September 30, 2003 and 2002 (Unaudited)		4

Statements of Operations – Nine months Ended September 30, 2003 and 2002 (Unaudited)		5

Statements of Cash Flows – Nine months Ended September 30, 2003 and 2002 (Unaudited)		6

Notes to the Financial Statements		7

Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations		15

Item 3 - Quantitative and Qualitative Disclosures About Market Risk		35

Item 4 - Controls and Procedures		36

PART II. OTHER INFORMATION

Item 6 - Exhibits and Reports on Form 8-K		37

Signatures		38

Tangram Enterprise Solutions, Inc.

Balance Sheets

(in thousands, except share amounts)

	September 30, 2003			December 31, 2002
	(unaudited)			(audited)
Assets
Current assets:
Cash and cash equivalents	$	1,410		$	418
Accounts receivable, net of allowance of $268 and $220 in 2003 and 2002, respectively		1,232			2,671
Other		290			296

Total current assets		2,932			3,385
Property and equipment:
Computer equipment and software		962			902
Office equipment and furniture		237			218
Leasehold improvements		37			37

		1,236			1,157
Less accumulated depreciation and amortization		(1,130	)		(1,057	)

Total property and equipment		106			100
Other assets:
Acquired software technology, net accumulated amortization of $1,682 and $1,244 in 2003 and 2002, respectively		1,071			1,509
Deferred software costs, net accumulated amortization of $2,875 and $1,671 in 2003 and 2002, respectively		2,885			3,472
Cost in excess of net assets of business acquired		1,415			1,415
Other intangibles, net accumulated amortization of $373 and $335 in 2003 and 2002, respectively		—			38
Other		15			15

Total other assets		5,386			6,449

Total assets	$	8,424		$	9,934

Liabilities and shareholders’ equity
Current liabilities:
Current portion of long-term debt – shareholders	$	1,823		$	467
Accounts payable		237			336
Accrued expenses		565			724
Deferred revenue		2,622			3,281

Total current liabilities		5,247			4,808
Long-term debt – shareholders		—			1,954
Other liabilities		727			542
Shareholders’ equity:
Convertible preferred stock – Series F, par value $0.01, $1,000 stated value, 3,000 shares authorized, designated, issued and outstanding (aggregate liquidation preference of $3,688 in 2003 and $3,475 in 2002)		—			—
Common stock, par value $0.01, authorized 48,000,000 shares, 19,802,439 issued and outstanding in 2003 and 2002, respectively		198			198
Additional paid-in capital		50,525			50,525
Accumulated deficit		(48,273	)		(48,093	)

Total shareholders’ equity		2,450			2,630

Total liabilities and shareholders’ equity	$	8,424		$	9,934

See accompanying notes.

Tangram Enterprise Solutions, Inc.

Statements of Operations

(in thousands, except per share amounts)

	Three months ended September 30
	2003			2002
	(unaudited)
Revenue:
Licenses and products	$	892		$	1,408
Services		1,840			1,626

Total revenue		2,732			3,034
Cost of revenue:
Cost of licenses and products		(3	)		10
Cost of services		369			369
Amortization of software costs		700			513

Total cost of revenue		1,066			892

Gross profit		1,666			2,142
Operating expenses:
Sales and marketing		818			1,195
General and administrative		357			522
Research and development		308			277
Depreciation and amortization		16			82
Restructuring charge		—			16

Total operating expenses		1,499			2,092

Income from operations		167			50
Other expense, net		(33	)		(31	)

Income before income taxes		134			19
Provision for income taxes		—			—

Net income	$	134		$	19

Per share calculation:
Net income	$	134		$	19
Preferred stock dividend		(72	)		(66	)

Net income (loss) available to common shareholders	$	62		$	(47	)

Income (loss) per common share-
Basic and diluted	$	0.00		$	0.00

Weighted average number of common shares outstanding:
Basic		19,802			19,802

Diluted		19,828			19,802

See accompanying notes.

Tangram Enterprise Solutions, Inc.

Statements of Operations

(in thousands, except per share amounts)

	Nine months ended September 30
	2003			2002
	(unaudited)
Revenue:
Licenses and products	$	2,327		$	3,534
Services		5,281			5,219

Total revenue		7,608			8,753
Cost of revenue:
Cost of licenses and products		26			41
Cost of services		951			1,192
Amortization of software costs		1,814			1,609

Total cost of revenue		2,791			2,842

Gross profit		4,817			5,911
Operating expenses:
Sales and marketing		2,562			3,972
General and administrative		1,213			1,535
Research and development		802			1,217
Depreciation and amortization		110			252
Restructuring charge		—			325

Total operating expenses		4,687			7,301

Income (loss) from operations		130			(1,390	)
Other expense, net		(98	)		(138	)

Income (loss) before income taxes		32			(1,528	)
Provision for income taxes		—			—

Net income (loss)	$	32		$	(1,528	)

Per share calculation:
Net income (loss)	$	32		$	(1,528	)
Preferred stock dividend		(212	)		(197	)

Net loss available to common shareholders	$	(180	)	$	(1,725	)

Loss per common share-
Basic and diluted	$	(0.01	)	$	(0.09	)

Weighted average number of common shares outstanding-
Basic and diluted		19,802			19,717

See accompanying notes.

Tangram Enterprise Solutions, Inc.

Statements of Cash Flows

(in thousands)

	Nine months ended September 30
	2003			2002
	(unaudited)
Operating activities
Net income (loss)	$	32		$	(1,528	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation		72			122
Amortization		1,851			1,749
Non cash interest expense		52			74
Reserve for doubtful accounts		49			35
Other		(27	)		(2	)
Cash provided by (used in) changes in working capital items:
Accounts receivable and other current assets		1,396			2,473
Accounts payable		(99	)		81
Accrued expenses		(159	)		(1,188	)
Deferred revenue		(659	)		(1,051	)

Net cash provided by operating activities		2,508			765
Investing activities
Deferred software costs		(788	)		(1,317	)
Expenditures for property and equipment		(78	)		(18	)
Decrease in other assets		—			18

Net cash used in investing activities		(866	)		(1,317	)
Financing activities
Net (repayments) borrowings on notes payable from shareholders		(650	)		500

Net cash (used in) provided by financing activities		(650	)		500

Net increase (decrease) in cash and cash equivalents		992			(52	)
Cash and cash equivalents, beginning of period		418			322

Cash and cash equivalents, end of period	$	1,410		$	270

Supplemental disclosure of non-cash activities
Cash paid during the period for interest	$	35		$	8

Issuance of stock to repay debt	$	—		$	300

See accompanying notes.

Tangram Enterprise Solutions, Inc

Notes to the Financial Statements

(Unaudited)

Note 1. Organization and Description of Business

Tangram Enterprise Solutions, Inc. (the “Company”) develops and markets lifecycle IT asset management software for large and midsize organizations across all industries, in both domestic and international markets. IT asset management is the process of controlling hardware and software assets throughout their lifecycle — from procurement, through daily operations, through final disposal. While asset management is primarily a business practice, it is supported by repository technology that consolidates diverse financial, contractual, ownership, and physical asset data. Tangram’s core business strategy and operating philosophy focus on delivering world-class customer care, providing phased asset management solutions that are tailored to our customers’ evolving business needs, and maintaining a leading-edge technical position that results in long-term customer loyalty and sustained shareholder value. The Company operates in the software industry, which is characterized by intense competition, rapid technological advances and evolving industry standards. Factors that could affect the Company’s future operating results and cash flows and cause actual results to vary materially from expectations include, but are not limited to, dependence on an industry that is characterized by rapid technological changes, fluctuations in end-user demands, evolving industry standards, and risks associated with a market that is intensely competitive. Failure by the Company to anticipate or respond adequately to technological developments in its industry, new competitive offerings or participants, changes in customer requirements or changes in industry standards could have a material adverse effect on the Company’s business and operating results.

The Company’s common stock trades on OTC Bulletin Board under the symbol TESI.OB. The Company is a partner company of Safeguard Scientifics, Inc. (NYSE: SFE) (“Safeguard”). Safeguard is a technology operating company that creates long-term value by focusing on technology-related asset acquisitions that are developed through superior operations and management. Safeguard acquires and develops companies in three areas: software, business and IT services, and emerging technologies. Safeguard is the majority shareholder of the Company holding approximately 58% of the Company’s outstanding voting shares (assuming conversion of the Series F Convertible Preferred Stock).

Note 2. Significant Accounting Policies

Basis of Presentation

The accompanying unaudited interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q 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 for complete financial statements. In the opinion of management, all adjustments (consisting solely of normal recurring accruals) considered necessary for a fair presentation of the statements have been included. The interim operating results are not necessarily indicative of the results that may be expected for a full fiscal year. The balance sheet at December 31, 2002 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. For further information, refer to the financial statements and accompanying footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from these estimates.

Key estimates in the accompanying financial statements include, among others, allowances for doubtful accounts receivable, deferral of software cost, valuation of intangibles, valuation allowances against deferred income tax assets, and revenue recognition.

Revenue Recognition

In October 1997, the Accounting Standards Executive Committee (AcSEC) issued Statement of Position (SOP) 97-2 “Software Revenue Recognition”, as amended in March 1998 by SOP 98-4 and October 1998 by SOP 98-9. These SOPs provide guidance on applying accounting principles generally accepted in the United States in recognizing revenue on software transactions. The Company adopted SOP 97-2 for software transactions entered into beginning January 1, 1998. Based on the current requirements of the SOPs, application of these statements did not have a material impact on the Company’s revenue recognition policies. However, AcSEC is currently reviewing further modifications to the SOP with the objective of providing more definitive, detailed implementation guidelines. This guidance could lead to unanticipated changes in the Company’s operational and revenue recognition practices.

In December 1999, the Securities Exchange Commission (“SEC”) staff released Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition,” as amended by SAB No. 101A and SAB No. 101B, to provide guidance on the recognition, presentation and disclosure of revenue in financial statements. SAB No. 101 explains the SEC staff’s general framework for revenue recognition, stating that certain criteria be met in order to recognize revenue. SAB No. 101 also addresses gross versus net revenue presentation and financial statement and Management’s Discussion and Analysis disclosures related to revenue recognition. In response to SAB No. 101, the Company undertook a review of its revenue recognition practices and determined its method of accounting for revenue to be in accordance with the provisions of SAB No. 101.

The Company licenses its products primarily under perpetual licenses. The Company recognizes revenue from licensing of software products to an end user when 1) persuasive evidence of an arrangement exists; 2) the software product has been delivered to the customer, provided there are no uncertainties surrounding product acceptance; 3) fees are fixed or determinable, and 4) collectibility is probable. For software arrangements involving multiple elements, such as software products, technical support (post contract support, or PCS), installation and training, revenue is allocated to each element based on the relative fair values of the elements. The fair value of an element is based on vendor-specific objective evidence (“VSOE”). The Company establishes VSOE based on the price charged when the same element is sold separately. If VSOE of all undelivered elements exists but VSOE does not exist for one or more delivered elements, then revenue is recognized using the residual method. Revenue associated with period or subscription licenses is recognized using the straight-line method over the period that the software rights or services are provided. For licensing of our software through indirect sales channels, revenue is recognized when the software is sold by the reseller, VAR or distributor to an end user customer. The Company’s resellers do not have any rights of return beyond the standard warranty that runs concurrent with post-contract support services. The Company considers all arrangements with payment terms longer than our normal business practice (payment terms that do not extend beyond 12 months) not to be fixed or determinable and revenue is recognized when the fee becomes due. If collectibility is not considered probable for reasons other than extended payment terms, revenue is recognized when the fee is collected. Service arrangements are evaluated to determine whether the services are essential to the functionality of the software. Revenue is recognized using contract accounting for arrangements involving customization or modification of the software or where software services are considered essential to the functionality of the software. Revenue from these software arrangements is recognized using the percentage-of-completion method with progress-to-complete measured using labor cost inputs.

The Company derives services revenue primarily from post contract support (“PCS”), consulting, training and user training conferences. PCS is recognized using the straight-line method over the period that the PCS is provided, generally one year and once collectibility is assured. Revenue from training arrangements or seminars and from consulting services is recognized as the services are performed or seminars are held.

Impairment of Long-Lived Assets and Identifiable Intangible Assets

The Company accounts for long-lived assets pursuant to Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.” The Company evaluates its property and equipment, certain intangible assets and other long-lived assets for impairment and assesses their recoverability based upon anticipated future cash flows. If changes in circumstances lead Company management to believe that any of its long-lived assets may be impaired, the Company will (a) evaluate the extent to which the remaining book value of the asset is recoverable by comparing the future undiscounted cash flows estimated to be associated with the

asset to the asset’s carrying amount and (b) write-down the carrying amount to market value or discounted cash flow value to the extent necessary. As of September 30, 2003, management did not consider any of the Company’s long-lived assets to be impaired.

Software development costs are accounted for in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed.” Costs associated with the planning and designing phase of software development, including coding and testing activities necessary to establish technological feasibility, are classified as product development and expensed as incurred. Once technological feasibility has been determined, additional costs incurred in development, including coding, testing, and product quality assurance, are capitalized.

SFAS No. 86 requires that at each balance sheet date, the unamortized capitalized costs of a computer software product be compared to the net realizable value of that product. The amount by which the unamortized capitalized costs of a computer software product exceed the net realizable value of that asset shall be written off. The net realizable value is determined based on the estimated future gross revenues from that product reduced by the estimated future costs of completing and disposing of that product, including the costs of performing maintenance and customer support required to satisfy the Company’s responsibility set forth at the time of sale. As of September 30, 2003, management did not consider any of the unamortized capitalized costs of computer software to be impaired.

In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment.

The Company adopted the provisions of SFAS No. 142 on its effective date, and as a result, the Company ceased amortization of goodwill on January 1, 2002. In lieu of amortization, the Company was required to perform an initial impairment review of goodwill in 2002 and an annual impairment review thereafter. SFAS No. 142 requires the Company to test goodwill for impairment at a level referred to as a reporting unit. The Company operates in a single industry and is engaged in the design and sale of a limited number of software products; therefore, management believes the Company meets the definition of a single reporting unit. SFAS No. 142 requires that if the fair value of the reporting unit is less than its carrying amount, the goodwill is considered potentially impaired and a loss is recognized to the extent its carrying value exceeds its implied fair value. To determine fair value, management used the quoted market price of the Company’s common stock. The required initial benchmark evaluation and the annual impairment review were performed in January 2002 and 2003, respectively, resulting in no impairment in the value of the Company’s goodwill and any related intangibles.

Income taxes

The Company utilizes the liability method of accounting for income taxes, as set forth in SFAS No. 109, “Accounting for Income Taxes.” SFAS No. 109 prescribes an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s financial statements. Deferred tax assets are recognized, net of any valuation allowance, for deductible temporary differences and operating loss and tax credit carryforwards. A valuation allowance is provided when it is considered more likely than not that some or all of the deferred tax assets may not be realized. As of September 30, 2003 and December 31, 2002, the Company had a valuation allowance against the entire net deferred tax asset.

Stock-Based Compensation

In December 2002, the FASB issued Statement No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The additional disclosure requirements of SFAS 148 are effective for fiscal years ending after December 15, 2002. The Company has elected to continue to follow the intrinsic value method of accounting as prescribed by Accounting Principles Board Opinion No. 25 (“APB No. 25”), “Accounting for Stock Issued to Employees,” to account for employee stock options. Under APB No. 25, no compensation expense is recognized unless the exercise price of our employee stock options is less than the market price of the underlying stock on the date of

grant. The Company has not recorded such expenses in the periods presented because it grants options at the fair market value of the underlying stock on the date of grant.

The Company has granted incentive and non-qualified stock options to employees and directors under three outstanding stock option plans: the 1988 Stock Option Plan (the “1988 Plan”), the Stock Option Plan for Directors (the “Directors’ Plan”), and the 1997 Equity Compensation Plan (the “1997 Plan”).

The Company may no longer grant options under the 1988 Plan or the Directors’ Plan. Through September 30, 2003, the Company had options outstanding under these plans of 141,800 shares (1988 Plan), 18,000 shares (Director’s Plan), and 1,097,900 (1997 Plan). Under the plans, the Board of Directors determines the option exercise price on a per-grant basis, but the price shall not be less than fair market value on the date of grant. Generally, outstanding options vest over periods not exceeding 4 years after the date of grant and expire 10 years after the date of grant. All options granted under the plans to date have been at exercise prices that have been equal to fair market value at date of grant. At September 30, 2003, the Company has approximately 2,125,200 shares of common stock reserved for future issuance under the plans.

The following information regarding net income (loss) and earnings (loss) per share prepared in accordance with SFAS No. 123 has been determined as if the Company had accounted for its employee stock options and employee stock plan under the fair value method prescribed by SFAS No. 123. The resulting effect on net income (loss) and earnings (loss) per share pursuant to SFAS No. 123 is not likely to be representative of the effects on net income (loss) and earnings (loss) per share pursuant to SFAS No. 123 in future periods due to subsequent periods including additional grants and periods of vesting. The fair value of options was estimated at the date of grant using a Black-Scholes option valuation model.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion the existing models do not provide a reliable single measure of the fair value of our employee stock options.

The following assumptions were used by the Company to determine the fair value of stock options granted using the Black-Scholes option-pricing model:

	Three Months Ended September 30,		Nine Months Ended September 30,
	2003	2002	2003	2002
Dividend yield	0%	0%	0%	0%
Expected volatility	287%	212%	287%	212%
Expected option life	3 years	8 to 10 years	3 years	4 to 10 years
Risk-free interest rate	1.9%	3.7% to 4.1%	1.7% to 1.9%	2.6% to 5.7%

The per share weighted-average fair value under SFAS No. 123 of all stock options issued by the Company during the nine-months ended September 30, 2003 and 2002 was $0.37 and $0.84, respectively.

For purposes of disclosures pursuant to SFAS No. 123 as amended by SFAS No. 148, the estimated fair value of options is amortized over the options’ vesting period.

The following table illustrates the effect on reported net income (loss) available to common shareholders and earnings (loss) per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (in thousands, except per share amounts):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
	(unaudited)						(unaudited)
Net income (loss) available to common shareholders, as reported	$	62		$	(47	)	$	(180	)	$	(1,725	)
Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards		(26	)		(130	)		(163	)		(388	)

Pro forma income (loss)	$	36		$	(177	)	$	(343	)	$	(2,113	)

Earnings (loss) per common share-
Basic and diluted	$	0.00		$	(0.01	)	$	(0.02	)	$	(0.11	)

Earnings Per Share

Basic net income (loss) per common share is computed by dividing net income (loss), after stock dividend requirements, attributable to common stockholders by the weighted average number of common shares outstanding. Diluted net income (loss) per common share (“Diluted EPS”) is computed by dividing net income (loss), after stock dividend requirements, attributable to common stockholders by the sum of the weighted average number of common shares outstanding and the weighted average dilutive common share equivalents then outstanding. The computation of Diluted EPS does not assume exercise or conversion of securities that would have an anti-dilutive effect.

Common share equivalents consist of shares issuable upon the exercise of stock options. During the three months ended September 30, 2002 and the nine months ended September 30, 2003 and 2002, there were 500, 2,300 and 17,100 outstanding common share equivalents, respectively, that were not included in the computation of Diluted EPS as their effect would have been anti-dilutive, thereby decreasing the net loss per common share. During the three months ended September 30, 2003, there were no outstanding common share equivalents that were not included in the computation of Diluted EPS.

Impact of Recently Issued Accounting Standards

In January 2003, the EITF published EITF Issue 00-21, “Revenue Arrangements with Multiple Deliverables,” which requires companies to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying EITF Issue 00-21, revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables in the arrangement meet certain criteria. Arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. EITF Issue 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF Issue 00-21 did not have an impact on the Company’s financial statements.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities”, which addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interest in variable interest entities obtained after January 31, 2003. The adoption of this Interpretation did not have an impact on the Company’s financial statements. The Interpretation becomes effective for entities created before February 1, 2003 as of the beginning of the first period after December 15, 2003. We do not anticipate the adoption of this provision of the Interpretation to have an impact on the Company’s financial statements.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”. SFAS No. 150 establishes standards for how an issuer of financial statements classifies and measures certain financial instruments that have characteristics of both liabilities and equity. SFAS No. 150 is effective for financial

instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have an impact on the Company’s financial statements.

From time to time the Staff of the United States Securities and Exchange Commission communicates its interpretations of accounting rules and regulations. The manner by which these views are communicated varies by topic. While these communications represent the views of the Staff, they do not carry the authority of law or regulation. Nonetheless, the practical effect of these communications is that changes in the Staff’s views from time to time can impact the accounting and reporting policies of public companies, including ours.

We do not expect the adoption of other recently issued accounting pronouncements to have a significant impact on our results of operations, financial position, or cash flows.

Note 3. Long-Lived Assets and Identifiable Intangible Assets

Long-lived assets and identifiable intangible assets consist of the following at September 30, 2003 and December 31, 2002 (in thousands):

Amortization
Method

Estimated
Lives

September 30,
2003

December 31,
2002

(unaudited)

(audited)

Acquired software technology

Straight-line

4 years

2,753

2,753

Cost in excess of net assets of business acquired

Not Applicable

Indefinite

8,588

8,588

Software development costs

Straight-line

2-3 years

5,760

5,143

Other intangibles

Straight-line

Fully amortized

373

373

17,474

16,857

Less accumulated amortization

(12,103

)

(10,423

)

Net intangible assets

5,371

6,434

Acquired software technology and other intangibles are stated at cost. Amortization is provided using the straight-line method over estimated useful lives of four and two years, respectively.

Software development costs are accounted for in accordance with SFAS No. 86. Research and development costs are comprised of the following as of September 30 (in thousands):

	Three months ended September 30						Nine months ended September 30
	2003			2002			2003			2002
	(unaudited)						(unaudited)
Research and development costs incurred	$	528		$	755		$	1,590		$	2,534
Less – capitalized software development costs		(220	)		(478	)		(788	)		(1,317	)

Research and development costs, net	$	308		$	277		$	802		$	1,217

Amortization of software development costs is provided on a product-by-product basis over the estimated economic life of the software, not to exceed three years, using the straight-line method. Amortization commences when a product is available for general release to customers. Included in cost of revenue is amortization of software development costs and acquired software technology of $700,000 and $513,000 for the three months ended September 30, 2003 and 2002, respectively. Amortization of software development costs and acquired software technology for the nine months ended September 30, 2003 and 2002 was $1.8 million and $1.6 million, respectively.

Note 4. Long-term Debt – Shareholders

On February 13, 2003, the Company modified the terms of its $3 million unsecured revolving line of credit with Safeguard and its $1.2 million unsecured non-interest bearing Promissory Note to TBBH Investments Europe AG (“TBBH”) (the successor in interest to Axial Technology Holding AG).

Under the terms of the new agreement, the Company issued to Safeguard Delaware, Inc. (“Safeguard Delaware”), a wholly owned subsidiary of Safeguard, a new $1.35 million unsecured, variable rate Revolving Note (the “Revolving Note”) and a $650,000 unsecured, variable rate Demand Note (the “Safeguard Demand Note”) (described below). The Revolving Note and the Safeguard Demand Note replace the previously existing $3 million unsecured revolving line of credit, of which $1.3 million was outstanding at the time of replacement, provided to the Company by Safeguard. Amounts outstanding under the Revolving Note bear interest at an annual rate equal to the prime rate of PNC Bank, N.A. plus one percent (1%), payable quarterly in arrears on the first business day of January, April, July and October. The Company may from time to time borrow, repay and reborrow up to $1.35 million outstanding under the Revolving Note through February 13, 2004, at which time the Revolving Note may be renewed by Safeguard Delaware at its sole discretion. Safeguard Delaware was required to notify the Company by November 13, 2003, whether or not Safeguard Delaware would renew the Revolving Note on February 13, 2004. On November 3, 2003, Safeguard Delaware notified the Company of its intentions not to renew the Revolving Note upon its expiration on February 13, 2004. As of November 14, 2003, there were no outstanding borrowings under the Revolving Note with Safeguard. If during the remaining term of the Revolving Note the Company were to borrow under the Revolving Note, the Company would be required to repay all such outstanding borrowings and accrued but unpaid interest by August 13, 2004. Repayment of the Revolving Note may occur earlier in the case of a sale of all or substantially all of the assets of the Company, a business combination or upon the closing of a debt or equity offering in excess of $2.5 million.

Concurrent with the modification of the terms of the $3 million unsecured revolving line of credit with Safeguard, the Company has issued to TBBH a $1.2 million unsecured variable rate Demand Note (the “TBBH Demand Note”) in replacement of the existing $1.2 million unsecured non-interest bearing Promissory Note, of which $500,000 was due on February 13, 2003. Amounts outstanding under both the $1.2 million TBBH Demand Note and the $650,000 Safeguard Demand Note bear interest at an annual rate equal to the announced prime rate of PNC Bank, N.A. plus one percent (1%), payable quarterly in arrears on the first business day of January, April, July and October. However, interest shall accrue only on $500,000 of the principal of the TBBH Demand Note until the first anniversary of the date of the TBBH Demand Note and thereafter shall accrue interest on the entire outstanding principal. All outstanding principal and accrued but unpaid interest on each of the Safeguard Demand Note and the TBBH Demand Note is due and payable six months after the date of demand by Safeguard and/or TBBH, however, such demand shall not occur earlier then February 13, 2004. The Company is required to notify Safeguard or TBBH of the other party’s demand for payment. Except for payments made on demand by only one lender (either Safeguard or TBBH), any payments on the Demand Notes shall be made pro rata as between Safeguard and TBBH. The outstanding principal amount of the Demand Notes may be prepaid in whole or in part upon notice to Safeguard and TBBH at any time or from time to time without any prepayment penalty or premium; provided, however, that there are no amounts outstanding under the Revolving Note. Repayment of the Demand Notes may occur earlier in the case of a sale of all or substantially all of the assets of the Company, a business combination or upon the closing of a debt or equity offering in excess of $2.5 million; provided, however, that any repayment will be applied first to the repayment of the then outstanding obligations under the Revolving Note and then to the repayment of the then outstanding obligations under the Demand Notes.

The following table presents the carrying amounts and fair values of the Company’s debt instruments as of September 30, 2003 and December 31, 2002 (in thousands):

	September 30, 2003			December 31, 2002
	(unaudited)			(audited)
Borrowings under revolving credit facility due Safeguard ⁽¹⁾	$	—		$	1,300
Borrowings under Revolving Note due Safeguard		—			—
Notes payable due Axial (shareholder) (less unamortized discount of $79 – effective rate of 9.5%) ⁽¹⁾		—			1,121
Demand Note due Safeguard		650			—
Demand Note due TBBH (shareholder) (less unamortized discount of $27 – effective rate of 9.5%)		1,173			—

		1,823			2,421
Less current portion		(1,823	)		(467	)

Long – term debt – shareholders	$	—		$	1,954

⁽¹⁾	– Retired February 13, 2003

On March 1, 2001, pursuant to an Asset Purchase Agreement dated February 13, 2001, the Company issued 3,000,000 shares of its common stock and $1.5 million in unsecured non-interest bearing Promissory Notes (“Notes”) to Axial Technology Holding AG (“Axial”). The Notes required the payment of $300,000, $500,000, and $700,000 on the first, second, and third anniversaries, respectively, of the Asset Purchase Agreement. The carrying amount of the Company’s notes due to Axial was established by discounting the expected future cash payment obligations using a current interest rate at which the Company could borrow for debt of similar size and maturity. With respect to the first note payment due on March 1, 2002, the Company could elect to provide, in lieu of cash, a number of shares of its common stock equivalent in aggregate value to the amount of such cash payment, the value of each such share to be deemed equal to 80% of the average NASDAQ closing price during the 20 trading days immediately prior to the relevant note payment date. On March 1, 2002, the Company issued 381,098 shares of its common stock in lieu of the first note payment. Related to this transaction, the Company recognized on March 1, 2002 an interest charge of $46,800, reflecting the discount on common stock given in payment of the first installment of the note. The remaining Notes were retired on February 13, 2003 in connection with the debt modifications described above.

Note 5. Equity Transactions

Safeguard is the holder of all 3,000 shares of the Series F Convertible Preferred Stock (“Series F Shares”). Under the terms of the Series F Shares, holders of the Series F Shares are entitled to a cumulative quarterly dividend, when and if declared by the Board, at a rate per share equal to 2% of the issuance price per quarter. At September 30, 2003, dividends in arrears on the Series F Shares were approximately $688,000 and are classified as an other long-term liability in the Company’s balance sheet presented herein.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, among others, statements containing the words “believes,” “anticipates,” “estimates,” “expects,” and words of similar import. Such statements are subject to certain risks and uncertainties, which include but are not limited to those important factors discussed in cautionary statements throughout the section below and those set forth in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 4, 2003, as amended, and are qualified in their entirety by those cautionary statements.

These statements involve known and unknown risks, uncertainties and other factors that may cause industry trends or our actual results, level of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these statements. These factors include those set forth in the following discussion and under the caption “Risk Factors” of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this Quarterly Report on Form 10-Q.

Although we believe that expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We will not update any of the forward-looking statements after the date of this Quarterly Report on Form 10-Q to conform these statements to actual results or changes in our expectations, except as required by law. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. You should carefully review the risk factors described in other documents that we file from time to time with the Securities and Exchange Commission.

Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to all such reports are available, free of charge, on our Internet website under “About Tangram—Investor Relations—Financial Filings Online,” as soon as reasonably practicable after we file electronically such material with, or furnish it to, the Securities and Exchange Commission. Our Internet website address is http://www.tangram.com. Information on our website does not constitute a part of this Quarterly Report on Form 10-Q.

Overview

Tangram develops and markets lifecycle information technology (“IT”) asset management (“ITAM”) software for large and mid-sized organizations across all industries, in both domestic and international markets. Our ITAM product line consists of Asset Insight^® and Enterprise Insight^®, which together deliver, what we believe, is the market’s first unified tool to manage physical, contractual, and financial IT asset data in a single repository for a comprehensive view of the enterprise. ITAM is the process of controlling hardware and software assets throughout their lifecycle — from procurement, through daily operations, through final disposal. While asset management is primarily a business practice, it is supported by repository technology that consolidates diverse financial, contractual, ownership, and physical asset data. Our core business strategy and operating philosophy focus on delivering world-class customer care, providing phased asset management solutions that are tailored to our customers’ evolving business needs, and maintaining a leading-edge technical position that results in long-term customer loyalty and sustained shareholder value. We are a partner company of Safeguard Scientifics, Inc. (NYSE:SFE) (“Safeguard”). Safeguard is an operating company that creates long-term value by focusing on technology-related companies that are developed through superior operations and management support. Safeguard is the majority shareholder of the Company, holding approximately 58% of the Company’s outstanding common shares (assuming the conversion of the Series F Convertible Preferred Stock).

In 1996, we began focusing our business on the asset tracking market and the introduction and sale of our Asset Insight product. Asset Insight, an information technology asset tracking product, allows businesses to track changes in their information technology asset base (including hardware and software), forward plan technology requirements, optimize end-user productivity, and calculate the cost of software and hardware upgrades. In October 2000, we announced a strategic move to become a leader in the ITAM market. This strategy allowed us to build upon our core Asset Insight tracking technology and expertise and expand into a steadily growing, multi-billion dollar market. In support of this business strategy, we purchased the technology of Wyzdom Solutions, Inc. from Axial Technology Holding AG (“Axial”) in March 2001, providing the technological foundation for Tangram’s asset management offering, Enterprise Insight. This lifecycle offering, which has been

rebranded as a member of the Tangram family of solutions, allows business leaders to manage their information technology assets from initial planning and procurement through final disposal—ensuring information technology assets are maximized to cost-effectively support corporate objectives. We continue to enhance our industry-leading asset tracking technology to ensure our customers can effectively manage new and emerging technologies, such as wireless and handheld personal digital assistant (PDA) devices. These asset tracking features remain the foundation of every asset management initiative. Additionally, in support of the commitment to make Asset Insight a fully web-enabled solution, all new features will be web-based, allowing our customers to access and analyze their diverse asset information directly from their web browsers. In early February 2003, we released what we believe to be the market’s first and only fully unified ITAM solution. This unified Insight solution automatically and seamlessly combines the physical IT asset information tracked by Asset Insight with the financial and contractual information managed by Enterprise Insight, delivering a single, holistic view of all enterprise IT assets from a common user interface, without the need for costly and difficult-to-implement data integrations. Tangram’s unified Insight solution allows customers to more quickly, efficiently, and accurately tackle critical IT business issues, such as software license compliance, disaster recovery planning, loss prevention, and lease management. On November 5, 2003 we announced the commercial availability of OverSight. OverSight utilizes patent-pending Crosshair^™ technology to provide management with a powerful methodology for denying access to any given file or software package, on any desktop in the enterprise. Specifically, this solution allows a company to immediately deploy policies that keep users from executing, reading, copying, renaming, or deleting files. It can target desktops with any level of granularity—segmenting by geography, business unit, individual desktop, or the entire enterprise. In particular, OverSight can be used to: minimize virus and worm outbreaks, shut down file-sharing programs and spyware, avoid unmonitored instant messaging, eliminate illegal or offensive materials, enforce desktop standards, and control file access and corporate confidentiality. OverSight uses a web-based interface to create and distribute policies from a central server to clients running the OverSight Compliance Monitor. Policies can be distributed immediately or per a schedule when timing is less critical. OverSight policies can be enforced using selective criteria, from the entire enterprise down to a single individual desktop. Once distributed, policies are enforced by each client system, which maintains control over the files that can be loaded and executed in its individual environment. As part of our lifecycle asset management offering, we are expanding our services offerings whereby we work closely with our customers to prioritize their asset management requirements, pinpointing the necessary process and technology changes and executing a phased asset management implementation plan that delivers significant value during each step of the deployment. This tailored service covers specific disciplines, such as (i) software license management; (ii) enterprise moves, adds and changes; (iii) lease management, and (iv) procurement. To further assist our customers in leveraging the extensive benefits of our solutions, we also offer a variety of deployment planning, strategic implementation, business process, best practices, and training services.

Our financial results reflect our growing dependence on revenue generated by sales of Asset Insight and our move into the ITAM market with the introduction of Enterprise Insight in July 2001. As a result, various risks and uncertainties relating to the development of the ITAM business may cause our actual results to differ materially from the results contemplated. Such uncertainties include: (i) our ability to sell Asset Insight and Enterprise Insight products to major accounts with full enterprise-wide deployment; (ii) encountering any unanticipated software errors or other technical problems that may arise in the future that could impact market acceptance of Enterprise Insight, (iii) the possibility of the introduction of superior competitive products; (iv) our ability to develop a sustainable stream of revenue from the sale of the Asset Insight and Enterprise Insight products; (v) our ability to recruit and retain key technical, sales, and marketing personnel; and (vi) our ability to secure adequate financing on reasonable terms or at all. In addition, many companies have been addressing their ITAM needs for systems and applications internally and only recently have become aware of the benefits of third-party software products such as ours. Our future financial performance will depend in large part on the continued growth in the number of businesses adopting third-party ITAM software products and their deployment of these products on an enterprise-wide basis and as such, there can be no assurance that we will be able to succeed or capitalize upon the opportunities in the ITAM market.

We have been and will continue to be dependent on closing large ITAM product sales in a given quarter. Our revenues in a given quarter could be adversely affected if we are unable to complete one or more large license agreements, if the completion of a large license agreement is delayed, or if the contract terms were to prevent us from recognizing revenue during that quarter. In addition, when negotiating large software licenses, many customers time their negotiations at our quarter-end in an effort to improve their ability to negotiate more favorable pricing terms. As a result, we recognize a substantial portion of our revenues in the last month or weeks of a quarter, and license revenues in a given quarter depend substantially on orders booked during the last month or weeks of a quarter. We expect our reliance on these large transactions to continue for the foreseeable future.

The license of our software generally requires us to engage in a sales cycle that typically takes approximately six to nine months to complete. Since the beginning of the second quarter of 2002, however, we have experienced an extension of normal sales cycles as a result of increased vendor disarray and confusion in the ITAM market as certain ITAM vendors underwent

consolidations and financial and regulatory issues. As a result of this vendor upheaval, industry analysts advised organizations to temporarily postpone their decisions on IT asset repository solutions. In turn, we believe many organizations have adopted a “wait and see” mentality—deferring their asset management purchasing decisions until there is more market stability and the final market impact can be determined. In addition, the length of the sales cycle has varied due to factors over which we have little or no control, such as the size of the transaction, the internal activities of potential customers, and the level of competition that we encounter in selling our products. As such, historically, we have experienced a certain degree of variability in our quarterly revenue and earnings patterns. This variability is typically driven by significant events that include: (i) the timing of major enterprise-wide sales of our ITAM products; (ii) “one-time” payments from existing legacy customers for license expansion rights (required to install on a larger or an additional computer base); (iii) budgeting cycles of our potential customers; (iv) changes in the mix of software products and services sold; and (v) software defects and other product quality problems. Additionally, maintenance renewals have accounted for a significant portion of our revenue; however, there can be no assurance that we will be able to sustain current renewal rates in the future. Cancellations of licenses or maintenance contracts could reduce our revenues and harm our operating results. In particular, our maintenance contracts with customers terminate on an annual basis. Substantial cancellations of maintenance agreements, or a substantial failure to renew these contracts, would reduce our revenues and harm our operating results.

Critical Accounting Policies

The Company’s discussion and analysis of its financial conditions and results of operations are based upon its financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires that management make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies, in which different judgments and estimates by our management could materially affect our reported condition and results of operations, include estimating the allowance for doubtful accounts, deferral of software cost, valuation of intangibles, deferred tax assets and revenue recognition.

Allowance for Doubtful Accounts

Our allowance for doubtful accounts relates to customer accounts receivable. The allowance for doubtful accounts is management’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable. We determine the allowance based on historical write-off experience and how our customers are affected by current general market and economic conditions. We review the allowance for doubtful accounts monthly. We specifically analyze customer receivables, as well as customer credits, customer concentrations, customer credit-worthiness, current economic trends, and changes in customer payment terms, when evaluating the adequacy of the allowance for doubtful accounts. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Likewise, should we determine that we would be able to realize more of our receivables in the future than previously estimated, an adjustment to the allowance would increase income in the period such determination was made. Past due balances over 90 days are reviewed individually for collectibility. All other balances are evaluated on a pooled basis. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. Material differences may result in the amount and timing of our charged to the allowance for any period if management made different judgments or utilized different estimates. Management believes that the current estimate of allowances for doubtful accounts recorded as of September 30, 2003, adequately covers potential credit risks.

Deferred Software Costs

We account for software development costs in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed.” Costs associated with the planning and designing phase of software development, including coding and testing activities necessary to establish technological feasibility, are classified as product development and expensed as incurred. Once technological feasibility has been determined, additional costs incurred in development, including coding, testing, and product quality assurance, are capitalized. Such capitalized costs are amortized on a product-by-product basis over the estimated economic life of the software, not to exceed three years, using the straight-line method. Amortization commences when a product is available for general release to customers. The market for our products is intensely competitive and diverse, and the technologies for our

products can change rapidly. New products may be introduced frequently and, historically, existing products have been continually enhanced. As a result, the lifecycles of our products are difficult to estimate. We periodically assess the remaining economic life of the software whenever events or changes in circumstances indicate that the product life has been shortened. If we determine the remaining economic life of the software is too long, we will adjust the amortization prospectively to reflect the reduction in the remaining economic life of the software.

SFAS No. 86 requires that, at each balance sheet date, the unamortized capitalized costs of a computer software product (including acquired software technology) be compared to the net realizable value of that product. The amount by which the unamortized capitalized costs of a computer software product exceed the net realizable value of that asset are written off. The net realizable value is determined based on management’s estimates of future gross revenues from the software product reduced by the estimated future costs of completing and disposing of such product, including the costs of performing maintenance and providing customer support required to satisfy the Company’s responsibility set forth at the time of sale. Had different assumptions or criteria been used to evaluate and measure the estimated future gross revenues and costs, our assessment of the potential impairment and the recoverability of the asset could have been materially different.

Valuation of Intangibles

We assess the impairment of goodwill and other intangible assets annually and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors that we consider important which could trigger an impairment review include: (i) significant under performance relative to historical or expected future operating results; (ii) significant changes in the manner or use of the acquired assets or the strategy for our overall business; (iii) significant negative industry trends; and (iv) economic trends or a decline in our stock price for a sustained period.

If we determine that the carrying value of intangible assets, exclusive of identifiable goodwill, may not be recoverable based upon the existence of one or more of the above indicators of impairment, we assess the recoverability of the intangibles by determining whether the carrying value of the intangible assets can be recovered through undiscounted future operating cash flows. The amount of impairment, if any, is measured based on projected discounted future operating cash flows using a discount rate commensurate with the risk inherent in our current business model. Had different assumptions or criteria been used to evaluate and measure the undiscounted future operating cash flows related to the intangible assets, our assessment of the potential impairment and the recoverability of the asset could have been materially different. As of September 30, 2003, the net carrying value of other intangible assets, exclusive of identifiable goodwill, was zero.

In 2002, SFAS No. 142, “Goodwill and Other Intangible Assets,” became effective, and as a result, we ceased amortization of goodwill on January 1, 2002. In lieu of amortization, we were required to perform an initial impairment review of goodwill in 2002 and an annual impairment review thereafter. SFAS No. 142 requires us to test goodwill for impairment at a level referred to as a reporting unit. We operate in a single industry and are engaged in the design and sale of a limited number of software products; therefore, we believe we meet the definition of a single reporting unit. SFAS No. 142 requires that if the fair value of the reporting unit is less than its carrying amount, the goodwill is considered potentially impaired and a loss is recognized to the extent its carrying value exceeds its implied fair value. To determine fair value, we used the quoted market price of our common stock. The required initial benchmark evaluation and the annual impairment review were performed in January 2002 and 2003, respectively, resulting in no impairment in the value of the Company’s goodwill or any related intangibles. Had different assumptions or criteria been used to evaluate and measure the impairment of goodwill under SFAS No. 142, our assessment of potential impairment could have been materially different.

Deferred Tax Assets

We are required to estimate income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We must assess the likelihood that the deferred tax assets will be recovered from future taxable income and to the extent that we believe recovery is not likely, we must establish a valuation allowance. We provided a valuation allowance of $8.4 million against our entire net deferred tax asset as of September 30, 2003. The valuation allowance was recorded given the trend of losses we had incurred through September 30, 2003 and the uncertainties regarding our future operating profitability and taxable income.

Revenue Recognition

Our revenues are derived from product licensing and services. Services are comprised of maintenance, professional services, and training. License fees are generally due upon the granting of the license. We also provide ongoing maintenance services (post-contract customer support or PCS), which include technical support and product enhancements, for an annual fee based upon the current price of the product. As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if management made different judgments or utilized different estimates.

We recognize revenue in accordance with Statement of Position 97-2, or SOP 97-2, as modified by SOP 98-9. SOP 97-2, as modified, generally requires revenue earned on software arrangements involving multiple elements such as software products, post-contract customer support, installation and training to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on vendor-specific objective evidence, or VSOE. We establish VSOE based on the price charged when the same element is sold separately. If VSOE of all undelivered elements exists but VSOE does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the license fee is recognized as revenue.

Revenues from license agreements are recognized currently, provided that all of the following conditions are met: (i) a non-cancelable license agreement has been signed; (ii) the product has been delivered; (iii) the fee is fixed or determinable; (iv) there are no material uncertainties regarding customer acceptance; (v) collection of the resulting receivable is deemed probable and the risk of concession is deemed remote; and (vi) no other significant vendor obligations related to the software exist. Generally, these criteria are met at the time of delivery. Revenue associated with period or subscription licenses is recognized using the straight-line method over the period that the software rights or services are provided. Service arrangements are evaluated to determine whether the services are essential to the functionality of the software. Revenue is recognized using contract accounting for arrangements involving customization or modification of the software or where software services are considered essential to the functionality of the software. Revenue from these software arrangements is recognized using the percentage-of-completion method with progress-to-complete measured using labor cost inputs. Provision is made at the time the related revenue is recognized for estimated product returns, which historically have been immaterial. We analyze historical returns, current economic trends, and changes in reseller and customer demands when evaluating the adequacy of provisions for sales returns. At the time of the transaction, we determine whether the fee is fixed and determinable based on the terms of the agreement associated with the transaction. If a significant portion of a fee is contingent on future events we will recognize revenue as the future events occur. The Company assesses collectibility based on a number of factors, including past transaction history with the customer and the creditworthiness of the customer. If we determine that collection of the fee is not reasonably assured, we will defer the revenue and recognize revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash. For all sales, we generally use a binding purchase order or signed license agreement as evidence of an arrangement. Revenue from products sold through indirect channels (“resellers”) is recognized upon shipment of the software, as long as evidence of an arrangement exists, collectibility is probable and the fee is fixed or determinable. Revenue is recorded net of any discounts. Our resellers do not have any rights of return beyond the standard warranty that runs concurrent with post-contract support services.

The Company derives services revenue primarily from PCS, consulting, training and user training conferences. Revenues from post-contract support services are recognized ratably over the term of the support period, generally one year and once collectibility is assured. Maintenance revenues, when and if bundled with license agreements, are unbundled using vendor-specific objective evidence. Consulting revenues are primarily related to implementation services performed on a time and material basis under separate service agreements for the installation of our products. Revenues from consulting and training services are recognized as the respective services are performed.

Revenue recognition in accordance with SOP 97-2 can be complex due to the nature and variability of our sales transactions. To continue recognizing software license revenue in the period in which we obtain persuasive evidence of an arrangement and deliver the software, we must have VSOE for each undelivered element. If we do not continue to maintain VSOE for undelivered elements, we would be required to defer recognizing the software license revenue until the other elements are delivered, which could have a significant negative impact on our revenue. As stated above, we recognize revenue using contract accounting for arrangements involving customization or modification of the software or where software services are considered essential to the functionality of the software using the percentage-of-completion method with progress-to-complete measured using labor cost inputs. Completion is measured based on hours incurred to total estimated hours to complete the project. Also, we are required to estimate the total costs to complete the project. These estimates could change

and the impact could be significant. As of September 30, 2003, we had deferred $21,800 of contract license revenue that will be recognized under the percentage of completion method as we complete the work under the contract. Further implementation guidelines relating to SOP 97-2 and related modifications may result in unanticipated changes in our revenue recognition practices and such changes could significantly affect our future revenues and results of operations.

Results of Operations

Revenue

Licenses and products revenue for the three-month period ended September 30, 2003 decreased 37% to $892,000, from $1,408,000 in the comparable period in 2002. For the nine-month period ended September 30, 2003, licenses and products revenue decreased 34% to $2.3 million from $3.5 million in the comparable nine-month period in 2002. Licenses and products revenue include the sales of our ITAM product line, which consists of Asset Insight and Enterprise Insight, and product upgrades and add-ons of AM:PM and our traditional mainframe product, Arbiter. For the three-month period ended September 30, 2003, Asset Insight licenses and products revenue contributed $665,000, or 75% of total licenses and products revenue, down 26% from $883,000, or 64%, in the comparable period in 2002. For the three-month period ended September 30, 2003, Enterprise Insight product revenue was $72,000 or 8% of total licenses and products revenue, up 73% from $42,000, or 3%, in the comparable period in 2002. For the nine-month period ended September 30, 2003, Asset Insight licenses and products revenue decreased 35% to $1.8 million from $2.7 million in the comparable period in 2002. Revenue from Enterprise Insight contributed $179,000 for the nine-month period ended September 30, 2003 increasing 328% from $42,000 in the comparable period in 2002. The softness in the overall IT spending environment due to the economic and geopolitical uncertainties that exist continued to challenge us through the first nine months of 2003. Our business and operating results are subject to the effects of changes in general economic conditions. There has been a rapid and severe downturn in the worldwide economy. We are uncertain as to its future severity and duration. We believe that these conditions, as well as the decline in worldwide economic conditions, have led our current and potential customers to reduce their IT spending and have had the effect of extending our normal product sales cycles. If these conditions worsen, demand for our products and services may be reduced as a result of even further reduced spending on IT products such as ours. Additionally, our sales engagement process requires our direct sales consultants to explore each organization’s asset management goals and business drivers prior to delivering a solution plan. The time investment devoted to each sale opportunity coupled with our limited resources associated with a small direct domestic sales force following our corporate cost restructuring in 2002 have limited the number of active opportunities our sales consultants can effectively work, thus further impacting our ability to grow our ITAM revenue. For the three-month period ended September 30, 2003, upgrade revenue from AM:PM and our traditional mainframe products was $155,000, or 17% of total licenses and products revenue, compared to $474,000, or 33% in the comparable period in 2002. Revenue from upgrades of AM:PM and our traditional mainframe products decreased to $386,000 for the nine months ended September 30, 2003 compared to $785,000 for the same nine-month period in 2002. Because we have focused our efforts on our core ITAM offerings and away from automated software distribution and the traditional mainframe product lines, we expect little, if any, future AM:PM and Arbiter license revenue and any future revenue to be unpredictable. Our business growth, increase in revenues, and improved operating results are contingent upon our ability to expand our operations internationally. For the nine-month period ended September 30, 2003, international licenses and products revenue amounted to $94,000, or 4%, of total licenses and products revenue, compared to $126,000, or 3.5% in the comparable period in 2002. International expansion will require significant management attention and financial resources, and we ultimately may not be successful in expanding our international operations. We have limited experience in developing local language versions of our products and, to date, limited success in marketing our products to international customers.

Services revenue for the three-month period ended September 30, 2003 increased 13% to $1.8 million from $1.6 million in the comparable period in 2002. Services revenue for the nine-month period ended September 30, 2003 increased 1% to $5.3 million in 2003 from $5.2 million in the comparable period in 2002. Services revenue includes PCS agreements, expert asset management consulting services, and training and support services not otherwise covered under maintenance agreements. PCS includes telephone support, bug fixes, and rights to upgrades on a when-and-if available basis. Consulting services consist primarily of implementation services performed on a time and material basis for the installation of our software products, best practices and implementation services, and on-site training services. PCS revenue from sales of the ITAM product line increased 9% to $1.4 million during the three-month period ended September 30, 2003 from $1.2 million for same period in 2002. For the nine-month period ended September 30, 2003, PCS revenue from sales of the ITAM product line increased 9% to $4.0 million from $3.7 million for same period in 2002. In accordance with our revenue recognition policy, we recognize revenues from post-contract support services ratably over the term of the support period, generally one year and once collectibility is assured. AM:PM and Arbiter PCS revenue decreased 14% to $238,000 for the three-month period ending September 30, 2003 from $277,000 in the comparable period in 2002. For the nine months ended September 30, 2003,

AM:PM and Arbiter PCS revenue decreased 26% to $754,000 from $1.0 million in the comparable period in 2002. As noted above, we expect the trend of declining AM:PM and Arbiter PCS revenue renewals to continue. For the three-month period ended September 30, 2003, our consulting services revenue was $246,000 compared to $102,000 in the comparable period in 2002. Consulting services revenue for the nine-month period ended September 30, 2003 increased to $502,000 from $498,000 during the same period in 2002. Recently, we have experienced an increased demand for our professional services as the result of existing customers preparing for the recent product release upgrade and the professional service component associated with Enterprise Insight sales. Current consulting services backlog (open customer POs for service but not yet scheduled by the customers) is $216,000. A key part of our strategy will be the continued delivery of expert asset management services. If we are unable to meet customers’ service requests with internal resources (due to limited capacity or business expertise), we will endeavor to partner with our resellers and other third-party service providers for additional support. There can be no assurance that we will be able to effectively maintain this new focus on providing consulting services. Our failure to implement solutions that address customers’ requirements and provide timely and cost-effective customer support and service could have a material adverse effect on our future business, operating results, and financial condition.

Cost of Revenue

Cost of licenses and products includes the costs related to the distribution of licensed software products. The principal materials and components used in our software products are CD-ROMs with documentation and occasionally hard copy installation guides. We occasionally use third-party vendors to print user manuals, packaging and related materials. All of the CD-ROM duplication is done at our distribution facility located in our corporate headquarters. Cost of licenses and products is relatively immaterial in relation to the associated revenue. Cost of licenses and products was ($3,000) for the three-month period ended September 30, 2003, and $10,000 in the comparable period in 2002. For the nine-month period ended September 30, 2003, cost of licenses and products decreased to $26,000 from $41,000 in the comparable period in 2002. Cost of licenses and products as a percentage of licenses and products revenue was 1% for the nine-month periods ended September 30, 2003 and 2002.

Cost of services reflects the cost of the direct labor force, including the associated personnel, travel and subsistence, and occupancy costs incurred in connection with providing consulting and maintenance services. Cost of services for the three-month periods ended September 30, 2003 and 2002 remained constant at $369,000. For the nine month period ended September 30, 2003, cost of services decreased 20% to $951,000 from $1.2 million during the same period in 2002. The overall decrease in cost of services is primarily the result of lower spending on personnel and related costs as well as reduced fixed and variable facilities cost resulting from last year’s restructuring initiatives. During 2002, we effected a restructuring plan designed to reduce our cost structure by consolidating our development staff and closing a facility located in Malvern, Pennsylvania, downsizing our corporate facility, and reducing our workforce. Because of the above-noted explanations, the cost of services as a percentage of services revenue for the three-month period ended September 30, 2003 decreased to 20% from 23% in 2002, and for the nine-month period ended September 30, 2003 decreased to 18% from 23% in 2002.

Software development costs are accounted for in accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed.” We capitalize certain software development costs incurred to develop new software or to enhance our existing software. Such capitalized costs are amortized on an individual product basis commencing when a product is generally available for release. Costs incurred prior to the establishment of technological feasibility are charged to research and development expense. Amortization of software development costs is provided on a product-by-product basis over the estimated economic life of the software, not to exceed three years, using the straight-line method. In 2001, we expended $3.5 million for the acquisition of software technology in connection with the purchase of the Wyzdom technology. Amortization of acquired software technology is provided using the straight-line method over an estimated useful life of four years. For the three-month period ended September 30, 2003, amortization of software development costs and acquired software technology increased 36% to $700,000 from $513,000 in 2002. For the nine-month period ended September 30, 2003 amortization of software development costs and acquired software technology increased 13% to $1.8 million compared to $1.6 million in 2002. The increase in amortization of software development costs and acquired software technology during the three month period ended September 30, 2003 is due to our release of Asset Insight v5 and Enterprise Insight v4 to customers in April 2003. Amortization of software development costs associated with the development effort for Asset Insight v5 and Enterprise Insight v4 resulted in an increase in our quarterly cost of approximately $250,000.

Sales and Marketing

Sales and marketing expenses consist principally of salaries, commissions, and benefits for sales, marketing, and channel support personnel, and the costs associated with product promotions and related travel. Sales and marketing expenses for the three-month period ended September 30, 2003 decreased 32% to $818,000, down from $1.2 million in the comparable period in 2002. For the nine months ended September 30, 2003, sales and marketing expenses decreased 36% to $2.6 million from $4.0 million during the same period in 2002. The reduction in overall spending in both the three and nine-month periods is principally as a result of lower spending on marketing initiatives, reduced personnel and related costs, and lower fixed and variable facilities costs resulting from last year’s restructuring initiatives noted above as well as a revised commission plan in put in for 2003. Sales and marketing expenses as a percentage of revenue decreased to 30% for the three-month period ended September 30, 2003 from 39% in the comparable period in 2002. For the nine-month period ended September 30, 2003, sales and marketing expenses as a percentage of revenue decreased to 34% from 45% in 2002. As noted earlier, our sales engagement process requires our direct sales consultants to explore each customer organization’s asset management goals and business drivers prior to delivering a solution plan. This process requires the efforts of experienced sales personnel, as well as specialized consulting professionals. The time investment devoted to each sale opportunity coupled with a small direct domestic sales force has limited the number of active opportunities our sales consultants can effectively work. In 2002, we started a process of evaluating every member of our direct sales force to determine whether they have the necessary skills. We have taken action, and may be required to take further action, where necessary to upgrade or replace skill sets, as well as invest in a larger sales force, in order to generate higher levels of sales activity. If we are unable to successfully expand our sales force or hire sales personnel in the future and train them in the use of our products, our business, operating results, and financial conditions could be harmed.

General and Administrative

General and administrative expenses consist principally of salaries and benefit costs for administrative personnel, general operating costs, legal, accounting and other professional services. General and administrative expenses for the three-month period ended September 30, 2003 decreased 32% to $357,000, down from $522,000 in the comparable period in 2002. For the nine months ended September 30, 2003, general and administrative expenses decreased 21% to $1.2 million from $1.5 million during the same period in 2002. The reduction in costs in 2003 was primarily the result of lower spending on personnel and related costs as well as reduced fixed and variable facilities cost resulting from last year’s restructuring initiatives noted above, offset in part by a lower reserve charge for bad debts in 2002 reflecting the general improvement in accounts receivable collections during that period. The allowance for doubtful accounts is management’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable. We determine the allowance based on historical write-off experience and how the our customers are affected by current general market and economic conditions. We review our allowance for doubtful accounts monthly. We specifically analyze customer receivables, as well as customer credits, customer concentrations, customer credit-worthiness, current economic trends, and changes in customer payment terms, when evaluating the adequacy of the allowance for doubtful accounts. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Likewise, should we determine that we would be able to realize more of our receivables in the future than previously estimated, a reduction to the allowance would increase income in the period such determination was made. Past due balances over 90 days are reviewed individually for collectibility. All other balances are evaluated on a pooled basis. At December 31, 2001, the Company increased its general and specific account reserve based on the continuing economic slowdown and business failures that had occurred, a higher write off experience in 2001 and 2000, and the recent bankruptcy filing of an existing account. In response to these concerns, in 2002 the Company allocated additional resource to the collection of existing accounts receivables. As a result of these actions and the validation by the bankruptcy judge of the outstanding receivable, management determined that the allowance for doubtful accounts could be reduced in June 2002. This adjustment in the allowance resulted in a reduction in general and administrative expenses in 2002 of approximately $140,000. For the three-month period ended September 30, 2003, as a percentage of total revenue, general and administrative expenses were 13% as compared to 17% in 2002. For the nine month period ended September 30, 2003, as a percentage of total revenue, general and administrative expenses were 16% compared to 18% in 2002.

Research and Development

Research and development expenses consist primarily of salaries and benefits for the software development and technical support staff and, to a lesser extent, costs associated with independent contractors. Gross expenditures for research and development for the three-month period ended September 30, 2003 decreased 30% to $528,000 from $755,000 in the comparable period in 2002. Comparing the nine months ended September 30, 2003 and 2002, gross research and development

decreased 37% to $1.6 million from $2.5 million, respectively. As a percentage of revenue, gross research and development costs decreased to 19% in the third quarter of 2003 from 25% in the same period in 2002 and decreased to 21% for the nine months ended September 30, 2003 down from 29% during the same period in 2002. The reduction in costs in 2003 was primarily the result of lower spending on personnel and related costs as well as reduced fixed and variable facilities costs resulting from last year’s restructuring initiatives noted above. In accordance with the provisions of SFAS No. 86, we capitalize certain software development costs incurred to develop new software or to enhance our existing software. For the three-month period ended September 30, 2003, we capitalized and deferred development costs of $220,000, or 41% of gross research and development costs, compared to $478,000, or 62% of gross research and development costs in the comparable period in 2002. Deferred development costs for the nine months ended September 30, 2003 was $788,000 compared to $1.3 million for the nine months ended September 30, 2002. The lower absolute deferral cost in 2003 is the result of the completion and release of Asset Insight v5 and Enterprise Insight v4 in April 2003 and the cost reductions noted above. As a result of rapid technological change in the industry, our position in existing markets can be eroded rapidly by product advances. The lifecycles of our products are difficult to estimate. Our growth and future financial performance depend in part upon our ability to improve existing products and develop and introduce new products that keep pace with technological advances, meet changing customer needs, and respond to competitive products. If we cannot compete effectively in our markets by offering products that are comparable in functionality, ease of use, and price to those of our competitors, our revenues will decrease, and our operating results will be adversely affected. Many of our current and potential competitors have substantially greater financial, technical, marketing, and other resources than we have. As a result, they may be able to devote greater resources than we can to the development, promotion, and sale of their products and may be able to respond more quickly to new or emerging technologies and changes in customer needs. As such, we will continue to commit substantial resources to research and development efforts in the future.

Depreciation and Amortization

The following table provides a summary by category of the charges to depreciation and amortization (excluding deferred software development costs) for the three and nine-month periods ended September 30, 2003 and 2002 (in thousands):

	Three months ended September 30				Nine months ended September 30
	2003		2002		2003		2002
	(unaudited)				(unaudited)
Depreciation	$	16	$	35	$	72	$	112
Amortization of other intangibles:		—		47		38		140

Total depreciation and amortization	$	16	$	82	$	110	$	252

Depreciation of property and equipment is provided using the straight-line method over estimated useful lives ranging from three to seven years.

Amortization of other intangibles associated with the purchase of the Wyzdom technology is provided using the straight-line method over an estimated useful life of two years. These assets were fully amortized in March 2003.

SFAS No. 142, “Goodwill and Other Intangible Assets,” requires that goodwill and intangible assets with indefinite useful lives to no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS No. 142. The Company adopted the provisions of SFAS No. 142 on its effective date, and as a result, we ceased amortization of goodwill on January 1, 2002. In lieu of amortization, we were required to perform an initial impairment review of goodwill in 2002 and an annual impairment review thereafter. The required initial benchmark evaluation and the annual impairment review were performed in January 2002 and 2003, respectively, resulting in no impairment in the value of the Company’s goodwill.

Amortization of software development costs (which includes amortization of acquired software technology) is provided on a product-by-product basis over the estimated economic life of the software, not to exceed three years, using the straight-line method. In accordance with the provisions of SFAS No. 86, included in cost of revenue is amortization of software development costs of $700,000 and $513,000 for the three-month periods ended September 30, 2003 and 2002, respectively. For the nine-month period ended September 30, 2003 amortization of software development costs was $1.8 million compared to $1.6 million in the comparable period in 2002.

Restructuring Charge

During 2002, we effected a restructuring plan designed to reduce our cost structure by reducing our workforce and closing a facility located in Malvern, PA,. As a result, we recorded a restructuring charge of $325,000 in the nine-month period ended September 30, 2002 reflecting severance benefits provided to terminated employees and the close down cost of vacating the Malvern, PA, facility. Severance was based on associates’ years of service as well as their position within the organization and was paid over the severance period. The reduction in workforce included 19 associates, which was expected to provide future annualized operating cost savings of $1.2 million. As of September 30, 2003, all costs associated with this restructuring plan have been paid.

Other Expense, Net

Other expense, net consists primarily of interest expense. For the three-month period ended September 30, 2003, interest expense, resulting principally from the Safeguard Demand Note and the TBBH Demand Note, was $37,000 compared to $38,000 in the comparable period in 2002. For the nine months ended September 30, 2003, interest expense was $102,000 compared to $149,000 during the comparable period in 2002. The reduction in interest expense for the nine-month period is the result of lower borrowing levels and the reduction in interest rates in 2003. Included in the interest expense for 2003 is interest income of $3,000 and a realized gain of $1,000 associated with the movements in foreign currency exchange rates. Included in the interest expense for 2002 is interest income of $5,000 and a realized gain of $6,000 associated with the movements in foreign currency exchange rates.

Provision for Income Taxes

There was no net provision for income taxes for the three and nine-month periods ended September 30, 2003 and 2002 due to the net operating loss carryforwards and net losses incurred. At December 31, 2002, the Company had net operating loss carryforwards of approximately $29.3 million, which are available to offset future federal taxable income and expire in various amounts from 2003 through 2022.

Net Earnings (Loss)

We have incurred substantial losses in recent years, and predicting our future operating results is difficult. If we continue to incur losses, if our revenues decline, or if our expenses increase without commensurate increases in revenues, our operating results will suffer and the price of our common stock may fall. For the three-month period ended September 30, 2003, we incurred net earnings of $134,000, compared to net earnings of $19,000, in 2002. For the nine-month period ended September 30, 2003, we incurred net earnings of $32,000, or ($0.01) per share (after giving effect to preferred dividend), compared to a net loss of $1.5 million, or ($0.09) per share (after giving effect to preferred dividend) during the same period in 2002. Although we experienced a decrease in revenues for the nine-month period ended September 30, 2003 when compared to 2002, as a result of the cost savings associated with our 2002 restructuring initiatives, we were able to significantly decrease our cost structure and net loss.

Impact of Recently Issued Accounting Standards

See Note 2 – Significant Accounting Policies to the Financial Statements with respect to the Impact of Recently Issued Accounting Standards.

Liquidity and Capital Resources

As of September 30, 2003, we had $1.4 million of cash on hand, $1.5 million in gross trade receivables, and $1.35 million of borrowing capacity on our revolving note with Safeguard. In the past, we have funded our operations through borrowings under a credit facility with Safeguard and cash generated from operations. However, the recent trend of operating losses, inconsistent revenue trends, and Safeguard’s notification of its intentions not to renew the Revolving Note upon its expiration on February 13, 2004 will likely require us to seek other sources of capital.

Our operating activities provided cash of $2.5 million for the nine-month period ended September 30, 2003 compared to $765,000 during the comparable period in 2002. Net cash provided by operating activities in 2003 consisted primarily of the net earnings of $32,000, adjusted for $2.0 million of non-cash charges to operations. Changes in operating assets and

liabilities provided $479,000 in cash for the nine-month period ended September 30, 2003 primarily related to a $1.4 million decrease in our accounts receivable and other assets balances. Net cash provided by operating activities for the nine-month period ended September 30, 2002 consisted primarily of the net loss of $1.5 million, adjusted for $1.9 million of non-cash charges to operations. Changes in operating assets and liabilities provided cash of $379,000 for the nine-month period ended September 30, 2002.

Investing activities used cash of $866,000 and $1.3 million in the nine-month periods ended September 30, 2003 and 2002, respectively, principally representing capitalized software development costs. In accordance with SFAS No. 86, we capitalized and deferred development costs of $788,000, or 49% of gross research and development costs, in 2003, and $1.3 million, or 47% of gross research and development costs, in 2002. Net cash used in investing activities reflects our continued and ongoing investment associated with our commitment to develop, enhance, and improve our ITAM product line. Our business is not capital asset intensive, and capital expenditures in any year normally would not be significant in relation to our overall financial position. Generally, our capital expenditures relate to information technology hardware and software purchases. Capital expenditures were approximately $78,000 for the nine-month period ended September 30, 2003 as compared to $18,000 in the first nine months of 2002. We currently expect our capital expenditure requirements for the remainder of 2003 to be in a range of $50,000 to 100,000.

Financing activities used cash of $650,000 in the nine-month period ended September 30, 2003. As result of the improvements in our net cash performance from operating activities, we were able to reduce our borrowings under our Safeguard revolving note by $650,000 in 2003. There were no exercises of employee stock options due to our stock price level.

In the past, we have funded our operations through borrowings under the credit facility with Safeguard and from cash generated from operations. Although operating activities may provide cash in certain periods, we anticipate that our operating and investing activities may use additional cash during the next twelve months. The recent trend of operating losses and inconsistent revenue trends may require us to obtain additional equity or debt financing. Additionally, Safeguard’s notification of its intentions not to renew the Revolving Note upon its expiration on February 13, 2004 will likely require us to seek a replacement source of operating capital. If we are unable to secure a replacement credit facility, our existing cash reserve may not be sufficient to satisfy our cash needs during the next twelve months. We have no present understanding, commitment, or agreement with respect to any such transaction. Accordingly, there can be no assurance that we will have access to adequate debt or equity financing or that, if available, it will be under terms and conditions satisfactory to us or which may not be dilutive. If we are unable to obtain sufficient additional funds, we may have to delay, scale back or eliminate some or all of our development activities or certain of our sales and marketing initiatives.

Contractual Obligations

Our contractual obligations consist of non-cancelable operating leases for facilities and equipment, debt financing, and cumulative dividend requirements on the Series F Convertible Preferred Stock. The following table summarizes our contractual obligations as of September 30, 2003 with management’s estimate of payments based upon existing contractual terms:

	Payments Due by Periods (in thousands)
Contractual Obligations	Total		Less than 1 Year		1-3 Years		After 3 Years
Operating leases	$	377	$	370	$	7	$	—
Revolving Note		—		—		—		—
Safeguard Demand Note		650		650		—		—
TBBH Demand Note		1,200		1,200		—		—
Series F Convertible Preferred Stock dividends		688		—		—		688

	$	2,915	$	2,220	$	7	$	688

We lease our corporate office facility and certain equipment under several non-cancelable operating lease agreements that expire at various times through 2005. Our facility lease contains fixed rental increases over the life of the lease. Net rental expense under these leases for the periods ended September 30, 2003 and 2002 totaled approximately $244,000 and $756,000, respectively. During 2002, the Company effected a restructuring plan designed to reduce its cost structure by consolidating its

development staff and closing its facility located in Malvern, Pennsylvania and downsizing its corporate facility. These initiatives reduced our monthly facility rental expense by approximately $59,000, or $1.5 million over the remaining term of the leases.

On February 13, 2003, we modified the terms of our $3 million unsecured revolving line of credit with Safeguard and our $1.2 million unsecured non-interest bearing Promissory Note to TBBH Investments Europe AG (“TBBH”) (the successor in interest to Axial Technology Holding AG).

Under the terms of the new agreement, we have issued to Safeguard Delaware, Inc. (“Safeguard Delaware”), a wholly owned subsidiary of Safeguard, a new $1.35 million unsecured, variable rate Revolving Note (the “Revolving Note”) and a $650,000 unsecured, variable rate Demand Note (the “Safeguard Demand Note”) (described below). The Revolving Note and the Safeguard Demand Note replace the previously existing $3 million unsecured revolving line of credit, of which $1.3 million was outstanding at the time of replacement, provided to us by Safeguard. Amounts outstanding under the Revolving Note bear interest at an annual rate equal to the prime rate of PNC Bank, N.A. plus 1%, payable quarterly in arrears on the first business day of January, April, July and October. We may from time to time borrow, repay and reborrow up to $1.35 million outstanding under the Revolving Note through February 13, 2004, at which time the Revolving Note may be renewed by Safeguard Delaware at its sole discretion. Safeguard Delaware was required to notify us by November 13, 2003 whether or not Safeguard Delaware would renew the Revolving Note on February 13, 2004. On November 3, 2003, Safeguard Delaware notified us of its intentions not to renew the Revolving Note upon its expiration on February 13, 2004. As of November 14, 2003, there were no outstanding borrowings under the Revolving Note with Safeguard. If during the remaining term of the Revolving Note we were to borrow under the Revolving Note, we would be required to repay all such outstanding borrowings and accrued but unpaid interest by August 13, 2004. Repayment of the Revolving Note may occur earlier in the case of a sale of all or substantially all of our assets, a business combination or upon the closing of a debt or equity offering in excess of $2.5 million.

Concurrent with the modification of the terms of the $3 million unsecured revolving line of credit with Safeguard, we issued to TBBH a $1.2 million unsecured variable rate Demand Note (the “TBBH Demand Note”) in replacement of the existing $1.2 million unsecured non-interest bearing Promissory Note, of which $500,000 was due on February 13, 2003. Amounts outstanding under both the $1.2 million TBBH Demand Note and the $650,000 Safeguard Demand Note bear interest at an annual rate equal to the announced prime rate of PNC Bank, N.A. plus 1%, payable quarterly in arrears on the first business day of January, April, July and October. However, interest shall accrue only on $500,000 of the principal of the TBBH Demand Note until the first anniversary of the date of the TBBH Demand Note and thereafter shall accrue interest on the entire outstanding principal. All outstanding principal and accrued but unpaid interest on each of the Safeguard Demand Note and the TBBH Demand Note is due and payable six months after the date of demand by Safeguard and/or TBBH, however, such demand shall not occur earlier than February 13, 2004. We are required to notify Safeguard or TBBH of the other party’s demand for payment. Except for payments made on demand by only one lender (either Safeguard or TBBH), any payments on the Demand Notes shall be made pro rata between Safeguard and TBBH. The outstanding principal amount of the Demand Notes may be prepaid in whole or in part upon notice to Safeguard and TBBH at any time or from time to time without any prepayment penalty or premium, provided, however, that there are no amounts outstanding under the Revolving Note. Repayment of the Demand Notes may occur earlier in the case of a sale of all or substantially all of our assets, a business combination or upon the closing of a debt or equity offering in excess of $2.5 million; provided, however, that any repayment will be applied first to the repayment of the then outstanding obligations under the Revolving Note and then to the repayment of the then outstanding obligations under the Demand Notes.

Safeguard is the holder of all 3,000 shares of our Series F Convertible Preferred Stock (“Series F Shares”). The Series F Shares are entitled to a cumulative quarterly dividend, when and if declared by the board, at a rate per share equal to 2% of the issuance price per quarter. At September 30, 2003, dividends in arrears on the Series F Shares were approximately $688,000.

Risk Factors

In addition to other information in this Quarterly Report on Form 10-Q, the following risk factors should be carefully considered in evaluating Tangram and our business because such factors currently may have a significant impact on Tangram’s business, operating results and financial condition. As a result of the risk factors set forth below and elsewhere in this Form 10-Q, and the risks discussed in Tangram’s other Securities and Exchange Commission filings including our Annual Report on Form 10-K for our fiscal year ended December 31, 2002, actual results could differ materially from those projected in any forward-looking statements. Moreover, the risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business

operations. If any of the following risks actually occur, our business could be materially harmed. In that event, the trading price of our common stock could decline.

If the market for ITAM software does not continue to develop as we anticipate, the demand for our products might be adversely affected.

As their needs have become more complex, many companies have been addressing their ITAM needs for systems and applications internally and only recently have become aware of the benefits of third-party software products such as ours. Our future financial performance will depend in large part on the continued growth in the number of businesses adopting third-party ITAM software products and their deployment of these products on an enterprise-wide basis.

We have a history of losses and negative cash flow from operations and cannot assure that we will be profitable in the future on an operating basis or otherwise.

We have incurred substantial losses in recent years, and predicting our future operating results is difficult. In the past, we have funded our operations through borrowings under the credit facility with Safeguard and from cash generated from operations. Although operating activities may provide cash in certain periods, we anticipate that our operating and investing activities may use additional cash. If we continue to incur losses and consume cash, if our revenues decline, or if our expenses increase without commensurate increases in revenues, our operating results will suffer and the price of our common stock may fall. The recent trend of operating losses and inconsistent revenue levels may require us to obtain additional equity or debt financing. Additionally, Safeguard’s notification of its intentions not to renew the Revolving Note upon its expiration on February 13, 2004 will likely require us to seek a replacement source of operating capital. However, we have no present understanding, commitment, or agreement with respect to any such transaction. Accordingly, there can be no assurance that we will have access to adequate debt or equity financing or that, if available, it will be under terms and conditions satisfactory to us or which may not be dilutive.

Recent unfavorable economic conditions and reductions in IT spending could limit our ability to grow our business. Our business and operating results are subject to the effects of changes in general economic conditions.

The significant downturn in the U.S. and worldwide economies during the past 18 months has negatively affected our revenues and operations. As companies experience economic downturns, they often delay or cease spending on capital assets and IT infrastructure (including software and related services). We are uncertain as to its future severity and duration. In the future, fears of global recession, war and additional acts of terrorism may continue to impact global economies negatively. We believe that these conditions, as well as the decline in worldwide economic conditions, have led our current and potential customers to reduce their IT spending. If these conditions worsen, demand for our products and services may be further reduced as a result of continued decreased spending on IT products such as ours.

Control by Safeguard Scientifics, Inc.

Safeguard Scientifics, Inc. (“Safeguard”) beneficially owns approximately 56% of our outstanding common stock and 3,000 shares of our Series F Convertible Preferred Stock. The 3,000 shares of Series F Convertible Preferred Stock are convertible at any time at the option of the holder into 1,500,000 shares of common stock, subject to anti-dilution adjustments. Safeguard is entitled to one vote for each share of common stock into which the Series F Convertible Preferred Stock may be converted and may vote on all matters submitted to a vote of the holders of common stock. Therefore, Safeguard controls approximately 58% of the Company’s outstanding voting shares.

As a result, Safeguard has the ability to control the election of Tangram’s board of directors and the outcome of all other matters submitted to our shareholders. In addition, Safeguard’s influence may either deter any acquisition of Tangram or our ability to acquire another entity, and its significant ownership position reduces the public float for our common stock. Consequently, this influence and significant ownership could adversely affect the market price and liquidity of our common stock.

We face strong competitors that have greater market share than we do and pre-existing relationships with our potential customers, and if we are unable to compete effectively, we might not be able to achieve sufficient market penetration to achieve or sustain profitability.

The market for our products is intensely competitive and diverse, and the technologies for our products can change rapidly. New products are introduced frequently and existing products are continually enhanced. Historically, we have encountered competition from a number of sources, including system management and infrastructure management companies. Vendors of system management software and infrastructure management offerings continue to enhance their products to include functionality that was provided by asset tracking and low-end discovery tool software. Even though the asset tracking functionality provided as standard features of asset management and infrastructure management software is more limited than that of our Asset Insight products, there can be no assurance that a significant number of potential customers would not elect to accept such functionality in lieu of purchasing additional software. While we believe we maintain a strong competitive advantage in functionality and features, this emergence of asset management software and infrastructure management offerings is having the effect of extending our sales cycle, as well as creating pressure on us to reduce prices for our Asset Insight product line.

Competitors vary in size and in the scope and breadth of software and services offered. There are many vendors in the infrastructure management market, which includes asset tracking and asset management. This has created confusion and overlap among vendors, such as Peregrine, Altiris, MRO/MainControl, Computer Associates, and Tally. Additionally, systems management suites provide auto-discovery features that overlap with our offerings. These vendors include Microsoft’s SMS, Hewlett-Packard’s OpenView, and Computer Associates’ Unicenter. In the mid-sized asset tracking market, Asset Insight express competes with low-end discovery tools, such as AssetMetrix, Blue Ocean’s TrackIT, Centennial Discovery, and Eracent’s EnterpriseAM. We also face competition from numerous start-up and other entrepreneurial companies offering products that compete with the functionality offered by one or more of our asset management products and the internal information technology departments of those companies with asset management needs.

If we cannot compete effectively in our markets by offering products that are comparable in functionality, ease of use, and price to those of our competitors, our revenues will decrease, and our operating results will be adversely affected. Many of our current and potential competitors have substantially greater financial, technical, marketing, and other resources than we have. As a result, they may be able to devote greater resources than we can to the development, promotion, and sale of their products and may be able to respond more quickly to new or emerging technologies and changes in customer needs.

Additional competition from new entrepreneurial companies or established companies entering our markets could have an adverse effect on our business, revenues, and operating results. In addition, alliances among companies that are not currently direct competitors could create new competitors with substantial market presence. Because few barriers to entry exist in the software industry, we anticipate additional competition from new and established companies, as well as business alliances. We expect that the software industry will continue to consolidate. In particular, we expect that large software companies will continue to acquire or establish alliances with our smaller competitors, thereby increasing the resources available to these competitors. These new competitors or alliances could rapidly gain significant market share at our expense.

The market addressed by our ITAM product suite is in turmoil, and a significant new competitor may emerge.

Our Asset Insight and Enterprise Insight products are targeted at the ITAM market. In the past, Peregrine Systems, Inc. had the biggest single share of this market; Peregrine recently filed for bankruptcy protection. As a result of Peregrine’s bankruptcy, some prospective Asset Insight and Enterprise Insight customers have questioned the validity of the ITAM market, and some have adopted a “wait and see” position towards purchasing products in this market. The ultimate disposition of Peregrine’s IT asset-related business may have a detrimental effect on our ability to market our Asset Insight and Enterprise Insight products. Peregrine has recently emerged from bankruptcy with a more streamlined operation and with the reduced burden of its pre-bankruptcy liabilities and, as such, we may be competing against a stronger competitor. Additionally, during the bankruptcy process, Peregrine may auction off its IT asset-related business, and the buyer could become a significant competitor to us in this market. This new competitor may have previously been a competitor of ours, or it may be a new entrant in our competitive landscape. There is considerable uncertainty about the future of Peregrine’s IT asset-related business, and the prospects for the IT asset management market and our ability to market and sell Asset Insight and Enterprise Insight may be affected by the outcome of Peregrine’s bankruptcy proceedings. If the ITAM market or Peregrine’s bankruptcy has an adverse effect on our sales, there could be an adverse impact on our business and results of operations.

If we do not respond adequately to our industry’s evolving technology standards, or do not continually develop products that meet the complex and evolving needs of our customers, sales of our products may decrease.

As a result of rapid technological change in our industry, our competitive position in existing markets, or in markets we may enter in the future, can be eroded rapidly by product advances and technological changes. As the market evolves and competitive pressures increase, we believe that we will need to further expand our product offerings and further improve the integration between our asset tracking and asset repository solutions. We may be unable to improve the performance and features of our products as necessary to respond to these developments. In addition, the lifecycles of our products are difficult to estimate. Our growth and future financial performance depend in part on our ability to improve existing products and develop and introduce new products that keep pace with technological advances, meet changing customer needs, and respond to competitive products. Our product development efforts will continue to require substantial investments. In addition, competitive or technological developments may require us to make substantial, unanticipated investments in new products and technologies, and we may not have sufficient resources to make these investments.

If we are unable to expand our business internationally, our business, revenues, and operating results could be harmed.

In order to grow our business, increase our revenues, and improve our operating results, we believe we must continue to expand internationally. We have expanded our European and Pacific Rim sales initiatives by establishing agreements with nine distributors that are marketing our Asset Insight and Enterprise Insight solutions in the United Kingdom, Germany, Ireland, Scandinavia, Switzerland, Italy, Portugal, the Benelux countries, Spain, Australia, New Zealand, Hong Kong, and Singapore. We carefully select distributors that share our customer-centric philosophy and are committed to selling Tangram’s solutions as their exclusive ITAM offerings. If we expend substantial resources while pursuing an international strategy and we are not successful, our revenues will fall short of our expectations, and our operating results will suffer. International expansion will require significant management attention and financial resources, and we may not be successful in expanding our international operations. Additionally, we have limited experience in developing local language versions of our products or in marketing our products to international customers. We may not be able to successfully translate, market, sell, and deliver our products internationally.

If we cannot attract and retain qualified sales and marketing personnel, software developers, and customer service personnel, we will not be able to sell and support our products.

Competition for qualified employees has been intense, particularly in the technology industry, and we have in the past experienced difficulty recruiting qualified employees. If we are not successful in attracting and retaining qualified sales and marketing personnel, software developers, and customer service personnel, our revenue growth rates could decrease, or our revenues could decline, and our operating results could be materially harmed. Our products and services require a sophisticated selling effort targeted at several key people within a prospective customer’s organization. This process requires the efforts of experienced sales personnel, as well as specialized consulting professionals. In addition, the complexity of our products, and issues associated with installing and maintaining them, require highly-trained customer service and support personnel. We intend to hire these personnel in the future and train them in the use of our products. We believe our success will depend in large part on our ability to attract and retain these key employees.

Product development delays could harm our competitive position and reduce our revenues.

If we experience significant product development delays, our position in the market would be harmed and our revenues could be substantially reduced, which would adversely affect our operating results. We have experienced product development delays in the past and may experience delays in the future. Delays may occur for many reasons, including an inability to hire a sufficient number of developers, discovery of software bugs and errors, or a failure of our current or future products to conform to industry requirements.

If our existing customers do not purchase additional licenses or renew post-contract customer support services, our sources of revenue might be limited to new customers and our ability to grow our business might be impaired.

Historically, we have derived, and expect to continue to derive, a significant portion of our total revenue from existing customers who purchase additional products and renew post-contract customer support services (“PCS”). New licenses and products to existing customers represented 38% of our revenue in 2001, 73% of our revenue in 2002, and 72% in the first nine months of 2003. If our customers do not purchase additional products or renew PCS, our ability to increase or maintain

revenue levels could be limited. A number of our current customers initially license a limited number of our products for use in a division of their enterprises. We actively market to these customers to have them license additional products from us and increase their use of our products on an enterprise-wide basis. Our customers may not license additional products and may not expand their use of our products throughout their enterprises. In addition, as we deploy new versions of our products or introduce new products, our current customers may not require or desire the functionality of our new products and may not ultimately license these products.

We also depend on our installed customer base for future revenue from PCS renewal fees. The terms of our standard license arrangements provide for a one-time license fee and the purchase of one year of PCS. PCS is renewable annually at the option of our customers and there are no minimum payment obligations or obligations to license additional software. PCS renewals have accounted for a significant portion of our revenue; however, there can be no assurance that we will be able to sustain current renewal rates in the future. Substantial cancellations of PCS agreements, or a failure of a substantial number of customers to renew these contracts, would reduce our revenues and harm our operating results.

Our revenues vary significantly from quarter to quarter for numerous reasons beyond our control. Quarter to quarter variations could result in a substantial decrease in our stock price if our revenues or operating results are less than the expectations of our investors.

Our revenues or operating results in a given quarter could be substantially less than anticipated by our investors, which could result in a substantial decline in our stock price. In addition, quarter to quarter variations could create uncertainty about the direction or progress of our business, which could also result in a decline in the price of our common stock. Our revenues and operating results will vary from quarter to quarter for many reasons, many of which are beyond our control, including:

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changes in demand for our products;

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the size, timing and contractual terms of orders for our products;

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any downturn in our customers and potential customers’ businesses, the domestic economy or international economies where our customers and potential customers do business;

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the timing of product releases or upgrades by us or by our competitors; and

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changes in the mix of revenue attributable to higher-margin software products as opposed to substantially lower-margin services.

As a result, our quarterly revenues and operating results are not predictable with any significant degree of accuracy.

Our quarterly revenue and revenue growth are increasingly dependent on a small number of large license transactions.

Our revenues in a given quarter could be adversely affected if we are unable to complete one or more large license agreements, if the completion of a large license agreement is delayed, or if the contract terms were to prevent us from recognizing revenue during that quarter.

Historically, we have been dependent on closing large Asset Insight product sales in a given quarter. We expect our reliance on these large transactions to continue for the foreseeable future. If we are unable to complete a large license transaction by the end of a particular quarter, our revenues and operating results could be materially below the expectations of our investors, and our stock price could fall. In particular, our dependence on a few relatively large license transactions could have a material adverse effect on our quarterly revenues or revenue growth rates as prospects may reduce their capital investments in technology in response to slowing economic growth, budget constraints, or other factors.

In addition, when negotiating large software licenses, many customers postpone their negotiations until quarter-end in an effort to improve their ability to obtain more favorable pricing terms. As a result, we recognize a substantial portion of our revenues in the last month or weeks of a quarter, and license revenues in a given quarter depend substantially on orders booked during the last month or weeks of a quarter.

Many of our channel partners experienced internal management and financial performance problems that impacted their ability to resell our product. In response, we have shifted from an exclusively indirect sales channel to a predominantly direct sales organization.

Our ability to sell our products into new markets and to increase our penetration into existing markets will be impaired if we fail to expand our distribution channels and sales force. Our products and services require a sophisticated selling effort targeted at several key people within a prospective customer’s organization. This process requires the efforts of experienced sales personnel, as well as specialized consulting professionals. In addition, the complexity of our products, and issues associated with installing and maintaining them, require highly-trained customer service and support personnel. We are in the process of transitioning and expanding our direct sales force to complement our marketing arrangements with our channel partners and distributors. Our direct sales force has limited experience selling and delivering our phased asset management solutions. If we are unable to successfully train our direct sales force or hire these personnel in the future and train them in the use of our products, our business, operating results, and financial conditions could be harmed.

A key part of our solution will be the delivery of expert asset management services. If we are unable to meet customers’ service requests with internal resources (due to limited capacity or business expertise), we will partner with our resellers and other third-party service providers for additional support. There can be no assurance that we will be able to effectively implement this new sales focus on providing consulting services. Our failure to implement solutions that address customers’ requirements and provide timely and cost-effective customer support and service could have a material adverse effect on our business, operating results, and financial condition.

We may be unable to expand our business and increase our revenues if we are unable to expand our distribution channels.

If we are unable to expand our distribution channels effectively, our business, revenues, and operating results could be harmed. In particular, we will need to expand our direct sales force and establish relationships with additional system integrators, resellers and other third-party channel partners who market and sell our products. If we cannot establish these relationships, or if our channel partners are unable to market our products effectively or provide cost-effective customer support and service, our business, revenues, and operating results could be harmed. Even where we are successful in establishing a new third-party relationship, our agreement with the third-party may not be exclusive. As a result, our partners may carry competing product lines.

Seasonal trends in sales of our software products may result in periodic reductions in our revenues and impairment of our operating results.

Seasonality in our business could result in our revenues in a given period being inconsistent. Seasonality could also result in quarter to quarter decreases in our revenues. In either of these events, seasonality could have an adverse impact on our results of operations. Historically, our revenues and operating results in our third and fourth quarters have tended to benefit, relative to our first and second quarters, from purchase decisions made by the large concentration of our customers with calendar year-end budgeting requirements. Our first and second quarters tend to produce the lowest revenues. Notwithstanding these seasonal factors, other factors, including those identified in this section, could still result in reduced revenues or operating results in our third and fourth quarters. Historical patterns may change over time. As our international operations expand, we may experience variability in demand associated with seasonal buying patterns in these foreign markets different from those in the United States.

Our quarterly revenues and revenue growth rates could be affected by the new products that we announce or that our competitors announce.

Announcements of new products or releases by us or our competitors could cause customers to delay purchases pending the introduction of the new product or release. In addition, announcements by us or our competitors concerning pricing policies could have an adverse effect on our revenues in a given quarter.

Our products and service offerings have different margins, and changes in our revenue mix could have an adverse effect on our operating results.

Changes in our revenue mix could adversely affect our operating results because some products and service offerings provide higher margins than others. For example, margins on software licenses tend to be higher than margins on maintenance

and services. Additionally, we have utilized both inside and outside professional services consultants trained in the deployment of Asset Insight to deliver our implementation services. The outside consultants who are subcontractors generally cost significantly more than the consultants employed directly by us. Our gross profit can fluctuate based upon the mix of use of consultants who are subcontractors versus consultants employed directly by us.

The long sales cycle for our products may cause substantial fluctuations in our revenues and operating results.

Delays in customer orders could result in our revenues being substantially below the expectations of our investors. The sales cycle for our products typically takes six to nine months to complete, and we may experience delays that further extend this period. The length of the sales cycle may vary depending on factors over which we have little or no control, such as the size of the transaction, the internal activities of potential customers, and the level of competition that we encounter in selling the products. Our customers’ planning and purchasing decisions involve a significant commitment of resources and a lengthy evaluation and product qualification process. As a result, we may incur substantial sales and marketing expenses during a particular period in an effort to obtain orders. If we are unsuccessful in generating offsetting revenues during that period, our revenues and earnings could be substantially reduced, or we could experience a large loss. During the sales cycle, we typically provide a significant level of education to prospective customers regarding the use and benefits of our products. Any delay in the sales cycle of a large license or a number of smaller licenses could have an adverse effect on our operating results and financial condition.

Conducting business internationally poses risks that could affect our financial results.

Even if we are successful in expanding our operations internationally, conducting business outside North America poses many risks that could adversely affect our operating results. In particular, we may experience gains and losses resulting from fluctuations in currency exchange rates, for which hedging activities may not adequately protect us. To date, the majority of our international revenue has been denominated in United States currency; therefore, we have not experienced any significant currency fluctuations. During the nine-month period ended September 30, 2003, approximately 2.1% of the U.S. dollar value of our invoices were denominated in currencies other than the United States dollar. For the year ended December 31, 2002, approximately 1.9% of the U.S. dollar value of our invoices were denominated in currencies other than the United States dollar. Accordingly, we have minimal exposure to adverse movements in foreign currency exchange rates. However, future exchange rate risks can have an adverse effect on our ability to sell our products in foreign markets. Since we sell our products in U.S. dollars, our sales could be adversely affected by declines in foreign currencies relative to the dollar, thereby making our products more expensive in local currencies. If we are to sell our products in local currencies, we could be competitively unable to change our prices to reflect exchange rate changes. Additional risks we face in conducting business internationally include longer payment cycles, difficulties in staffing and managing international operations, problems in collecting accounts receivable, and the adverse effects of tariffs, duties, price controls, or other restrictions that impair trade.

Our future revenues and operating results may be adversely affected if the software application market continues to evolve toward a subscription-based model, which may prove less profitable for us.

We expect our revenue growth rates and operating results to be adversely affected as customers move to a subscription-based application service provider model. Historically, we have sold our asset management solutions on a perpetual license basis in exchange for an up-front license fee. Businesses are increasingly attempting to reduce their up-front capital expenditures by purchasing software applications under a hosted subscription service model. Under the hosted model, the customer subscribes to use an application from the software provider. The application is generally hosted on a server managed by the software provider or a third-party hosting service. Under the subscription revenue model, revenue is recognized ratably over the term of a subscription. As a result, our rate of revenue growth under a subscription model will be less than under a license model. In addition, the price of our services will be fixed at the time of entering into the subscription agreement. If we are unable to adequately predict the costs associated with maintaining and servicing a customer’s subscription, then the periodic expenses associated with a subscription may exceed the revenues we recognize for the subscription in the same period, which would adversely affect our operating results.

If the asset management market evolves toward a subscription-based model and if an increasing number of our future customers demand a subscription-based solution, or if we are not successful in implementing a subscription-based revenue model, or if market analysts or investors do not believe that the model is attractive relative to our traditional license model, our business could be impaired, and our stock price could decline.

Errors or other software bugs in our products could result in significant expenditures to correct the errors or bugs, potentially resulting in our inability to deliver product, and could result in product liability claims.

Software products as complex as those we offer may contain errors that may be detected at any point in a product’s lifecycle. While we continually test our products for errors and work with customers through our customer support services to identify and correct bugs, errors in our products may be found in the future even after our products have been commercially introduced. Testing for errors is complicated in part because it is difficult to simulate the complex, distributed computing environments in which our customers use our products, as well as because of the increased functionality of our product offerings. We have experienced errors in the past that resulted in delays in product shipment and increased costs. There can be no assurance that, despite our testing, errors will not be found. If we were required to expend significant amounts to correct software bugs or errors, our revenues could be harmed as a result of an inability to deliver the product, and our operating results could be impaired as we incur additional costs without offsetting revenues. Such errors may result in loss of, or delay in, market acceptance and sales, diversion of development resources, injury to our reputation, or increased service and warranty costs, any of which could have a material adverse effect on our business, results of operations, and financial condition.

If we were held liable for damages incurred as a result of our products, our operating results could be significantly impaired. Our license agreements with our customers typically contain provisions designed to limit exposure to potential product liability claims. These limitations, however, may not be effective under the laws of some jurisdictions. Although we have not experienced any product liability losses to date, the sale and support of our products entails the risks of these claims.

We may experience integration or other problems with future acquisitions, which could have an adverse effect on our business or results of operations. New acquisitions could dilute the interests of existing shareholders, and the announcement of new acquisitions could result in a decline in the price of our common stock.

As part of our business strategy, we may find it desirable in the future to make acquisitions of, or significant investments in, businesses that offer complementary products, services and technologies. We may also make acquisitions of, or investments in, businesses that we believe could expand our distribution channels. If we identify an appropriate acquisition candidate, we may not be able to negotiate the terms of the acquisition successfully or finance the acquisition. If we consummate one or more significant acquisitions in which the consideration consists of stock or other securities, shareholder ownership percentages in Tangram could be significantly diluted. In addition, we may be required to write off or amortize significant amounts of goodwill and other intangible assets in connection with future acquisitions, which could materially impair our operating results and financial condition. Any future acquisition or substantial investment would present numerous risks. The following are examples of these risks:

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difficulties in assimilating the technology, operations, or personnel of the acquired businesses into ours;

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potential disruption of our ongoing business;

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difficulty in realizing the potential financial or strategic benefits of the transaction;

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problems in maintaining uniform standards, controls, procedures, and policies;

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impairment of our relationships with our employees and clients as a result of any integration of new businesses and management personnel; and

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the diversion of our management’s attention.

Our business could be harmed if we lose the services of one or more members of our senior management team.

The loss of the services of one or more of our executive officers or key employees, or the decision of one or more of these individuals to join a competitor, could adversely affect our business and harm our operating results and financial condition. Our success depends to a significant extent on the continued service of our senior management and other key sales, consulting, technical, and marketing personnel.

We could be competitively disadvantaged if we are unable to protect our intellectual property.

If we fail to adequately protect our proprietary rights, competitors could offer similar products relying on technologies we developed, potentially harming our competitive position and decreasing our revenues. We attempt to protect our intellectual property rights by limiting access to the distribution of our software, documentation, and other proprietary information and by relying on a combination of copyright, trademark, and trade secret laws. In addition, we enter into confidentiality agreements with our employees and certain customers, vendors, and strategic partners.

Despite precautions that we take, it may be possible for unauthorized third parties to copy aspects of our current or future products or to obtain and use information that we regard as proprietary. Policing unauthorized use of software is difficult, and some foreign laws do not protect proprietary rights to the same extent as United States laws. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, or to determine the validity and scope of the proprietary rights of others, any of which could adversely affect our revenues and operating results.

If we become involved in an intellectual property dispute, we may incur significant expenses or may be required to cease selling our products, which would substantially impair our revenues and operating results.

In recent years, there has been significant litigation in the United States involving intellectual property rights, including rights of companies in the software industry. Intellectual property claims against us, and any resulting lawsuit, may result in our incurring significant expenses and could subject us to significant liability for damages and invalidate what we currently believe are our proprietary rights. These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and could divert management’s time and attention. Any potential intellectual property litigation against us could also force us to do one or more of the following:

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cease selling or using products or services that incorporate the infringed intellectual property;

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obtain from the holder of the infringed intellectual property a license to sell or use the relevant technology, which license may not be available on acceptable terms, if at all; or

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redesign those products or services that incorporate the disputed technology, which could result in substantial unanticipated development expenses.

If we are subject to a successful claim of infringement and we fail to develop non-infringing technology or license the infringed technology on acceptable terms and on a timely basis, our revenues could decline or our expenses could increase.

We may in the future initiate claims or litigation against third parties for infringement of our proprietary rights or to determine the scope and validity of our proprietary rights or the proprietary rights of competitors. These claims could also result in significant expense and the diversion of technical and management personnel’s attention.

Our stock price has been and is likely to continue to be highly volatile, which may make our common stock difficult to resell at attractive times and prices.

The trading price of our common stock has been and is likely to remain highly volatile. Our stock price could be subject to wide fluctuations in response to a variety of factors, including the following:

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actual or anticipated variations in our quarterly operating results;

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announcements of technological innovations;

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new products or services offered by us or our competitors;

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conditions or trends in the software industry generally or specifically in the markets for asset management enterprise solutions;

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changes in the economic performance and/or market valuations of our competitors and the software industry in general;

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announcements by us or our competitors of significant contracts, changes in pricing policies, acquisitions, strategic partnerships, joint ventures, or capital commitments;

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adoption of industry standards and the inclusion of our technology in, or compatibility of our technology with, the standards;

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adverse or unfavorable publicity regarding us or our products;

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our loss of a major customer;

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additions or departures of key personnel;

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sales of our common stock in the public market; and

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other events or factors that may be beyond our control.

In addition, the markets for securities of technology and software companies have experienced extreme price and volume volatility and a significant cumulative decline in recent months. This volatility has affected many companies irrespective of, or

disproportionately to, the operating performance of these companies. These industry factors can materially and adversely affect the market price of our common stock, regardless of our actual operating performance.

We risk liability from potential product liability claims that our insurance may not cover, which could materially adversely affect our business, financial condition, and results of operations.

In testing, manufacturing, and marketing our products, we risk liability from the failure of the products to perform as we expect. Although we currently have product liability insurance and seek to obtain indemnification from licensees of the products, obtaining additional insurance or indemnification may be inadequate, unobtainable, or prohibitively expensive. We must renew our policies each year. We may not be able to renew our current policies or obtain additional insurance in the future on acceptable terms or at all. Our inability to obtain sufficient insurance coverage on reasonable terms, or otherwise protect ourselves against potential product liability claims in excess of our insurance, could materially adversely affect our business, financial condition, and results of operations.

Future changes in accounting standards, particularly changes affecting revenue recognition, could cause unexpected revenue fluctuations.

Future changes in accounting standards, particularly those affecting revenue recognition, could require us to change our accounting policies. These changes could cause deferment of revenue recognized in current periods to subsequent periods or accelerate recognition of deferred revenue to current periods, each of which could cause shortfalls in meeting investors’ expectations. Any of these shortfalls could cause a decline in our stock price.

Certain provisions of Pennsylvania law and our articles of incorporation and bylaws could have the effect of making it more difficult for a third-party to acquire, or of discouraging a third-party from attempting to acquire, control of us.

We are a Pennsylvania corporation. Certain provisions of Pennsylvania law and our articles of incorporation and bylaws could have the effect of making it more difficult for a third-party to acquire, or of discouraging a third-party from attempting to acquire, control of us. While these provisions may provide us with flexibility in managing our business, they could discourage or make a merger, tender offer, or proxy contest more difficult, even though certain shareholders may wish to participate in the transaction. These provisions could also potentially adversely affect the market price of the common stock. These provisions include:

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a provision allowing us to issue preferred stock with rights senior to those of the common stock without any further vote or action by the holders of common stock; and

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the issuance of preferred stock could decrease the amount of earnings and assets available for distribution to the holders of common stock or could adversely affect the rights and powers, including voting rights, of the holders of the common stock. In certain circumstances, the issuance of preferred stock could have the effect of decreasing the market price of the common stock.

Item 3.

Quantitative and Qualitative Disclosure about Market Risk

We are exposed to market risk from changes in interest rates. Such changes in interest rates impact interest cost on our interest rate-sensitive liabilities. Interest rate-sensitive liabilities are assumed to be those for which the stated interest rate is not contractually fixed for the next 12-month period. Thus, liabilities that have a market-based index, such as the prime rate, are rate sensitive. As of November 14, 2003, the only interest rate-sensitive liabilities are the Revolving Note, the Safeguard Demand Note, and the TBBH Demand Note. Assuming a hypothetical, immediate 100 basis point increase in the interest rate, our interest expense over the following 12-month period would be increased by approximately $23,000. The hypothetical model prepared by us assumes that the balance of interest rate-sensitive liabilities fluctuates based on our anticipated borrowing levels over the next 12-month period. Thus, this model represents a static analysis, which cannot adequately portray how we would respond to significant changes in market conditions. Furthermore, the analysis does not necessarily reflect our expectations regarding the movement of interest rates in the near term, including the likelihood of an immediate 100 basis point change in the interest rates nor the actual effect on interest cost if such a rate change were to occur. We have not historically used financial instruments to hedge interest rate exposure, do not use financial instruments for trading purposes, and are not a party to any leveraged derivatives.

Foreign Currency Risk

Our business is principally transacted in United States currency. In 2003, the majority of revenue has been denominated in United States currency. Through the first nine months of 2003, 2.1% of the U.S. dollar value of our invoices were denominated in currencies other than the United States dollar. Accordingly, we have minimal exposure to adverse movements in foreign currency exchange rates. This exposure is primarily related to local currency denominated revenue and operating expenses in the United Kingdom. We will continue to assess our need to hedge currency exposures on an ongoing basis and if we are successful in growing our international revenues. However, as of September 30, 2003, we had no hedging contracts outstanding.

Item 4.

Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”), we carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Disclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective as of the Evaluation Date in timely alerting them to material information required to be included in our periodic SEC reports. It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

We intend to review and evaluate the design and effectiveness of our disclosure controls and procedures on an ongoing basis, improve our controls and procedures over time, and correct any deficiencies that we may discover in the future. Our goal is to ensure that our senior management has timely access to all material financial and non-financial information concerning our business. While we believe the present design of our disclosure controls and procedures is effective to achieve our goal, future events affecting our business may cause us to modify our disclosure controls and procedures.

There has been no change in our internal control over financial reporting during the quarter ended September 30, 2003, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Included on Exhibits 31.1 and 31.2 of this Quarterly Report of Form 10-Q are certifications of our Chief Executive Officer and Chief Financial Officer, which are required in accordance with Rule 13a-14 of the Exchange Act. This Controls and Procedures section includes the information concerning the controls evaluation referred to in the certifications and it should be read in conjunction with the certifications for a more complete understanding of the topics presented.

PART II - OTHER INFORMATION

Item 6.

Exhibits and Reports on Form 8-K

Exhibits

Exhibit Number		Exhibit Description

31.1		Certification of President and Chief Executive Officer Pursuant to Exchange Act Rule 13a-14(a).

31.2		Certification of Senior Vice President and Chief Financial Officer Pursuant to Exchange Act Rule 13a-14(a).

32.1		Certification of Norman L. Phelps, President and Chief Executive Officer of Tangram Enterprise Solutions, Inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of John N. Nelli, Senior Vice President and Chief Financial Officer of Tangram Enterprise Solutions, Inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

b)	Reports on Form 8-K

On August 8, 2003, the registrant furnished to the Commission a Current Report on Form 8-K, dated August 7, 2003, to report that the registrant had issued a press release announcing its second quarter 2003 results. This information shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or incorporated by reference in any filing under the Securities Act of 1933, as amended (the “Securities Act”), or the Exchange Act, except as shall be expressly set forth by specific reference in such a filing.

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.

				Tangram Enterprise Solutions, Inc.

Date November 14, 2003				/s/ John N. Nelli

				John N. Nelli Senior Vice President and Chief Financial Officer (Principal Financial & Accounting Officer)

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TANGRAM ENTERPRISE SOLUTIONS INC 10-Q