Annual Reports

 
Quarterly Reports

 
8-K

 
Other

PHARSIGHT CORP 10-K 2006
Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-K

x Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Fiscal Year Ended March 31, 2006

or

¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Transition Period from              to             

Commission File Number: 000-31253


PHARSIGHT CORPORATION

(Exact name of Registrant as specified in its charter)


Delaware   77-0401273
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification Number)

321 E. Evelyn Ave., 3rd Floor

Mountain View, CA 94041-1530

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code: 650-314-3800


Securities registered pursuant to Section 12(b) of the Act: None

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

Common Stock, $0.001 par value

(Title of Class)


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

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

Large accelerated filer  ¨

  

Accelerated filer  ¨

  

Non-accelerated filer  x

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

As of September 30, 2005, the last day of the registrant’s most recently completed second fiscal quarter, there were 19,404,251 shares of the registrant’s Common Stock outstanding, and the aggregate market value of such shares held by non-affiliates of the registrant (based on the closing sale price of such shares on the OTC Bulletin Board on September 30, 2005) was $1.74. Shares of Common Stock held by each executive officer and director and by each person who beneficially owns 5% or more of the outstanding Common Stock have been excluded in that such persons may under certain circumstances be deemed to be affiliates. This determination of executive officer or affiliate status is not necessarily a conclusive determination for other purposes.

The number of shares of the registrant’s Common Stock outstanding as of June 22, 2006: 19,407,289


DOCUMENTS INCORPORATED BY REFERENCE

The Registrant has incorporated by reference into Part III of this Form 10-K portions of its Proxy Statement for the Registrant’s 2006 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form 10-K.

 



Table of Contents

TABLE OF CONTENTS

 

          Page

PART I

Item 1.

   Business    3

Item 1A.

   Factors that may affect future results and market price of stock    12

Item 1B.

   Unresolved Staff Comments    21

Item 2.

   Properties    21

Item 3.

   Legal Proceedings    21

Item 4.

   Submission of Matters to a Vote of Security Holders    22
PART II

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   25

Item 6.

   Selected Financial Data    26

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    27

Item 7A.

   Quantitative and Qualitative Disclosures about Market Risks    45

Item 8.

   Financial Statements and Supplementary Data    46

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    77

Item 9A.

   Controls and Procedures    77

Item 9B.

   Other Information    77
PART III

Item 10.

   Directors and Executive Officers of the Registrant    78

Item 11.

   Executive Compensation    78

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   78

Item 13.

   Certain Relationships and Related Transactions    78

Item 14.

   Principal Accounting Fees and Services    78
PART IV

Item 15.

   Exhibits, Financial Statement Schedules    79
Signatures    80

 

2


Table of Contents

PART I

 

FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections, including statements regarding the benefits of our products and services, anticipated revenue or operating expenses, anticipated product development, trends in customer demand, expansion opportunities for our products and services, revenue from sales to certain customers and our competitive position. In some cases, these forward-looking statements can be identified by words such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “assume,” “potential,” “continue,” “intend,” “hope,” “can,” or the negative of such terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including without limitation the business risks discussed under the caption “Item 1A—Risk Factors” in this Annual Report on Form 10-K. These forward-looking statements involve risks and uncertainties that could cause our, or our industry’s, actual results, levels of activity, performance or achievements to differ materially from any future results, levels of activities, performance or achievements expressed or implied in such forward-looking statements. These business risks should be considered in evaluating our prospects and future financial performance. Although we believe that expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Our expectations are as of the date we file this Annual Report on Form 10-K, and we do not intend to update any of the forward-looking statements after the date we file this Annual Report on Form 10-K to conform these statements to actual results, unless required by law.

 

ITEM 1. BUSINESS

 

General

 

Pharsight Corporation develops and markets software and provides strategic consulting services that help pharmaceutical and biotechnology companies improve the efficiency of the drug development decision making process by reducing the costs and time requirements of their drug discovery, development, and commercialization efforts. Our products include proprietary software for clinical trial simulation and computer-aided trial design, the statistical analysis and mathematical modeling of data, and the storage, management, and regulatory reporting of derived data and models in data repositories. Both our software products and our services utilize expertise in the sciences of pharmacology, drug and disease modeling, biostatistics and strategic decision-making. Our service offerings use this expertise to interpret and improve the design of scientific experiments and clinical trials and to optimize clinical trial design and portfolio decisions. By integrating scientific, clinical, and business decision criteria into a dynamic model-based methodology, we help our customers to optimize the value of their drug development programs and portfolios from discovery to post-launch marketing

 

Our goal is to enable pharmaceutical and biotechnology companies to reduce the time, cost and risks of drug development activities and improve the abilities of these companies to market the use of their pharmaceutical products once approved by governing regulatory agencies. Our products and services are designed to help our customers use a more rigorous scientific and statistical process to identify earlier drug candidates that will not be successful, to enhance the likelihood that the remaining candidates will successfully complete clinical trials and to maximize marketing impact upon approval. This process is significant because the process of clinical development has remained lengthy and unpredictable while the productivity of molecule discovery research has accelerated dramatically in recent years.

 

Our strategic consulting services are used by 20 of the world’s largest 50 pharmaceutical companies. In addition, all of the world’s largest 50 pharmaceutical companies use our software products. Our software products are currently licensed for use on more than 4,000 desktops.

 

3


Table of Contents

We believe our products and services provide the following benefits to customers:

 

    Reduced time required for transforming, analyzing, and reporting information required for drug approval;

 

    More effective trial designs with higher probability of success and greater information yield;

 

    More rapid, robust and objective decision-making with wider data availability and quantified assessment of value versus risk;

 

    Improved workflow and organizational efficiency with faster regulatory acceptance of trial results;

 

    More efficient development programs requiring fewer clinical trials and patients, less time and lower cost to reach the market; and

 

    Strengthened competitive position due to improved product labels and earlier opportunity to establish a competitive franchise.

 

The following illustrates several typical customer applications of our software products and services:

 

    In designing phase II clinical trials, companies often face significant uncertainty in selecting the appropriate doses to test. Our products and services integrate information from phase I and pre-clinical activities, information concerning related drugs that have been developed by the customer, information in scientific literature about other drugs in the same therapeutic area, and knowledge of the relevant physiological and disease processes. This information, along with carefully identified assumptions, is used to develop a mathematical model enabling a computer simulation of the proposed trial. Using this approach, customers are often able to identify proposed doses that have little chance of success and should be excluded, or to identify additional doses that are more likely to yield important information.

 

    In designing phase III clinical trials, companies often face significant uncertainty concerning the most appropriate treatment strategy, patient inclusion/exclusion criteria and/or clinical measurements. Our products and services for phase III clinical trials use an information gathering and modeling approach similar to that described for the phase II clinical trials above, but incorporate phase II data and detailed mathematical models of the relevant patient populations. Our products and services are often able to identify patient groups with low chance of demonstrating efficacy, or an unacceptable chance of demonstrating side effects, prior to conducting the actual trial. In addition, we may be able to predict which clinical measurements will be most likely to provide conclusive results in the proposed trial.

 

    In making drug portfolio decisions, companies need to integrate scientific and clinical results, such as those described above, with market and financial information for all of the drug candidates in the development pipeline. We believe that our products and services help companies make better decisions concerning “go/no-go” criteria, prioritization of potential label objectives to be pursued and optimal sequencing of clinical trials within a development program. Our products and services can also help customers adopt a more quantitative and scientific approach to resource allocation among programs within their drug portfolios.

 

    The production of industry standard pharmacokinetic, or PK, reports required by the United States Food and Drug Administration, or FDA, for a new drug submission are often characterized by lengthy cycle times, increasing both expense and required resources along with potential variability and quality issues regarding the display of results within a clinical development organization. Much of an individual scientist’s time in a typical client organization may be involved with tasks such as data preparation needed for analysis, display of PK analysis via report creation, and the quality control measures needed to ensure correct information is presented to the FDA. These tasks may reduce time available to focus on the quality and impact of the scientific decisions that drive compound development. The lack of industry standards and an integrated software platform to drive the adoption and automation of standards can often lead to lengthy report cycles and delays in regulatory submissions.

 

   

By deploying our Pharsight® Knowledgebase Server™, or PKS™, suite of applications and services (PKS, WinNonlin®, PKS Reporter™, PKS Validation Suite™ and PK Automation), we believe our

 

4


Table of Contents
 

clients have succeeded in delivering sustainable productivity improvements to their regulatory submission process. Our PKS data repository affords integration to legacy laboratory and clinical data sources, reducing the time needed for data preparation prior to analysis by our clients’ scarce scientific resources. The PKS suite seamlessly integrates PKS with WinNonlin, PKS Reporter, and third-party applications and provides the opportunity to automate a majority of the standard PK reports required by the FDA.

 

    We believe many of our clients have experienced significant productivity improvements in creation of standard PK reports, including significant reductions in report cycle time, along with improvements in quality and consistency of analysis and display of analytical results. As a result of these increases in productivity, we believe our clients are able to reallocate resources to other aspects of the drug development process.

 

    A typical example of the use of Drug Model Explorer™, or DMX®, to support quantitative decision making is in the area of analyzing a potential new drug in a pharmaceutical company’s key therapeutic area franchise. To this end, we collaborated with a pharmaceutical company to build model-based projections of the competitive landscape. The modeling effort combined internal study data with published trials and FDA submissions on competing compounds to generate an integrated and quantified assessment of the drug’s likely performance. The client’s clinical development project team used DMX to evaluate and communicate the modeling results. Through DMX, the team explored clinical effects and associated uncertainty for the drug and competitors across multiple endpoints, treatments, and patient populations based on pre-simulated responses defined and prepared as part of the model-building effort. The results showed that the new drug was unlikely to outperform its main competitor; development was discontinued in the target patient population. The modeling project supported a more confident decision without investment in additional trials, and allowed team members to re-deploy to other programs. It also provided an enduring, evolving knowledge database to support future development decisions.

 

The use of our software and leading edge methodology developed by our strategic consulting group greatly enhances the traditional drug-development process, which is heavily dependent upon clinical trials and patient testing. Although our methodology does not displace the use of human trials in drug development, we believe our software and our methodology renders human trials more efficient and relevant. The continued growth of our customer base, the increase in number of contracts with our existing customers, and the increase in our average contract value over time have shown a trend that we believe demonstrates increased acceptance of our methodology and an increased demand for its use. This demand can be met by increased deployment of our software and services, by proprietary solutions developed by our clients, or by increased internal resources within our customers. We believe that these trends, in addition to increasing regulatory requirements from the FDA, demonstrate a potential for increased revenue growth resulting from increased demand for our current products and services, as well as long-term opportunities to expand the breadth and coverage of both our software product offerings and strategic consulting services.

 

Pharsight Products and Services

 

Our software products and services provide an iterative method for enhancing the design of a clinical trial or development program, based on a series of steps. Each step utilizes available data to produce and validate a mathematical model that is in turn used to select a better strategy for moving to the next stage of clinical development, while improving productivity and efficiency in the drug development process.

 

We provide both strategic consulting services and computer-based drug model development and database applications. In fiscal 1997, we first offered our WinNonlin, WinNonMix® and Trial Simulator™ applications and scientific services. At the end of fiscal 2001, we combined our scientific, decision support, methodology and training groups into an integrated group renamed Strategic Consulting Services. In fiscal 2002, we began selling our Pharsight® Knowledgebase Server, providing a means of capturing and managing both summary and detailed

 

5


Table of Contents

pharmacokinetic/pharmacodynamic, or PK/PD, data across a large set of compounds and development phases. In fiscal 2004, we introduced and began selling our DMX, a software-based communication technology.

 

In fiscal 2006, 2005 and 2004, revenues from our software product offerings and related services generated 59%, 53%, and 55% of our total revenues, respectively, and revenues from our strategic consulting services generated 41%, 47% and 45% of our total revenues, respectively. In fiscal 2006, 2005 and 2004, revenues from our software product offerings and related services were $13.4 million, $12.1 million and $9.7 million, respectively, and revenues from our strategic consulting services were $9.3 million, $10.5 million, and $8.0 million, respectively.

 

We operate in two business segments comprised of Software Products and Strategic Consulting Services. Our revenues from external customers, profit and loss and total assets, are set forth in our financial statements, which appear in “Item 8—Financial Statements and Supplementary Data.” Information regarding sales to customers by major geographic regions is set forth in Note 12 to our financial statements, which appears in “Item 8—Financial Statements and Supplementary Data.” No foreign country accounted for 10% or more of our total revenues in the fiscal years ended March 31, 2006, 2005, and 2004. All of our significant long-lived assets are located within the United States.

 

Software Products

 

Our software products and software deployment and integration services provide the analytical tools and conceptual framework to help clinical researchers optimize the decision-making required to perform the clinical testing needed to bring drugs to market. By applying mathematical modeling and simulation to all available information regarding the compound being tested, researchers can clarify and quantify which trial and treatment design factors will influence the success of clinical trials.

 

WinNonlin and WinNonMix. These software applications are used to efficiently analyze clinical and preclinical data, allowing the creation of PK/PD models and validating the assumptions and information on which the models are based. The analysis and modeling foster better understanding of the data and better decision making with respect to dosage and dosing regimens. Such analysis is both cost-effective and required by FDA regulations for new drug submissions.

 

WinNonlin Validation Suite. The WinNonlin Validation Suite streamlines on-site validation of the WinNonlin product. The Validation Suite provides a selection of automated tests, each of which runs a specific WinNonlin analysis or function and tests the results against standardized, known output. The Validation Suite efficiently and effectively provides documentation of on-site validation activities, through automated generation of validation reports via Microsoft® Word. Clients use WinNonlin Validation Suite to reduce effort and time needed for validation planning, testing, and reporting.

 

Pharsight Knowledgebase Server. PKS provides a means of capturing and managing both summary and detailed (PK/PD) data across a large set of compounds and development phases. PKS also provides a unified data environment for supporting clinical pharmacology modeling, analysis and reporting activities. PKS is directly integrated with WinNonlin and other industry standard modeling and analysis tools. PKS was developed to help enable compliance with FDA regulation 21 CFR 11, which requires electronic data security and auditing on submissions to the FDA. We believe that industry acceptance of PKS has been positively affected by our clients’ need for efficiency gains, as well as compliance with increased regulatory requirements. When linked to PKS, PKS Reporter 1.0 provides regulatory-compliant authoring of Microsoft® Word documents containing analysis results, source data, tables, and plots produced by WinNonlin, or other tools, while being securely managed within the PKS Suite.

 

PKS Validation Suite. PKS Reporter addresses the need for streamlined, systematic, and automated report generation and signature. Using the Pharsight Knowledgebase Server™ (PKS™) as an underlying source of

 

6


Table of Contents

secure, regulatory-compliant report content, PKS Reporter allows researchers to use familiar tools such as WinNonlin® and Microsoft Word® to construct, update, review and approve any type of report. PKS Reporter is directly integrated with PKS, as both a source of report content and a secure repository for report storage and version control. PKS Reporter links reports in Microsoft Word directly to PKS, where it draws report content from data and modeling results created in WinNonlin Enterprise, NONMEM®, SAS and other industry-standard modeling and analysis tools. From within Microsoft Word, researchers can browse the PKS database, loading objects and values drawn from various PKS studies and analysis scenarios. When the source data change, PKS Reporter marks its content as out of date, ready for automatic update. QA staff can automate the verification of report data by simply opening the document and selecting to have all references checked. Development teams can create standardized report templates specifying report layout, formatting and specific content elements. Report sign-off is smooth and automatically tracked with Reporter’s signature tool and e-mail notification.

 

Trial Simulator. Trial Simulator uses known information about a drug, or candidate drug, and about patient populations to help design and optimize clinical trial protocols. Poor protocol design may result in ambiguous trial results that fail to identify ineffective candidates early, increase expense and time in identifying successful candidates and expose trial patients to unnecessary risk. Poor protocol dosing decisions may cause the rejection of a candidate drug that might otherwise be approved at an appropriate dose. Computer-aided trial design, using Trial Simulator, cannot guarantee successful trials, but can help to improve the efficiency, required time, and likelihood of definitive and successful results.

 

Drug Model Explorer. DMX is a software program that communicates the essential findings of drug models while freeing the user from the need to understand the drug model’s complex underlying mathematics. With DMX, project teams made up of physicians, marketers, and other non-modelers can visualize and explore key modeled drug attributes, and the uncertainty around those attributes, given the current state of knowledge about a development program. DMX generates views of program data from queries of underlying drug-disease models and simulated responses over a defined problem-space (e.g., treatments, endpoints, covariates and competitors).

 

We believe that our continued growth is highly dependent upon continuing to deliver new products to our current and prospective customers. These new products need to address an ever-expanding set of customer needs related to clinical development of drugs and thereby expand the number of prospective users within pharmaceutical companies to whom we may sell.

 

Strategic Consulting Services

 

Our strategic consulting services consist of consulting, training and process redesign conducted by our clinical and decision scientists in the application and implementation of our core decision methodology. The methodology employed by our services group uses three types of models that can work independently or in concert. Illustrative models are listed below:

 

•    Drug-Disease Models

Our drug-disease models predictively characterize the distribution of treatment outcomes (safety, efficacy, surrogate outcomes) for a new chemical entity, or NCE, and related compounds as a function of dosing strategy, disease and patient and trial characteristics.

 

•    Trial Models

Our trial models predict probability distributions of outcomes and reductions in uncertainty around them as a function of dosing strategy, number of treatment arms, type of control, sample population characteristics, sample size and treatment duration.

 

•    Market Models

Our market models characterize the demand for products (market size and share) under different feature sets and different competitive and innovation scenarios, and their evolution over time.

 

7


Table of Contents

By using these models in an integrated fashion, our consultants are able to place key development decisions into quantitative terms of uncertainty and value. Drug development is a process by which uncertainty about a drug’s efficacy and safety is progressively reduced. Our methodology enables customers to identify which uncertainties are greatest and matter most, and then to design development programs, trial sequences, and individual trials in such a way that those trials systematically reduce the identified uncertainties, in the most rapid and cost-effective manner possible.

 

This methodology is valuable at all stages of development. The integration of our models at the asset strategy phase (overall positioning of a new drug) and program/trial strategy phase (focusing on a specific indicator) enables us to help our customers position their drugs as competitively as possible in the market; to do so while avoiding unnecessary trials (and only as large, lengthy and costly as is required); and to redeploy resources away from unpromising compounds at the earliest possible decision point.

 

The following chart depicts typical issues that we are asked to address in strategic consulting projects throughout development and post marketing:

 

Phase I


  

Phase II/Phase III


  

Phase IV


•      Bridge preclinical results to clinical process.

  

•      Balance efficacy with side effects.

  

•      Explore new indications and label changes.

•      Explore dose ranging and population variability.

  

•      Explore trial sensitivity to patient compliance and dropout.

  

•      Plan life-cycle strategy, e.g. generic defense and “over-the-counter” switch.

•      Determine surrogate endpoint relevance, i.e. alternate indicators of efficacy.

  

•      Investigate impact of population genetic variability.

  

•      Evaluate special patient populations.

•      Support early “go/no-go” decisions.

  

•      Evaluate alternate protocols.

    

•      Assess strategic fit in franchise.

         

 

Our strategic consulting personnel are located throughout the United States, Europe and Australia. Most have Ph.D. degrees with post-doctoral training in medicine, clinical pharmacology, biostatistics, pharmacokinetics, mathematics, engineering, decision analysis or other relevant disciplines. Our senior consultants each have more than a decade of experience in drug disease modeling, trial design or strategic consulting. We also utilize a network of consultants with expertise in various specialized disciplines and therapeutic areas.

 

We believe that our continued growth is dependent upon continually refining our strategic consulting methodologies and introducing new technologies, while also expanding our activities at the portfolio level and into new therapeutic areas.

 

Customers

 

Our software customers range in size from the largest pharmaceutical companies to small and medium-sized pharmaceutical and biotechnology organizations.

 

During our fiscal year ended March 31, 2006, we provided products and services for which we recognized revenue to more than 1,100 customers. In fiscal 2006, Pfizer Inc., or Pfizer, our largest customer, accounted for 25% of our total revenue, and Eli Lilly and Company, or Eli Lilly, also accounted for 17% of our total revenue. In fiscal 2005, Pfizer and Eli Lilly accounted for 25% and 20%, respectively, of our total revenue. While we were successful in diversifying our customer base and reducing our dependency on Pfizer and Eli Lilly, we are still

 

8


Table of Contents

dependent on them for a substantial portion of our revenues. If we were to lose either Pfizer or Eli Lilly as a customer, it would have a material adverse effect on our revenues and business. See “Item 1A—Risk Factors—Our revenue is concentrated in a few customers, and if we lose any of these customers our revenue may decrease substantially.”

 

Our strategic consulting customers range in size from the largest pharmaceutical companies to small pharmaceutical companies, and the focus of our work differs depending upon the size and maturity of the customer. In our smaller and medium-sized customers, we tend to engage in discrete projects often with challenging analytic and design problems, where modeling and simulation can be particularly valuable. This kind of work may or may not lead to subsequent engagements. By contrast, at our largest customers, we tend to have ongoing relationships which are more strategic in nature, and we focus on helping improve the process by which they develop drugs, broadening and deepening the application of modeling and simulation over time, with the intent of achieving systematic, lasting performance improvement.

 

Product Development

 

Within our software products segment, we employ engineers with expertise in software development, web-based applications, database systems, network architecture, and mathematical modeling, and scientists with expertise in clinical development, decision analysis, statistical modeling, and clinical pharmacology and development. Our product development personnel work closely with our strategic consulting personnel and our client base in designing and testing products to meet customer requirements.

 

Our research and development efforts are focused on improving and enhancing our existing products and services, as well as developing new products and services. Our research and development efforts take place principally at our offices in Mountain View, California, and Cary, North Carolina.

 

In November 2002, we refocused our research and development activities to concentrate on our analysis tools and data repository products and the development of our next generation modeling platform, while reducing non-core development headcount accordingly. In fiscal 2004, we invested in development to expand our ability to achieve potential breakthrough improvements in drug development productivity for our customers. The primary focus of this investment has been in software that enables customers to adopt and implement our model-based drug development methodology. The introduction of DMX in fiscal 2004 represented a significant accomplishment in this area, enabling a much larger number of other participants in the drug development process to utilize those models in a systematic, integrated fashion to collaborate and make better decisions. See “Item 1A—Risk Factors—We may lose existing customers or be unable to attract new customers if we do not keep pace with technological changes.”

 

Our research and development expenses were $3.5 million in fiscal 2006 and $2.9 million in fiscal 2005, and 2004, respectively.

 

Sales and Marketing

 

Sales of our strategic consulting services and our software products are primarily generated in the United States and Europe through a direct field sales organization as well as an inside sales organization. Sales of our strategic consulting services can range from discrete single projects, where modeling and simulation can be particularly valuable, to expansions of ongoing relationships at our larger clients, which are more strategic in nature. Our desktop software applications are primarily sold through an inside sales organization. Our typical PKS software customer’s purchase decision can involve many groups, potentially including clinical pharmacology, ADME (Absorption, Distribution, Metabolism and Excretion), toxicology, biostatistics, regulatory and early clinical as well as information technology (IT) and procurement. PKS also involves a significant validation process. PKS therefore requires a longer selling cycle than our previous software products, and demands a team of sales, marketing and support professionals in the sales process. DMX software sales

 

9


Table of Contents

requires a team of Strategic Consulting Services consultants, sales and product management. A customer’s purchase decision for DMX may involve several groups in research and development potentially including PK/PD, modeling and simulation, clinical pharmacology, and biostatistics, as well as IT. A purchaser would typically be a company whose decision process already incorporates modeling and simulation methodology.

 

Government Regulation

 

The pharmaceutical industry is regulated by a number of federal, state, local and international governmental entities. Although the FDA or comparable international agencies do not directly regulate our products and services, the use of certain of our analytical software products by our customers may be regulated. We currently provide assistance to our customers in achieving compliance with these regulations.

 

Competition

 

Software Products Segment. We compete based on a number of factors, including the functionality, reliability and ease of implementation and use of our software products. Our WinNonlin, WinNonMix and PKS products compete with products produced by Thermo Electron Corporation and the Globomax division of ICON plc. Although we believe we currently do not have direct competitors for our Trial Simulator product line or our DMX product, other companies may compete with us in the future. Potential competitors may have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the pharmaceutical industry than we have. In addition, competitors may merge or form strategic alliances and be able to offer, or bring to market earlier, services that are superior to our own.

 

Strategic Consulting Segment. We compete based on a number of factors, including cost, quality and effectiveness of our services and degree of complexity of the consulting offering. Other entities provide modeling services, some of which are similar to those provided by our strategic consulting services group. In addition, our customers are primarily large pharmaceutical companies that have substantial research and development budgets, and these customers may internally develop the expertise that we provide. Although we believe we currently do not have direct competitors for our comprehensive set of services offerings, as well as modeling and simulation services integrated with the DMX product, other entities may compete with us in selected offerings in the future.

 

Intellectual Property Rights

 

Technology In-Licensing

 

Although our products are based on our research and development, we license software from third parties when it is more efficient to incorporate pre-existing programs or routines, when there are novel technologies available by license that would improve our products, or when brand recognition of established products provides a marketing advantage. We incorporate such third-party software that we have rights to use under the terms of license agreements that require us to pay royalties to the licensor based upon either a percentage of the sales of products containing the licensed software or a fixed fee for each product shipped. Although all of the software we license for use in our products is replaceable with software from other vendors or our own development efforts, the loss of a license could delay the sales of certain of our products.

 

Intellectual Property

 

Our success is dependent in part upon our ability to develop and protect our proprietary technology and intellectual property rights. We rely primarily on a combination of contractual provisions, confidentiality procedures, trade secrets, and patent, copyright and trademark laws to accomplish these goals.

 

We license our software products pursuant to non-exclusive license agreements, which impose restrictions on customers’ ability to utilize the software. In addition, we seek to avoid disclosure of our trade secrets by

 

10


Table of Contents

restricting access to our source code, and requiring employees, customers and others with access to our proprietary information to execute confidentiality agreements with us. We also seek to protect our software, documentation and other written materials under trade secret and copyright laws.

 

We have five U.S. patents with expirations dates between September 29, 2020 and May 31, 2021, and three U.S. patent applications pending. It is possible that the patents that we have applied for, if issued, or our potential future patents may be successfully challenged or that no patent will be issued from our patent applications. It is also possible that we may not develop proprietary products or technologies that are patentable, that any patent issued to us may not provide us with any competitive advantages, or that the patents of others will seriously harm our ability to do business.

 

Despite our efforts to protect our proprietary rights, existing laws afford only limited protection. Attempts may be made to copy or reverse engineer aspects of our product or to obtain and use information that we regard as proprietary. Accordingly, there can be no assurance that we will be able to protect our proprietary rights against unauthorized third party copying or use. Use by others of our proprietary rights could materially harm our business. Furthermore, policing the unauthorized use of our product is difficult and expensive litigation may be necessary in the future to enforce our intellectual property rights. See “Item 1A—Risk Factors—Our business depends on our intellectual property rights, and if we are unable to adequately protect them, our competitive position will suffer,” and “—If we become subject to infringement claims by third parties, we could incur unanticipated expense and be prevented from providing our products and services.”

 

Employees

 

As of March 31, 2006, we had a total of 85 employees—7 in software and deployment; 27 in strategic consulting services; 18 in sales and marketing; 18 in research and development; and 15 in executive, general and administrative and information technology functions. None of our employees are represented by a collective bargaining agreement, nor have we experienced any work stoppage.

 

11


Table of Contents

ITEM 1A. FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK

 

We operate in a rapidly changing economic and technological environment that presents numerous risks. Many of these risks are beyond our control and are driven by factors that we cannot predict. The following discussion, as well as our discussion above of critical accounting policies and estimates, highlights some of these risks. You should carefully consider the risks and uncertainties described below and the other information in this report before deciding whether to invest in shares of our common stock. If any of the following risks actually occur, our business, financial condition or operating results could be materially adversely affected. This could cause the trading price of our common stock to decline, and you may lose part or all of your investment.

 

Risks That Affect Our Future Operations

 

We may not be able to generate sufficient revenues to sustain profitability.

 

We commenced our operations in April 1995 and incurred net losses every quarter until attaining profitability in the fourth quarter of fiscal 2004. While we have maintained annual profitability for fiscal 2005 and 2006; as of March 31, 2006, we had an accumulated deficit of $76.5 million. We may incur losses again as we continue to develop our business. Our ability to sustain profitability is based on a number of assumptions, including some outside of our control, including the state of the overall economy and the demand for our products. If these assumptions do not prove to be accurate then we may not be able to generate sufficient revenues to sustain profitability. Furthermore, even if we do sustain profitability and positive operating cash flow, we may not be able to increase profitability or positive operating cash flow on a quarterly or annual basis. If our profitability does not meet the expectations of investors, the price of our common stock may decline.

 

We have a limited amount of capital resources and we may not be able to sustain or grow our business if we cannot sustain profitability or raise additional funds on a timely basis.

 

We believe we have adequate cash to sustain operations through the next 12 months, and we are managing the business to achieve positive cash flow utilizing existing assets. However, even if we sustain profitability, we may not be able to generate sufficient profits to grow our business. As a result, we may need to raise additional funds through public or private financings or other sources to fund our operations. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, these equity securities might have rights, preferences or privileges senior to our common stock and preferred stock. In addition, the necessity of raising additional funds could force us to incur debt on terms that could restrict our ability to make capital expenditures and incur additional indebtedness.

 

The terms of our credit facilities contain covenants that limit our flexibility and prevent us from taking certain actions.

 

The terms governing our credit facilities with Silicon Valley Bank include a number of significant restrictive covenants. In June 2006, the revolving credit facility was extended until May 2007. The covenants were modified whereby, beginning in the quarter ending June 30, 2006, the Company shall maintain a minimum tangible net worth in the amount not less than $3 million. These covenants could adversely affect us by limiting our ability to plan for or react to market conditions, meet our capital needs and execute our business strategy. These covenants will, among other things, limit our ability to:

 

    incur additional debt;

 

    make certain investments;

 

    create liens; or

 

    sell certain assets.

 

These covenants may significantly limit our operating and financial flexibility and limit our ability to respond to changes in our business or competitive activities. Our failure to comply with these covenants could

 

12


Table of Contents

result in an event of default, which, if not cured or waived, could result in our being required to repay these borrowings before their scheduled due date. In addition, Silicon Valley Bank could foreclose on our assets.

 

Our quarterly operating results may fluctuate significantly and may not be predictive of future financial results.

 

Our quarterly operating results may fluctuate in the future, and may vary from investors’ expectations, depending on a number of factors, including:

 

    Variances in demand for our products and services;

 

    Timing of the introduction of new products or services and enhancements of existing products or services;

 

    Our ability to complete fixed-price service contracts without committing additional unplanned resources;

 

    Unanticipated changes in the capacity of our services organization;

 

    Delays or deferrals of customer implementations of our software products;

 

    Delays or deferrals of client drug development processes;

 

    The tendency of some of our customers to wait until the end of a fiscal quarter or fiscal year in the hope of obtaining more favorable terms;

 

    Changes in industry conditions affecting our customers, including industry consolidation; and

 

    Our ability to realize operating efficiencies through restructuring or other actions.

 

As a result, quarterly comparisons may not indicate reliable trends of future performance.

 

We manage our expense levels in part based upon our expectations concerning future revenue, and these expense levels are relatively fixed in the short term. If we have lower revenue than expected, we may not be able to reduce our spending in the short term in response. Any shortfall in revenue would have a direct impact on our results of operations.

 

In the past we have taken actions intended to reduce our expenses on an annualized basis. Our cost reduction measures have left us with less excess capacity to deliver our products and services. If there is a significant increase in demand from what we estimate, it will take us longer to address this demand, which would limit our ability to grow our business and sustain profitability.

 

We may be required to defer recognition of software license revenue for a significant period of time after entering into an agreement, which could negatively impact our results of operations.

 

We may have to delay recognizing license revenue for a significant period of time for a variety of types of transactions, including:

 

    transactions that include both currently deliverable software products and software products that are under development or contain other currently undeliverable elements;

 

    transactions where the customer demands services that include significant modifications, customizations or complex interfaces that could delay product delivery or acceptance;

 

    transactions that involve non-standard acceptance criteria or identified product-related performance issues; and

 

    transactions that include contingency-based payment terms or fees.

 

These factors and other specific accounting requirements for software revenue recognition require that we have very precise terms in our license agreements to allow us to recognize revenue when we initially deliver

 

13


Table of Contents

software or perform services. Although we have a standard form of license agreement that we believe meets the criteria for current revenue recognition on delivered elements, we negotiate and revise these terms and conditions in some transactions. Therefore, it is possible that from time to time we may license our software or provide service with terms and conditions that do not permit revenue recognition at the time of delivery or even as work on the project is completed. In fiscal 2006, software license revenue accounted for 47% of our total revenue. The majority of our large PKS software transactions include services pertaining to modification and customization of the core PKS software product, which may result in delayed revenue recognition for a significant period of time.

 

An increase in service revenue as a percentage of total revenue, or a decrease in software license revenue as a percentage of total revenue, may decrease our overall margins.

 

We realize lower margins on service revenue than on license revenue. In addition, we may contract with certain third parties to supplement the services we provide to customers, which generally yields lower gross margins than those margins generated by our deployment organization or internal scientific staff. As a result, if service revenue increases as a percentage of total revenue or if we increase our use of third parties to provide such services, our gross margins would be lower and our operating results may be adversely affected. In fiscal 2006, service revenue decreased to 53% of total revenue from 57% in fiscal 2005 and 54% in fiscal 2004. During the same time period, service costs as a percentage of service revenue decreased from 73% in fiscal 2004 to 58% in fiscal 2005, and increased to 62% in fiscal 2006. Overall gross margin has increased from 56% in fiscal 2004 to 66% in fiscal 2006, as an increasing percentage of our total revenues is attributable to software revenue.

 

Because our sales and implementation cycles are long and unpredictable, our revenues are difficult to predict and may not meet our expectations or those of our investors.

 

The lengths of our sales and implementation cycles are difficult to predict and depend on a number of factors, including the type of product or services being provided, the nature and size of the potential customer and the extent of the commitment being made by the potential customer. Our sales cycle is unpredictable and may take six months or more. Our implementation cycle is also difficult to predict and can be longer than one year. Each of these can result in delayed revenues, increased selling expenses and difficulty in matching revenues with expenses, which may contribute to fluctuations in our results of operations. A key element of our strategy is to market our product and service offerings to large organizations. These organizations can have particularly lengthy decision-making processes and may require evaluation periods, which could extend the sales and implementation cycle. Moreover, we often must provide a significant level of education to our prospective customers regarding the use and benefit of our product and service offerings, which may cause additional delays during the evaluation and acceptance process. We therefore have difficulty forecasting the timing and recognition of revenues from sales of our product and service offerings.

 

Our revenue is concentrated in a few customers, and if we lose any of these customers our revenue may decrease substantially.

 

We receive a substantial majority of our revenue from a limited number of customers. For fiscal 2006, 2005 and 2004, sales to sales to our top two customers accounted for 42%, 45% and 28% of total revenue, respectively and sales to our top five customers accounted for 52%, 62% and 50%. In fiscal 2006, Pfizer Inc., or Pfizer, our largest customer, accounted for 25% of our total revenue, and Eli Lilly and Company, or Eli Lilly, accounted for 17% of our total revenue. In fiscal 2005, Pfizer accounted for 25% and Eli Lilly accounted for 20% of our total revenue. In fiscal 2004, Pfizer accounted for 16% and Eli Lilly accounted for 11% of our total revenue. Consequently, we are dependent on Pfizer and Eli Lilly for a substantial portion of our revenues, and if we were to lose Pfizer or Eli Lilly as a customer, it would have a material adverse effect on our revenues and business. We expect that a significant portion of our revenue will continue to depend on sales to a small number of customers. In addition, the worldwide pharmaceutical industry has undergone, and may in the future undergo, substantial consolidation, which may further reduce the number of our existing and potential customers. If we do not generate as much revenue from these major customers as we expect to, if revenue from such customers is delayed, or if we lose any of them as customers, our total revenue may be significantly reduced.

 

14


Table of Contents

We may need to change our pricing models to compete successfully.

 

The markets in which we compete can put pressure on us to reduce our prices. If our competitors offer deep discounts on certain products in an effort to recapture or gain market share, we may then need to lower prices or offer other favorable terms in order to compete successfully. Any such changes would be likely to reduce margins and could adversely affect operating results. We have periodically changed our pricing model and any broadly based changes to our prices and pricing policies could cause service and license revenues to decline or be delayed as our sales force implements and our customers adjust to the new pricing policies. If we do not adapt our pricing models to reflect changes in customer use of our products, our revenues could decrease.

 

If we are unable to generate additional sales from existing customers and/or generate sales to new customers, we may not be able to realize sufficient revenues to sustain or increase our profitability.

 

Our success depends on our ability to develop our existing customer relationships and establish relationships with additional pharmaceutical and biotechnology companies. If we lose any significant relationships with existing customers or fail to establish additional relationships, we may not be able to execute our business plan and our business will suffer. Developing customer relationships with pharmaceutical companies can be difficult for a number of reasons. These companies are often very large organizations with complex decision-making processes that are difficult to affect. In addition, because our products and services relate to the core technologies of these companies, these organizations are generally cautious about working with outside companies. Some potential customers may also resist working with us until our products and services have achieved more widespread market acceptance. Our existing customers could also reassess their commitment to us, not renew existing agreements or choose not to expand the scope of their relationship with us.

 

Our revenues and results of operations would be adversely affected if a customer cancels a contract for services or software deployment with us.

 

Our customers can cancel many of our services agreements upon prior notice. Additionally, due to the nature of our services and deployment engagements, customers sometimes delay projects because of timing of the clinical trials and the need for data and information that prevent us from proceeding with our projects. These delays and contract cancellations cannot be predicted with accuracy and we cannot assure you that we will be able to replace any delayed or canceled contracts with the customer or other customers. If we are unable to replace those contracts, our revenues and results of operations would be adversely affected.

 

We may lose existing customers or be unable to attract new customers if we do not develop new products and services or if our offerings do not keep pace with technological changes.

 

The successful growth of our business depends on our ability to develop new products and services and incorporate new capabilities, including the expansion of our product and services offerings to address a broader set of customer needs related to clinical development of drugs and thereby expand the number of our prospective users, on a timely basis. If we cannot adapt to changing technologies, emerging and evolving industry standards, new scientific developments and increasingly sophisticated customer needs, we may not achieve revenue growth and our products and services may become obsolete, and our business could suffer. We have suffered product delays in the past, resulting in lost product revenues. In addition, early releases of software often contain errors or defects. We cannot assure you that, despite our extensive testing, errors will not be found in our products before or after commercial release, which could result in product redevelopment costs and loss of, or delay in, market acceptance. Furthermore, a failure by us to introduce new products or services on schedule could harm our business prospects. Any delay or problems in the installation or implementation of new products or services may cause customers to forego purchases from us. We may need to accelerate product introductions and shorten product life cycles, which will require high levels of expenditures of research and development that could adversely affect our operating results. A failure by us to introduce new services on a timely and cost-effective basis to meet evolving customer requirements, or to integrate new services with existing services, could harm our business prospects.

 

15


Table of Contents

If the security or confidentiality of our customers’ data is compromised or breached, we could be liable for damages and our reputation could be harmed.

 

As part of implementing our products and services, we inherently gain access to certain highly confidential proprietary customer information. It is critical that our facilities and infrastructure remain secure and are perceived by the marketplace to be secure. Despite our implementation of a number of security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. We do not have insurance to cover us for losses incurred in many of these events. If we fail to meet our customers’ security expectations, we could be liable for damages and our reputation could suffer.

 

If we are unable to complete a project due to scientific limitations or otherwise meet our customers’ expectations, our reputation may be adversely affected and we may not be able to generate new business.

 

Because our projects may contain scientific risks, which are difficult to foresee, we cannot guarantee that we will always be able to complete them. Any failure to meet our customers’ expectations could harm our reputation and ability to generate new business. On a few occasions, we have encountered scientific limitations and been unable to complete a project. In each of these cases, we have been able to successfully renegotiate the terms of the project with the particular customer. We cannot assure you that we will be able to renegotiate our customer agreements if such circumstances occur in the future. Moreover, even if we complete a project, we may not meet our customers’ expectations regarding the quality of our products and services or the timeliness of our services.

 

Our future success depends on our ability to continue to retain and attract qualified employees.

 

We believe that our future success depends upon our ability to continue to train, retain, effectively manage and attract highly skilled technical, scientific, managerial, sales and marketing personnel. We currently have limited personnel and other resources to staff and complete consulting and software deployment projects. In addition, as we grow our business, we expect an increase in the number of complex projects and large deployments of our products and services, which require a significant amount of personnel for extended periods of time. In particular, there is a limited supply of modeling and simulation personnel worldwide, and competition for these personnel from numerous companies and academic institutions may limit our ability to hire these persons on commercially reasonable terms. From time to time, we experience difficulties in locating enough highly qualified candidates in desired geographic locations, or with required scientific or industry-specific expertise. Staffing projects and deploying our products and services will become more difficult as our operations and customers become more geographically diverse. If we are not able to adequately staff and complete our projects, we may lose customers and our reputation may be harmed. Any difficulties we may have in completing customer projects may impair our ability to grow our business.

 

If we lose key members of our management, scientific or development staff, or our scientific advisors, our reputation may be harmed and we may lose business.

 

We are highly dependent on the principal members of our management, scientific and development staff. Our reputation is also based in part on our association with key scientific advisors. The loss of any of these personnel might adversely impact our reputation in the market and harm our business. Failure to attract and retain key management, scientific and technical personnel could prevent us from achieving our strategy and developing our products and services. In addition, our management team has experienced significant personnel changes over the past years and may continue to experience changes in the future. If our management team continues to experience attrition, high turnover, or does not work effectively together, it could harm our business. Additionally, we do not currently hold key-man life insurance policies on our CEO, CFO or other key contributors. The demise of any of these individuals could adversely impact our business.

 

16


Table of Contents

Our business depends on our intellectual property rights, and if we are unable to adequately protect them, our competitive position will suffer.

 

Our intellectual property is important to our competitive position. We protect our proprietary information and technology through a combination of patent, trademark, trade secret and copyright law, confidentiality agreements and technical measures. We cannot assure you that the steps we have taken will prevent misappropriation of our proprietary information and technology, nor can we guarantee that we will be successful in obtaining any patents or that the rights granted under such patents will provide a competitive advantage. Misappropriation of our intellectual property could harm our competitive position. We may also need to engage in litigation in the future to enforce or protect our intellectual property rights or to defend against claims of invalidity, and we may incur substantial costs as a result. In addition, the laws of some foreign countries provide less protection of intellectual property rights than the laws of the United States and Europe. As a result, we may have an increasingly difficult time adequately protecting our intellectual property rights as our sales in foreign countries grow.

 

If we become subject to infringement claims by third parties, we could incur unanticipated expense and be prevented from providing our products and services

 

We cannot assure you that infringement claims by third parties will not be asserted against us or, if asserted, will be unsuccessful. These claims, whether or not meritorious, could be expensive and divert management resources from operating our company. Furthermore, a party making a claim against us could secure a judgment awarding substantial damages, as well as injunctive or other equitable relief that could block our ability to provide products or services, unless we obtain a license to such technology. In addition, we cannot assure you that licenses for any intellectual property of third parties that might be required for our products or services will be available on commercially reasonable terms, or at all.

 

International sales of our product account for a significant portion of our revenue, which exposes us to risks inherent in international operations.

 

We market and sell our products and services in the United States and internationally. International sales of our products and services as a percentage of our total revenue for fiscal 2006, 2005 and 2004 were approximately 24%, 22% and 29%, respectively. We have a total of 12 employees based outside the United States who deploy our software, perform consulting services and perform research in Europe and Australia. We cannot be certain that we have fully complied with all rules and regulations in every applicable jurisdiction outside of the United States with respect to our current and previous operations outside of the United States. The failure to comply with such rules and regulations could result in penalties, monetary or otherwise, against us. Our existing marketing efforts into international markets may require significant management attention and financial resources. We cannot be certain that our existing international operations will produce desired levels of revenue. We currently have limited experience in developing localized versions of our products and services and marketing and distributing our products internationally. Our international operations also expose us to the following general risks associated with international operations:

 

    disruptions to commercial activities or damage to our facilities as a result of political unrest, war, terrorism, labor strikes and work stoppages;

 

    difficulties and costs of staffing and managing foreign operations;

 

    the impact of recessions or inflation in economies outside the United States;

 

    greater difficulty in accounts receivable collection and longer collection periods;

 

    reduced protection for intellectual property rights in some countries;

 

    potential adverse tax consequences, including higher tax rates generally in Europe;

 

    tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries;

 

17


Table of Contents
    unexpected changes in regulatory requirements of foreign countries, especially those with respect to software, pharmaceutical and biotechnology companies; and

 

    fluctuations in the value of currencies.

 

To the extent that such disruptions and costs interfere with our commercial activities, our results of operations could be harmed.

 

Changes in government regulation could decrease the need for the products and services we provide.

 

Governmental agencies throughout the world, but particularly in the United States, highly regulate the drug development and approval process. A large part of our software and services business involves helping pharmaceutical and biotechnology companies through the regulatory drug approval process. Any relaxation in regulatory approval standards could eliminate or substantially reduce the need for our services, and, as a result, our business, results of operations and financial condition could be materially adversely affected. Potential regulatory changes under consideration in the United States and elsewhere include mandatory substitution of generic drugs for patented drugs, relaxation in the scope of regulatory requirements or the introduction of simplified drug approval procedures. These and other changes in regulation could have an impact on the business opportunities available to us.

 

While we believe we currently have adequate internal control over financial reporting, we will be required, as of March 31, 2008, to evaluate and report on the effectiveness of our internal control under Section 404 of the Sarbanes-Oxley Act of 2002 and any adverse results from the evaluation and reporting could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.

 

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with our Annual Report on Form 10-K for the fiscal year ending March 31, 2008, based on SEC final rule—33-8618, September 22, 2005, we will be required to furnish a report by our management on our internal control over financial reporting. Such report will contain, among other matters, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. Such report must also contain a statement that our independent registered public accounting firm have issued an attestation report on management’s assessment of such internal control. PCAOB Auditing Standard No. 2 provides the professional standards and related performance guidance for independent registered public accounting firms to attest to, and report on, management’s assessment of the effectiveness of internal control over financial reporting under Section 404.

 

While we currently believe our internal control over financial reporting is effective, we are in the process of system and process documentation and evaluation needed to comply with Section 404, which is both costly and challenging. During this process, if our management identifies one or more material weaknesses in our internal control over financial reporting, and those weaknesses are not appropriately remediated prior to March 31, 2008, we will be unable to assert such internal control is effective. If we are unable to assert that our internal control over financial reporting is effective as of March 31, 2008 (or if our independent registered public accounting firm is unable to attest that our management’s report is fairly stated or they are unable to express an opinion on our management’s evaluation or on the effectiveness of the internal control), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price, and our business and operating results could be harmed.

 

While we currently anticipate being able to satisfy the requirements of Section 404 in a timely fashion, we cannot be certain as to the timing of completion of our evaluation, testing and any required remediation due in large part to the fact that there is no precedent available by which to measure compliance with the new PCAOB Auditing Standard No. 2. If we are not able to comply with the requirements of Section 404 in a timely manner or if our independent registered public accounting firm is not able to complete the procedures required by Audit

 

18


Table of Contents

Standard No. 2 to support their attestation report, we would likely lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price, and our business and operating results could be harmed.

 

Risks Related To Our Industry

 

Our market may not develop as quickly as expected, and companies may enter our market, thereby increasing the amount of competition and impairing our business prospects.

 

Because our products and services are new and still evolving, there is significant uncertainty and risk as to the demand for, and market acceptance of, these products and services. As a result, we are not able to predict the size and growth rate of our market with any certainty. In addition, other companies, including potential strategic partners, may enter our market. Our existing customers may also elect to terminate our services and internally develop products and services similar to ours. If our market fails to develop, grows more slowly than expected, or becomes saturated with competitors, our business prospects will be impaired.

 

Government regulation of the pharmaceutical industry may restrict our operations or the operations of our customers and, therefore, adversely affect our business.

 

The pharmaceutical industry is regulated by a number of federal, state, local and international governmental entities. Although United States Food and Drug Administration or comparable international agencies do not directly regulate our products and services, the use of some of our analytical software products by our customers may be regulated. We currently provide assistance to our customers in achieving compliance with these regulations. The regulatory agencies could enact new regulations or amend existing regulations with regard to these or other products that could restrict the use of our products or the business of our customers, which could harm our business.

 

Consolidation in the pharmaceutical industry could cause disruptions of our customer relationships, interfere with our ability to enter into new customer relationships and have a negative impact on our revenues

 

In recent years, the worldwide pharmaceutical industry has undergone substantial consolidation. If any of our customers consolidate with another business, they may delay or cancel projects, lay off personnel or reduce spending, any of which could cause our revenues to decrease. In addition, our ability to complete sales or implementation cycles may be impaired as these organizations undergo internal restructuring.

 

Reductions in the IT and/or research and development budgets of our customers may affect our sales.

 

Our customers include researchers at pharmaceutical and biotechnology companies, academic institutions and government and private laboratories. Fluctuations in the IT and research and development budgets of these researchers and their organizations could have a significant effect on the demand for our products. Research and development and IT budgets fluctuate due to changes in available resources, spending priorities, internal budgetary policies and the availability of grants from government agencies. Our business could be harmed by any significant decrease in research and development or IT expenditures by pharmaceutical and biotechnology companies, academic institutions or government and private laboratories.

 

Recent or continued withdrawals of drugs from the public market could affect pharmaceutical spending, reduce the demand for our products and have a negative impact on our revenues.

 

Recently, the pharmaceutical industry has experienced, and may continue to experience, forced withdrawal of certain drugs from the public market due to safety risks. Recent or future drug withdrawals could affect our ability to market and sell our products and services to companies faced with withdrawals. For example, withdrawals of drugs from the public market by our customers or potential customers may result in the reduction of current levels of spending on software solutions and strategic consulting services by these companies to

 

19


Table of Contents

minimize the impact of a potential decline in revenues. In addition, we may provide products or services to customers with drugs in the same class as the drugs withdrawn from the market. If the demand for drugs within the class of drugs faced with recent withdrawals decreases, we may experience a decrease in demand for our products or services in that class of drugs. A decrease in demand for our products, or a decrease in IT or research and development spending by pharmaceutical companies, could prevent us from increasing or sustaining our software and strategic consulting revenues and adversely affect our revenues and results of operations.

 

Risks Related to Our Stock

 

Our common stock only trades on the Over-the-Counter Bulletin Board system, and has experienced reduced trading volumes and stock price since it began to be traded there.

 

On November 8, 2002 our stock was removed from trading on the Nasdaq National Market as a result of failure to meet the continuing listing requirements, and our common stock is now quoted on the Over-the-Counter Bulletin Board system. Our common stock does not experience large trading volumes. In addition, our delisting from the Nasdaq National Market has caused the loss of our exemption from the provisions of Section 2115 of the California Corporations Code that imposes particular aspects of California corporate law on certain non-California corporations operating within California. As a result, (i) our Board of Directors is no longer classified and our stockholders elect all of our directors at each annual meeting, (ii) our stockholders are entitled to cumulative voting, and (iii) we are subject to more stringent stockholder approval requirements and more stockholder-favorable dissenters’ rights in connection with certain strategic transactions. Some of these changes may impact any possible transaction involving a change of control of Pharsight, which could negatively impact your investment. Other consequences include a reduction in analyst coverage, a lower share price as a result of lower trading volumes, and the loss of certain state securities law exemptions available to us while our securities were traded on the Nasdaq National Market, which may impact our ability to provide for future issuances of our securities, among other consequences.

 

Should we decide to relist our common stock on the Nasdaq National Market, the criteria for relistment may be difficult for us to achieve.

 

The market price of our common stock has been lower than the required minimum bid price for relistment on Nasdaq, and the reduced trading volumes that we currently experience may prevent our stock from reaching the required minimum bid price for Nasdaq relistment. Additionally, our current stockholder’s deficit balance and our history of net losses may make it difficult for us to relist on Nasdaq at any point in the near future, if at all. We may be required to restructure our capital or debt structure, including our redeemable convertible preferred stock, in order to relist on Nasdaq. There is no guarantee that we would be able to effect such restructuring under terms as favorable as our current equity and debt, if at all.

 

The public market for our common stock may be volatile.

 

The market price of our common stock has been, and we expect it to continue to be, highly volatile and to fluctuate significantly in response to various factors, including:

 

    actual or anticipated variations in our quarterly operating results or those of our competitors;

 

    announcements of technological innovations or new services or products by us or our competitors;

 

    timeliness of our introductions of new products;

 

    changes in management; and

 

    changes in the conditions and trends in the pharmaceutical market.

 

For instance, during fiscal 2006 the price of our common stock closed as low as $1.20 and as high as $2.32 per share. We have experienced very low trading volume in our stock, and thus small purchases and sales can

 

20


Table of Contents

have a significant effect on our stock price. In addition, the stock markets have experienced extreme price and volume fluctuations, particularly in the past year, that have affected the market prices of equity securities of many technology companies. These fluctuations have often been unrelated or disproportionate to operating performance. These broad market factors may materially affect the trading price of our common stock. General economic, political and market conditions, such as recessions and interest rate fluctuations, may also have an adverse effect on the market price of our common stock.

 

Insiders continue to hold a majority of our stock, which may negatively affect your investment.

 

Entities affiliated with two of our directors beneficially own or control a majority of the outstanding common stock, calculated on an as-if-converted basis, as of March 31, 2006. If these parties choose to act or vote together, they will have the power to control all matters requiring the approval of our stockholders, including the election of directors and the approval of significant corporate transactions. This ability may have the effect of delaying or otherwise influencing a possible change in control transaction, which may or may not be favored by our other stockholders. In addition, without the consent of these parties, we would likely be prevented from entering into transactions that could result in our stockholders receiving a premium for their stock.

 

Our preferred stockholders may elect to receive their dividend payments in the form of shares instead of cash, which may negatively impact our profitability.

 

Our preferred stockholders have elected in the past, and may continue to elect, to receive their quarterly dividend payments in the form of Series B Preferred shares instead of cash. We record the value of these dividend payments in the form of shares at fair market value as of the dividend payment date on our statement of operations. The fair market value is defined as the amount at which the capital stock would change hands between a willing buyer and a willing seller, each having reasonable knowledge of all relevant facts, neither being under any compulsion to act, with equity to both. Because there is no market for such Series B Preferred shares, we perform a valuation of the fair market value of these shares. This valuation is impacted by numerous factors, including but not limited to our operations, financial conditions, future prospects and projected operations and performance of the company, as well as historical market prices and trading volume for our publicly traded securities. As such, the valuation of these dividend payments may fluctuate widely, may be greater or lesser than the stated value of the Series B Preferred shares, and may impact our ability to sustain or increase our profitability. We are unable to project with any accuracy the impact of fair market value of the Series B Preferred shares on our statement of operations.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None

 

ITEM 2. PROPERTIES

 

Our principal executive office, totaling approximately 14,000 square feet, is located in Mountain View, California under a lease that expires in August 2010. We also lease approximately 13,000 square feet in Cary, North Carolina for a sales, development and training facility, under a lease that expires in March 2011. We believe that our existing facilities are adequate for our current needs and that additional space will be available as needed.

 

ITEM 3. LEGAL PROCEEDINGS

 

From time to time, Pharsight may become involved in claims, legal proceedings, or state or federal government agency proceedings that arise in the ordinary course of its business. We are not currently a party to any material litigation and are currently not aware of any pending or threatened litigation that could have any material adverse effect upon our business, operating results or financial condition.

 

21


Table of Contents

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

 

No matters were submitted to a vote of Pharsight’s stockholders during the fourth quarter of our fiscal year ended April 30, 2006.

 

EXECUTIVE OFFICERS OF THE REGISTRANT

 

The following table provides information concerning our executive officers and key employees as of June 10, 2006:

 

Name


   Age

  

Position


Executive Officers

         

Shawn M. O’Connor

   46    President, Chief Executive Officer and Chairman

William Frederick

   42    Senior Vice President, Chief Financial Officer and Corporate Secretary

James D. Hayden

   38    Senior Vice President, Global Sales

Mark Hovde

   49    Senior Vice President, Marketing

Daniel L. Weiner

   56    Senior Vice President, Software Products

Key Employees

         

Rene Bruno

   50    Managing Director, Strategic Consulting Services, Europe

William Gillespie

   54    Vice President, Strategic Consulting Services, East Coast Operations

E. Gregory Lee

   57    Vice President, Engineering

Nancy Risch

   57    Vice President, Global Sales

 

Shawn M. O’Connor, Pharsight’s President, Chief Executive Officer and Chairman since February 2003, joined Pharsight in September 2002 as its Senior Vice President and Chief Financial Officer. Mr. O’Connor has more than 20 years of experience in high technology executive management. Prior to joining Pharsight, Mr. O’Connor was the President and Chief Operating Officer of QRS Corporation, a leading provider of business-to-business e-commerce services to the retail industry, from 1995 to 2001. Prior to QRS, he served as Chief Financial Officer of Diasonics Ultrasound, Inc., a publicly held worldwide medical equipment manufacturer, from 1987 to 1994. Mr. O’Connor began his career with the accounting firm Peat Marwick, where he served as a CPA in both San Francisco and London. Mr. O’Connor holds a B.S. from the University of California, Berkeley, in Finance & Business Administration and is a graduate of the Executive Education Program at the Stanford Graduate School of Business.

 

William Frederick, joined Pharsight in April, 2006. Prior to joining Pharsight, Mr. Fredrick was Vice President and Chief Financial Officer of Versata, Inc. from January 2004 to January 2005. Mr. Frederick joined Versata in December 2002 as Corporate Controller and was appointed as Vice President and Chief Financial Officer in January 2004. In February 2005, Mr. Frederick was also appointed as Versata’s interim Chief Executive Officer and President. From August 2000 through March 2002, Mr. Frederick served as Vice President, Finance at Clarent Corporation. From January 2000 through August 2000, Mr. Frederick was Corporate Controller at ACT Networks, Inc. a developer and manufacturer of broadband access equipment that was acquired by Clarent in August 2000. From May 1999 to November 1999, Mr. Frederick was the Chief Financial and Administrative Officer of IAM.com, Inc, a business-to-business web application company. From January 1998 to May 1999, Mr. Frederick was in the corporate finance department of The Disney Store division of The Walt Disney Company. Mr. Frederick holds a M.B.A degree from California State University at Long Beach and a bachelor’s degree in finance from California State University at Fullerton.

 

22


Table of Contents

James D. Hayden joined Pharsight in April 2005 as Senior Vice President, Global Sales. Mr. Hayden has 15 years of experience in sales, marketing and management within the life sciences industry. From May 1998 to April 2005, Mr. Hayden held various positions with Accelrys, Inc., a leading provider of software for computation, simulation, and the management and mining of scientific data used by biologists, chemists and materials scientists. While at Accelrys, he led a sales team as National Director of Sales from 2000 to 2005 responsible for major account sales of the company’s software solutions in the Americas region. In this role, he successfully reestablished the company’s presence in a failing geographical region and also developed a variety of sales infrastructure tools that allowed the company to gauge the progress of its sales team. He also helped to successfully launch the company’s presence into the emerging nanotechnology market. From June 1991 to April 1998 he held various positions at Bio-Rad Laboratories, a developer of innovative tools and services for the clinical diagnostics and life sciences research markets including Product Support Manager and Senior Account Manager. Mr. Hayden began his career as an electrical engineer at Raytheon and holds an MBA from Rutgers University and a B.S. in Electrical Engineering from Boston University.

 

Mark Hovde joined Pharsight in April 2005 as Senior Vice President, Marketing. Mr. Hovde has more than 15 years of experience in marketing and business development for pharmaceutical software, data, and services companies. Prior to joining Pharsight, from October 2003 to April 2005, Mr. Hovde was the President and founder of Hovde Associates, LLC, a management consulting firm specializing in counsel on pharmaceutical development. Prior to this, from September 2000 to October 2003, he was the Vice President, Sales and Business Development at Fast Track Systems, Inc., a developer of software focused on improving the protocol quality and the speed of the clinical trial process. While at Fast Track, Mr. Hovde was responsible for the formation and management of the company’s sales and marketing organizations and successfully created a unique consulting services program, which was offered to the company’s major accounts. From 1989 to August 2000, Mr. Hovde was also the co-founder of DataEdge, LLC, a developer of novel informatics that help reduce the time and cost of clinical trials. At DataEdge he pioneered the PICAS and CROCAS databases, leading clinical cost benchmarking tools, which improved trial cost control. Mr. Hovde has authored several publications and presentations and holds a Bachelor of Science degree in Finance from the Wharton School of the University of Pennsylvania, where he was also named a Benjamin Franklin Scholar, and an MBA from Harvard Business School.

 

Daniel L. Weiner, Ph.D., rejoined Pharsight as Senior Vice President, Software Products in June 2004. Dr. Weiner worked as an independent pharmaceutical consultant before taking the position of Senior Vice President and Head of Global Clinical Development at IVAX Corporation from May 2003 to May 2004. From February 1998 until December 2002, Dr. Weiner held the position of Senior Vice President of Software Development with Pharsight. Dr. Weiner has extensive drug development experience and has served as an expert consultant to the FDA on pharmacokinetic modeling and bioequivalence assessment. Prior to his previous tenure with Pharsight as a Senior Vice President, Dr. Weiner held several management positions including Head, Biostatistics, Merrell Dow Pharmaceuticals; Vice President, Statistical Consultants, Inc.; Vice President, Syntex Development Research; and Senior Vice President and Principal Scientist, Quintiles. Dr. Weiner graduated from the University of Kentucky with a doctoral degree in Mathematical Statistics, with emphasis on compartmental modeling, as well as an M.S. in Statistics, and a B.S. in Mathematics.

 

Rene Bruno, Ph.D. Managing Director, Strategic Consulting Services, Europe. Prior to joining Pharsight, Dr. Bruno spent the last three years at Genentech, Inc. in South San Francisco, Calif., where he was most recently senior scientist and head of the pharmacometry unit. Before Genentech, Dr. Bruno held various scientific research positions, including research advisor, over the course of 13 years at Rhone-Poulenc Rorer in Antony, France and Collegeville, Pa. Prior to Rhone-Polenc Rorer, Dr. Bruno was a pharmacokineticist at Syntex Research in France. To date, he has authored or co-authored more than 130 manuscripts and scientific communications in the field of drug development. Dr. Bruno has undertaken extensive work in the areas of modeling and simulation and has been an industry leader in supporting this methodology in the drug development process across several global projects. Dr. Bruno holds a Ph.D. in pharmacology from the University of Aix-Marseille, department of Pharmacokinetics and Toxicokinetics in School of Pharmacy. In addition, he holds a “Habilitation a des Recherches” from University of Aix-Marseille, the highest academic

 

23


Table of Contents

degree in France. Dr. Bruno held a “Maitre-Assistant” (Assistant Professor) position in the department of Pharmacokinetics and Toxicokinetics, School of Pharmacy, Marseilles before moving to the Pharmaceutical Industry.

 

William Gillespie, Ph.D. Vice President, Strategic Consulting Services, East Coast Operations. Dr. Gillespie joined Pharsight in April 1999 as a Senior Consultant, Scientific Affairs. From 1997 to April 1999, he was Vice President for Pharmacokinetic Research and Development at GloboMax LLC. From 1993 to 1997, he was with the Center for Drug Evaluation and Research, U.S. Food and Drug Administration serving as Associate Director for Scientific Affairs and heading the Pharmacometrics Staff in the Office of Clinical Pharmacology and Biopharmaceutics. From 1987 to 1993, he was Assistant Professor of Pharmaceutics at the University of Texas at Austin, College of Pharmacy. He received his Ph.D. in Pharmacy from the University of Iowa in 1987. Dr. Gillespie’s recent research efforts have concentrated on novel applications of PK and PK/PD modeling including clinical trial simulations, Bayesian approaches to population PK/PD modeling, in vivo/in vitro correlation, and bioequivalence assessment based on pharmacodynamic measurements. He has published over 50 research articles pertaining to pharmacokinetics and biopharmaceutics.

 

E. Gregory Lee, Ph.D., a Pharsight founder and its Vice President, Engineering, joined Pharsight in 1995. Dr. Lee has extensive experience in the commercial development of mathematically and statistically oriented software programs. Prior to joining Pharsight, Dr. Lee was Director of Engineering at Sunrise Test Systems, a leading developer of electronic design automation software. From 1984 until 1993, Dr. Lee held technical and management positions at Weitek Corporation, a provider of specialized semiconductor technology. Previously, Dr. Lee held technical positions at Applicon (Schlumberger) and Floating Point Systems. Dr. Lee received his Ph.D. in mathematics from MIT and his undergraduate degree from Reed College.

 

Nancy Risch, Pharsight’s Vice President, Global Sales joined Pharsight in June 1996. Ms. Risch has more than 20 years of experience in the pharmaceutical and healthcare industry. Prior to joining Pharsight, Ms. Risch was the Eastern Regional Director for BBN Corporation, a provider of clinical data management solutions for the pharmaceutical industry. Previously, as one of the initial team-members of Interleaf, a publicly-held provider of high-end publishing and document management solutions, Ms. Risch served as Director of Worldwide Industry Sales and continued there for more than 15 years, consistently over-achieving the sales goals. Prior to joining Interleaf, Ms. Risch held management positions in the Information Systems organization at General Electric Aircraft Engines. Ms. Risch also held various positions in software and statistical analysis at Wang and Union Carbide. She majored in mathematics at West Virginia University.

 

24


Table of Contents

PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Our common stock is currently listed on the Over-The-Counter Bulletin Board system under the symbol “PHST.OB.” Our common stock first traded publicly on August 9, 2000, concurrent with the underwritten initial public offering of shares of our common stock, on the Nasdaq National Market and continued to be traded there until November 8, 2002.

 

As of June 22, 2006, there were 19,407,289 shares of common stock outstanding that were held by approximately 110 stockholders of record. Because many of our shares of common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders.

 

Set forth below are the high and low closing prices for our common stock reported on the Over-The-Counter Bulletin Board system for the periods indicated:

 

     High

   Low

Fiscal year ended March 31, 2006

             

Fourth Quarter

   $ 2.05    $ 1.37

Third Quarter

     1.90      1.20

Second Quarter

     2.32      1.65

First Quarter

     1.90      1.35

Fiscal year ended March 31, 2005

             

Fourth Quarter

   $ 2.03    $ 0.95

Third Quarter

     1.20      0.75

Second Quarter

     1.06      0.90

First Quarter

     1.70      1.03

 

The over-the-counter quotations reflect inter-dealer prices, without retail mark-up, markdown or commission and may not necessarily represent actual transactions.

 

We have never declared or paid any cash dividends on our common stock and do not anticipate paying such cash dividends on our common stock in the foreseeable future. We currently anticipate that we will retain all of our future earnings, if any, for use in the development and expansion of our business and for general corporate purposes. Any determination to pay dividends on our common stock in the future will be at the discretion of our board of directors and will depend upon our results of operation, financial condition and other factors as our board of directors, in its discretion, deems relevant. In addition, under the terms of some of our debt agreements, we are prohibited from paying dividends without the consent of the lender.

 

25


Table of Contents

ITEM 6. SELECTED FINANCIAL DATA

 

You should read the following historical selected consolidated financial data in conjunction with the financial statements and related notes and “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this Annual Report on Form 10-K. We have derived our consolidated balance sheet data as of March 31, 2006 and 2005 and consolidated statement of operations data for each of the years ended March 31, 2006, 2005 and 2004, from our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. We have derived our balance sheet data as of March 31, 2004, 2003 and 2002 and statement of operations data for the years ended March 31, 2003 and 2002 from our audited consolidated financial statements not included in this Annual Report on Form 10-K. Our historical results are not necessarily indicative of results to be expected for any future period.

 

     Years Ended March 31,

 
     2006

    2005

    2004

    2003

    2002

 
     (In thousands, except per share data)  

Consolidated Statement of Operations Data

                                        

Revenues

   $ 22,742     $ 22,593     $ 17,730     $ 13,968     $ 14,249  

Gross profit

     15,043       14,832       9,937       7,666       5,974  

Total operating expenses

     14,461       11,841       11,673       18,837       25,138  

Income (loss) from operations

     582       2,991       (1,736 )     (11,171 )     (19,164 )

Net income (loss)

     530       2,733       (1,997 )     (11,542 )     (18,952 )

Net income (loss) attributable to common stockholders

   $ (208 )   $ 2,123     $ (2,990 )   $ (12,163 )   $ (18,952 )

Net income (loss) per share attributable to common stockholders:

                                        

Basic

   $ (0.01 )   $ 0.11     $ (0.16 )   $ (0.65 )   $ (1.03 )

Diluted

   $ (0.01 )   $ 0.10     $ (0.16 )   $ (0.65 )   $ (1.03 )

Shares used to compute net income (loss) per share attributable to common stockholders:

                                        

Basic

     19,421       19,122       19,051       18,800       18,419  

Diluted

     19,421       28,509       19,051       18,800       18,419  
     As of March 31,

 
     2006

    2005

    2004

    2003

    2002

 
     (In thousands)  

Consolidated Balance Sheet Data

                                        

Cash, cash equivalents and short-term investments

   $ 10,832     $ 10,579     $ 10,027     $ 10,875     $ 13,492  

Total assets

     17,786       16,822       15,294       15,574       19,954  

Long-term obligations, net of current portion

     699       536       1,610       2,024       3,194  

Redeemable convertible preferred stock

     6,641       6,266       6,164       5,608       —    

Total stockholders’ equity (deficit)

   $ (2,659 )   $ (2,630 )   $ (4,915 )   $ (2,127 )   $ 6,684  

 

26


Table of Contents
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This section and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties. Our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed under the caption “Factors That May Affect Future Results and Market Price of Stock” below. The following discussion should be read in conjunction with the Financial Statements and notes thereto set forth under “Item 8—Financial Statements and Supplementary Data.”

 

Overview

 

Pharsight Corporation develops and markets software and provides strategic consulting services that help pharmaceutical and biotechnology companies improve the efficiency of the drug development decision making process, by reducing the costs and time requirements of their drug discovery, development, and commercialization efforts. Our products include proprietary software for clinical trial simulation and computer-aided trial design, the statistical analysis and mathematical modeling of data, and for the storage, management, and regulatory reporting of derived data and models in data repositories. Both our software products and our services utilize expertise in the sciences of pharmacology, drug and disease modeling, biostatistics and strategic decision-making. Our service offerings use this expertise to interpret and improve the design of scientific experiments and clinical trials, and to optimize clinical trial design and portfolio decisions. By integrating scientific, clinical, and business decision criteria into a dynamic model-based methodology, we help our customers to optimize the value of their drug development programs and portfolios from discovery to post-launch marketing.

 

The use of our software and methodology is on the leading edge of the traditional drug-development process, which is heavily dependent upon clinical trials and patient testing. Although our methodology does not displace the use of human trials in drug development, we believe our software and our methodology renders human trials more efficient and relevant. The continued growth of our customer base, the increase in the number of contracts with our customers, and the increase in our average contract values over time have shown a trend that we believe demonstrates increased acceptance of our methodology and an increased demand for its use. We believe that these trends, in addition to increasing regulatory requirements from the FDA, demonstrate a potential for increased revenue growth resulting from increased demand for our current products and services, as well as long-term opportunities to expand the breadth and coverage of both our consulting services and software product offerings.

 

For reporting purposes, we operate in two business segments: Software Products and Strategic Consulting. Our Software Products segment consists of software products and software deployment and integration services that provide the analytical tools and conceptual framework to help clinical researchers optimize the decision-making required to perform clinical testing needed to bring drugs to market. Our Strategic Consulting segment consists of consulting, training and process redesign conducted by our clinical and decision scientists in the application and implementation of our core decision methodology. These segments were determined based on how management and our Chief Operating Decision Maker, or CODM, who is our Chief Executive Officer, view and evaluate our business.

 

We were incorporated in California in April 1995, and we reincorporated in Delaware in June 2000. In August 2000, we completed our initial public offering and our common stock began trading on the Nasdaq National Market. In November 2002, our common stock ceased to trade on the Nasdaq National Market and it is currently traded on the Over-The-Counter Bulletin Board system. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge through our website at http://www.pharsight.com as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission or SEC. Copies of our annual report will be made available, free of charge, upon written request to the Chief Financial Officer, c/o Pharsight Corporation, 321 E. Evelyn Ave., 3rd Floor, Mountain View, CA 94041-1530.

 

27


Table of Contents

Financial Highlights for Fiscal 2006

 

    Our revenues for fiscal 2006 were $22.7 million, a slight increase over fiscal 2005 of $22.6 million, primarily due to an increase in software license revenue offset by a decrease in service revenue.

 

    Our revenue from the software business segment for fiscal 2006 was approximately $13.4 million compared with $12.1 million for fiscal 2005. License, renewal and maintenance revenue for fiscal 2006 accounted for approximately $10.8 million, up from approximately $9.8 million for fiscal 2005. Software services revenue accounted for $2.7 million for fiscal 2006, up from $2.3 million for fiscal 2005.

 

    Our net income for fiscal 2006 was $530,000 compared to $2.7 million in fiscal 2005. The decrease in net income was primarily due to the increase in operating expenses that resulted from our planned investments in sales and marketing and research and development for fiscal 2006.

 

Challenges and Risks

 

We achieved our first quarter of profitability in the fourth quarter of fiscal 2004 and maintained annual profitability during fiscal 2005 and fiscal 2006. Prior to that time we had incurred losses since inception. We currently have an accumulated deficit of approximately $76.5 million. To meet increased demand for our products and services, we may be required to invest further in our operations, technology and infrastructure, which may result in our inability to sustain profitability. Despite the recent decreases in service revenue, we still experience increased demand for our consulting services. However, we may have difficulty expanding our capacity to deliver such services in a profitable manner, if at all.

 

We achieved positive operating cash flow in fiscal 2004 and continued to have positive operating cash flow in fiscal 2005 and fiscal 2006. Although we believe that our current cash balances are sufficient to meet our working capital needs for the next twelve months, our ability to generate positive net cash flow and sustain positive operating cash flow on a quarterly and annual basis is based on a number of factors, including some which are outside of our control, such as the state of the overall economy, the demand for our products and the length and lack of predictability of our sales cycle. As a result, we may need to raise additional funds through public or private financings or other sources to fund our operations. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, these equity securities might have rights, preferences or privileges senior to our common stock and preferred stock. In addition, the necessity of raising additional funds could force us to incur debt on terms that could restrict our ability to make capital expenditures and to incur additional indebtedness.

 

For the fiscal year ending March 31, 2006, we generated 47% of our total revenues, or $10.8 million, from software license and renewal fees, compared to 43% of total revenues, or $9.8 million, in fiscal 2005. Software services revenue increased to $2.7 million or 12% of total revenue in fiscal 2006, compared to $2.3 million or 10% of total revenue in fiscal 2005. Total revenue for our software business segment for fiscal 2006 was 59% of our total revenue, or $13.4 million, compared to 53% of total revenue, or $12.1 million, in fiscal 2005. The increase was a result of the increase in the software business segment revenue offset by a similar decrease in the strategic consulting services segment revenue. The 11% increase in revenue from our software business segment from fiscal 2005 to fiscal 2006 was primarily attributable to a higher rate of renewals, completion of one PKS install base project, two automation projects, sales of three DMX contracts, and a large install base of desktop software. While we expect that the overall long-term revenue trend in our software business will continue to increase in response to customer demand, the revenue in individual quarters may fluctuate significantly, based upon timing of completion of large software installations and related revenue recognition. Unanticipated delays in deployment schedules may have significant impact on the timing of revenue recognition and may have corresponding significant impact on our net income in that quarter. The additional spending in Sales and Marketing by adding new sales personnel as well as hiring the two Senior Vice President of Sales and Senior Vice President of Marketing was an effort to produce more revenue. As an initial result of the investment, we were able to diversify our customer base in our Strategic Consulting business segment and increase our

 

28


Table of Contents

consulting revenue in the fourth quarter of fiscal 2006. We anticipate that these new resources will begin to deliver more noticeable results after some required ramp up time.

 

We generate a significant portion of our revenue from a limited number of clients. During our fiscal year ended March 31, 2006, we provided products and services for which we recognized revenue to more than 1,100 customers. In fiscal 2006, Pfizer Inc., or Pfizer, our largest customer, accounted for 25% of our total revenue, and Eli Lilly and Company, or Eli Lilly, also accounted for 17% of our total revenue. In fiscal 2005, Pfizer accounted for 25% of our total revenue, and Eli Lilly accounted for 20% of our total revenue. In fiscal 2004, Pfizer accounted for 16% and Eli Lilly accounted for 11% of revenue. Consequently, we are dependent on Pfizer and Eli Lilly for a substantial portion of our revenues, and if we were to lose Pfizer or Eli Lilly as a customer, it would have a material adverse effect on our revenues and business. See “Item 1A—Risk Factors—Our revenue is concentrated in a few customers, and if we lose any of these customers our revenue may decrease substantially.” We expect that a significant portion of our revenue will continue to depend on sales to a small number of clients. In addition, the worldwide pharmaceutical industry has undergone, and may in the future undergo, substantial consolidation, which may reduce the number of our existing and potential clients. The loss of one of our large clients would hurt our business and prevent us from sustaining profitability.

 

Our strategic consulting customers range in size from the largest pharmaceutical companies to small biopharmaceutical companies, and the focus of our work differs depending upon the size and maturity of the customer. In our smaller and medium-sized customers, we tend to engage in discrete projects often with challenging analytic and design problems, where modeling and simulation can be particularly valuable. This kind of work may or may not lead to subsequent engagements. By contrast, at our largest customers, we tend to have ongoing relationships which are more strategic in nature, and we focus on helping improve the process by which they develop drugs, broadening and deepening the application of modeling and simulation over time, with the intent of achieving systematic, lasting performance improvement.

 

Our clients may also expand their internal drug development organizations to include functions and individuals that might perform services similar to those performed by our strategic consulting group. As a result, our consulting business could have difficulty sustaining its current levels of revenues, or increasing its revenues in the future. Unanticipated delays in consulting project schedules may have significant impact to the timing of revenue recognition and may have corresponding significant impact on our net income in that quarter.

 

The pharmaceutical industry in general has recently experienced, and may continue to experience, forced withdrawal of certain drugs from the public market due to unforeseen safety risks. Our clients may, as a result, experience declines in their revenues, which may lead to reductions in their current level of spending on software solutions and strategic consulting services. This could adversely affect our business and prevent us from increasing or sustaining our software and strategic consulting revenues.

 

Critical Accounting Policies and Estimates

 

We prepare our financial statements in accordance with U.S. generally accepted accounting principles, or GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The primary critical accounting policies that currently affect our financial condition and results of operations are revenue recognition and allowance for doubtful accounts, which impacts revenue. We believe that this accounting policy is critical to fully understand and evaluate our reported financial results.

 

29


Table of Contents

Revenue Recognition

 

Our revenues are derived from two primary sources: (1) initial and renewal fees for term-based and perpetual product licenses, and post-contract customer support (PCS), and (2) services related to scientific and training consulting and software deployment.

 

Our revenue recognition policy is in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” or SOP 97-2, as amended. For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, collection is probable, and no significant post-delivery obligations remain unfulfilled. If any of these criteria are not met, we defer revenue recognition until such time as all of the criteria are met. We do not currently offer, have not offered in the past, and do not expect to offer in the future, extended payment term arrangements. If we do not consider collectability to be probable, we defer recognition of revenue until the fee is collected.

 

We enter into arrangements for one-year software licenses (initial and renewal fees) bundled with post-contract support services, or PCS, from which we receive solely license and renewal fees. We do not have vendor specific objective evidence to allocate the fee to the separate elements, as we do not sell PCS separately. Therefore, we do not present PCS revenue separately, and we do not believe other allocation methodologies, namely allocation based on relative costs, provide a meaningful and supportable allocation between license and PCS revenues. We recognize each of the initial and renewal license fees ratably over the one-year period of the license during which the PCS is expected to be provided as required by paragraph 12 of SOP 97-2.

 

We enter into arrangements consisting of perpetual or one-year licenses, one-year PCS, implementation/installation services and optional scientific consulting services. We recognize revenue attributable to license, PCS and implementation/installation ratably over the remaining period of the PCS term once the implementation and installation services are completed and accepted by the customer. The optional scientific consulting services meet the criteria of paragraph 65 of SOP 97-2 for separate accounting, as they are not essential to the functionality of the delivered software, are described and priced separately in the arrangement and are sold separately. We recognize fees from optional scientific consulting services (equal to the amounts set in the contracts) as revenue as these services are provided or upon their acceptance, as applicable.

 

We also enter into arrangements that consist of perpetual and term-based licenses, PCS and implementation/installation services. For arrangements involving a significant amount of services related to installation and implementation of our software products, we recognize revenue for the entire arrangement ratably over the remaining period of the PCS term once the implementation and installation services are completed and accepted by the customer. We currently do not have vendor specific objective evidence for PCS, however revenues from maintenance renewals on perpetual licenses are classified as maintenance revenue on our income statement.

 

For arrangements consisting solely of services, we recognize revenue as consulting services are performed. Arrangements for consulting services may be charged at daily rates for different levels of consultants and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee contracts, with payments based on milestones or acceptance criteria, we recognize revenue as such milestones are achieved, or if customer acceptance of the milestone’s completion is required, upon such customer acceptance, which approximates the level of services provided. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.

 

We have one international distributor. There is no right of return or price protection for sales to the international distributor. Revenue on sales to this distributor is recognized ratably over the license term when the software is delivered to the distributor and other revenue recognition criteria are met. Revenue from this distributor was less than 1%, 2% and 3% of our total revenues in fiscal 2006, fiscal 2005 and fiscal 2004, respectively.

 

30


Table of Contents

Judgments affecting revenue recognition. Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter. We recognize revenue in accordance with GAAP rules that have been prescribed for the software industry. The accounting rules related to revenue recognition are complex and are affected by interpretations of the rules and an understanding of industry practices, both of which are subject to change. Consequently, the revenue recognition accounting rules require management to make significant judgments.

 

We do not record revenue on sales to customers whose ability to pay is in doubt at the time of sale. Rather, we recognize revenue from these customers as cash is collected. The determination of a customer’s ability to pay requires significant judgment. In this regard, management considers the international region of the customer and the financial viability of the customer in assessing a customer’s ability to pay.

 

We generally do not consider revenue arrangements with extended payment terms to be fixed or determinable and, accordingly, we do not generally recognize revenue on these arrangements until the customer payments become due. The determination of whether extended payment terms are fixed or determinable requires management to exercise significant judgment, including assessing such factors as the past payment history with the individual customer and evaluating the risk of concessions over an extended payment period. The determinations that we make can materially impact the timing of recognition of revenues. Our normal payment terms currently range from “net 30 days” to “net 60 days,” which are not considered by us to be extended payment terms.

 

The majority of our PKS software arrangements include software deployment services. We defer revenue for software deployment services, along with the associated license revenue, until the services are completed. If there is significant uncertainty about the project completion or receipt of payment for the professional services, we defer revenue until the uncertainty is sufficiently resolved.

 

Additionally, for fixed fee strategic consulting contracts, with payments based on milestones or acceptance criteria, we recognize revenue as such milestones are achieved, or if customer acceptance is required, upon customer acceptance, which approximates the level of services provided. Management makes a number of estimates related to recognizing revenue for such contracts, as discussed above. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.

 

Allowance for Doubtful Accounts

 

We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than the full payment on our currently outstanding receivables. We make judgments as to our ability to collect receivables and provide allowances for the portion of receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding invoices. In determining our allowances, we analyze our historical collection experience and current economic trends.

 

Results of Operations

 

The following table sets forth, for the periods given, selected consolidated financial data by reportable segment as a percentage of our revenue and the percentage of period-over-period change. The table and the discussion below should be read in connection with the consolidated financial statements and the notes thereto which appear elsewhere in this report. All percentage calculations set forth in this section have been made using figures presented in the consolidated financial statements, and not from the rounded figures referred to in the text of this management discussion and analysis.

 

31


Table of Contents

Total revenues

 

    

Year Ended

March 31,


   Percentage of Dollar
Change Year Over Year


    Percentage of Total Revenues
Year Ended March 31,


 
     2006

   2005

   2004

   2006/2005

    2005/2004

    2006

    2005

    2004

 
     (In thousands, except percentages)  

Total Revenues:

                                                   

License and renewal

   $ 10,769    $ 9,790    $ 8,145    10 %   20 %   47 %   43 %   46 %

Services

     11,973      12,803      9,585    (6 )%   34 %   53 %   57 %   54 %
    

  

  

              

 

 

Total revenues:

   $ 22,742    $ 22,593    $ 17,730    1 %   27 %   100 %   100 %   100 %
    

  

  

              

 

 

Software Products Segment Revenues:

                                                   

License and renewal

   $ 10,769    $ 9,790    $ 8,145    10 %   20 %   47 %   43 %   46 %

Services

     2,680      2,288      1,531    17 %   49 %   12 %   10 %   9 %
    

  

  

              

 

 

Total software products segment revenues:

   $ 13,449    $ 12,078    $ 9,676    11 %   25 %   59 %   53 %   55 %
    

  

  

              

 

 

Strategic Consulting Segment Revenues

   $ 9,293    $ 10,515    $ 8,054    (12 )%   31 %   41 %   47 %   45 %
    

  

  

              

 

 

 

Comparison of Year Ended March 31, 2006 and 2005 and Comparison of Year Ended March 31, 2005 and 2004

 

Revenue

 

Year Ended March 31, 2006 and 2005

 

Total revenue for fiscal 2006 increased slightly to $22.7 million, compared to $22.6 million for fiscal 2005. The increase was a result of the increase in the software business segment revenue offset by a similar decrease in the strategic consulting services segment revenue. The 11% increase in revenue from our software business segment from fiscal 2005 to fiscal 2006 was primarily attributable to a higher rate of renewals, completion of one PKS install base project, two automation projects, sales of three DMX contracts, and a large install base of desktop software.

 

Software Products Segment Revenues

 

License and renewal and maintenance revenues

 

For fiscal 2006, desktop software products revenues increased to $6.8 million from $5.9 million in fiscal 2005. The increase is mainly attributable to $763,000 increased in our initial desktop software product revenue which includes revenue of $400,000 from an initial desktop license revenue transaction with one of our major customers in the third quarter of fiscal 2006.

 

PKS software revenues decreased to $2.2 million in fiscal 2006 from $3.3 million in fiscal 2005. The decrease in revenue is due to larger projects closed in fiscal 2005 than in fiscal 2006. In addition, there was a change in product mix between initial PKS licenses and renewal of PKS licenses in second quarter of fiscal 2006. As PKS renewals are priced at lower rates than PKS initials, the change in product mix resulted in a decrease in PKS software product revenue. Furthermore, less PKS installation software projects were completed in the third quarter of fiscal 2006 than that in the same quarter of fiscal 2005. This resulted in less PKS license revenue recognized. In addition the average selling price for software products for which revenue was recognized during fiscal 2006 increased by 5% as compared to fiscal 2005.

 

DMX software revenues were $1.8 million in fiscal 2006 compared to $552,000 in fiscal 2005. The increase is mainly due to recognizing revenue on a large DMX project over the second and third quarter of fiscal 2006 as

 

32


Table of Contents

well as recognizing revenue on various smaller DMX projects completed in the fourth quarter of fiscal 2006. As a result, a full year worth of DMX software revenue was recognized throughout the fiscal year 2006, whereas only one quarter worth of revenue was recognized in fiscal 2005.

 

Services revenues

 

Software services revenues were $2.7 million in fiscal 2006 compared to $2.3 million in fiscal 2005. The increase in software services revenue was primarily attributable to increased customized services associated with PKS installation, deployment and automation projects. One PKS installation project completed in the first quarter of fiscal 2006, two PKS deployment and automation framework projects completed in each of the remaining quarters of fiscal 2006.

 

Strategic Consulting Segment Revenues

 

Strategic Consulting segment revenues were $9.3 million in fiscal 2006 compared to $10.5 million in fiscal 2005. The decrease was primarily due to the unexpected downturn of the pharmaceutical industry starting in the second quarter of fiscal 2006. During the second and third quarter we were particularly affected by the decrease spending by our largest customer. We did however see an increase in consulting revenue in the fourth quarter, compared to the third quarter, largely driven by growth from clients outside of our top two customers. However, even though we saw quarterly revenue growth of 47% in the fourth quarter, total revenue for the 2006 fiscal year was still down 12% compared to fiscal 2005.

 

Year Ended March 31, 2005 and 2004

 

Revenue for fiscal 2005 increased approximately 27% to $22.6 million, compared to $17.7 million in fiscal 2004. This increase was primarily attributable to both new and renewal software license revenues, an increase in the number of PKS software installations completed, resulting in an increase in software deployment services, and growth in strategic consulting services revenues due to an increase in business with key customers and higher utilization of our strategic consulting personnel.

 

Software Products Segment Revenues

 

License and renewal revenues. For fiscal 2005, desktop software products revenues increased to $5.9 million from $5.6 million in fiscal 2004, primarily as a result of an increase in our installed base in the current and previous year, and our ability to maintain a high rate of license renewals during fiscal 2005.

 

PKS software products revenues increased to $3.3 million in fiscal 2005, from $2.4 million in fiscal 2004. The increase in revenue is mainly attributable to the commencement of revenue recognition related to the installation and acceptance of several large PKS contracts, which increased the total number of PKS license seats on which revenue was recognized in fiscal 2005 by 125% over fiscal 2004. In addition the average selling price for software products for which revenue was recognized during fiscal 2005 increased by 7% as compared to fiscal 2004.

 

DMX software revenues were $552,000 in fiscal 2005, compared to $148,000 in fiscal 2004. The increase is due to the first full year of revenue in fiscal 2005, as DMX was introduced in the second quarter of fiscal 2004.

 

Services revenues. Software services revenues were $2.3 million in fiscal 2005, compared to $1.5 million in fiscal 2004. Software services revenue in fiscal 2005 was largely driven by increased implementation and customization services revenues associated with deployment of our PKS products.

 

33


Table of Contents

Strategic Consulting Segment Revenues

 

Strategic Consulting segment revenues were $10.5 million in fiscal 2005, compared to $8.1 million in fiscal 2004. The increase in Strategic Consulting segment revenues in fiscal 2005 compared to the same period in fiscal 2004 was driven by an increase in the average size of our consulting contracts as well as overall growth in our strategic consulting business and higher utilization of our scientific personnel.

 

Cost of Revenues

 

   

Year Ended

March 31,


  Percentage of Dollar
Change Year Over Year


    Percentage of Total Revenues
Year Ended March 31,


 
    2006

  2005

  2004

  2006/2005

    2005/2004

    2006

    2005

    2004

 
    (In thousands, except percentages)  

Cost of Revenues:

                                               

License and renewal

  $ 295   $ 379   $ 759   (22 )%   (50 )%   1 %   2 %   4 %

Services

    7,404     7,382     7,034   0 %   5 %   33 %   32 %   40 %
   

 

 

             

 

 

Total cost of revenues:

  $ 7,699   $ 7,761   $ 7,793   (1 )%   0 %   34 %   34 %   44 %
   

 

 

             

 

 

Cost of Software Products Segment Revenues:

                                               

License and renewal

  $ 295   $ 379   $ 759   (22 )%   (50 )%   1 %   2 %   4 %

Services

    1,495     1,597     1,860   (6 )%   (14 )%   7 %   7 %   11 %
   

 

 

             

 

 

Total software products:

  $ 1,790   $ 1,976   $ 2,619   (9 )%   (25 )%   8 %   9 %   15 %
   

 

 

             

 

 

Cost of Strategic Consulting Segment Revenues

  $ 5,909   $ 5,785   $ 5,174   2 %   12 %   26 %   25 %   29 %
   

 

 

             

 

 

 

Year Ended March 31, 2006 and 2005

 

Total Cost of Revenues

 

Total cost of revenues decreased slightly from $7.8 million in fiscal 2005 to $7.7 million in fiscal 2006. The decrease was primarily attributable to the increased cost efficiencies in both software licenses and software services.

 

Cost of Software Products Segment Revenues

 

Cost of license and renewal revenues. Cost of license and renewal revenues consists of royalty expense for third-party software included in our products, and cost of materials for both initial products and product updates provided for in our annual license agreements.

 

Cost of license and renewal revenues was $295,000 for fiscal 2006 compared to $379,000 in fiscal 2005. The decrease in cost of license and renewal revenues in fiscal 2006 in absolute dollars is due to a decrease in royalty expense, as we currently make payments to only one vendor compared to the two vendors we paid in fiscal 2005. In addition, there was a decrease in royalty expense associated with the decrease in sales of our Trial Simulator product in the third quarter of fiscal 2006.

 

Cost of services revenues. Cost of service revenues consists of payroll and related costs, travel expenses, and facilities and overhead costs associated with our deployment services group.

 

Cost of services revenue was $1.5 million for fiscal 2006 compared to $1.6 million in fiscal 2005. The decrease in cost of services revenues is due to cost efficiencies gained in expenses related to service revenue and efficiencies gained in the utilization of our professionals’ consulting hours during fiscal 2006. We have completed more projects in fiscal 2006, one PKS install base project and two automation projects; however we were still able to keep a lower total cost of services revenue at the end of fiscal 2006 than that in fiscal 2005.

 

34


Table of Contents

Cost of Strategic Consulting Segment Revenues

 

Cost of services for our Strategic Consulting segment consists of payroll and payroll related costs, travel expenses, and facilities and overhead costs associated with our strategic consulting personnel.

 

Cost of services for our Strategic Consulting segment was $5.9 million for fiscal 2006 compared to $5.8 million in fiscal 2005. The increase in cost of services for our Strategic Consulting segment in fiscal 2006 was primarily attributable to increased headcount as a result of our planned growth at the beginning of fiscal 2006, and payroll-related costs, employment fees, sign-on bonuses associated with the new headcount as well as our annual salary increases and the increase in common costs allocated to our Strategic Consulting segment. The total year to year increase in salary and related payroll expenses is $460,000 and the total year to year increase in common costs allocated to Strategic Consulting segment is $196,000.

 

Year Ended March 31, 2005 and 2004

 

The amounts discussed below for costs of license and renewal revenues, cost of services revenues, research and development, sales and marketing, and general and administrative expenses exclude amortization of deferred stock-based compensation.

 

Total Cost of Revenues

 

Total cost of revenues did not change significantly in absolute dollars in fiscal 2005 as compared to fiscal 2004. The decrease as a percentage of revenues in fiscal 2005 as compared to fiscal 2004 reflects increased efficiencies in our services organization and lack of subcontracted software customization expenses in fiscal 2005, compared to fiscal 2004. In addition, in fiscal 2005 intellectual property and third-party licenses costs decreased by $83,000 from fiscal 2004.

 

Cost of Software Products Segment Revenues

 

Cost of license and renewal revenues. Cost of license and renewal revenues was $379,000 for fiscal 2005, compared to $759,000 in fiscal 2004. The decrease in cost of license and renewal revenues in fiscal 2005 in absolute dollars is due to no subcontracted software customization expenses in fiscal 2005, as compared to $350,000 in fiscal 2004. In addition, in fiscal 2005 intellectual property and third-party licenses decreased by $83,000 from fiscal 2004. Cost of license and renewal revenues as a percentage of revenues during fiscal 2005 decreased due to the larger relative contribution of our PKS product, which does not carry royalty costs, as well as lower overall support costs.

 

Cost of services revenues. Cost of services revenue was $1.6 million for fiscal 2005, compared to $1.9 million in fiscal 2004. Cost of services revenue in fiscal 2005 decreased in absolute dollars primarily due to increased efficiencies within the deployment organization. In the first half of fiscal 2004, the software deployment organization had not yet become fully operational.

 

Cost of Strategic Consulting Segment Revenues

 

Cost of services for our Strategic Consulting segment was $5.8 million for fiscal 2005, compared to $5.2 million in fiscal 2004. The increase in cost of services for our Strategic Consulting segment in absolute dollars in fiscal 2005 was primarily attributable to increased headcount and payroll-related costs. The decrease as a percentage of revenues in fiscal 2005 was related to increased efficiencies in our strategic consulting organization.

 

35


Table of Contents

Operating Expenses

 

   

Year Ended

March 31,


  Percentage of Dollar
Change Year Over Year


    Percentage of Total Revenues
Year Ended March 31,


 
    2006

  2005

  2004

  2006/2005

    2005/2004

    2006

    2005

    2004

 
    (In thousands, except percentages)  

Research and development expense:

                                               

Software products segment

  $ 3,497   $ 2,932   $ 2,899   19 %   1 %   15 %   13 %   16 %

Strategic Consulting segment

    —       —       —     0 %   0 %   0 %   0 %   0 %
   

 

 

             

 

 

Total research and development

  $ 3,497   $ 2,932   $ 2,899   19 %   1 %   15 %   13 %   16 %
   

 

 

             

 

 

Sales and marketing

                                               

Software products segment

  $ 3,343   $ 2,472   $ 2,185   35 %   13 %   15 %   11 %   12 %

Strategic Consulting segment

    2,295     1,511     1,801   52 %   (16 )%   10 %   7 %   10 %
   

 

 

             

 

 

Total sales and marketing

  $ 5,638   $ 3,983   $ 3,986   42 %   0 %   25 %   18 %   22 %
   

 

 

             

 

 

General and administrative

                                               

Software products segment

  $ 3,046   $ 2,485   $ 2,432   23 %   2 %   13 %   11 %   14 %

Strategic Consulting segment

    2,261     2,326     2,086   (3 )%   12 %   10 %   10 %   12 %

Corporate

    19     115     72   (83 )%   60 %   0 %   1 %   0 %
   

 

 

             

 

 

Total general and administrative

  $ 5,326   $ 4,926   $ 4,590   8 %   7 %   23 %   22 %   26 %
   

 

 

             

 

 

 

Year Ended March 31, 2006 and 2005

 

Research and Development

 

Research and development expenses consist mainly of payroll, payroll related expenses and consulting expenses.

 

Software Products Segment

 

Research and development expenses were $3.5 million in fiscal 2006 compared to $2.9 million in fiscal 2005. The increase in research and development expenses in absolute dollars, and as a percentage of revenue, for fiscal 2006 compared to fiscal 2005 was primarily due to an increase in third-party consulting expense of approximately $134,000 in the first quarter of fiscal 2006 as well as an increase in salaries and payroll related expenses resulting from the hiring and reallocation of five employees from other departments.

 

Strategic Consulting Segment

 

The Strategic Consulting segment does not engage in research and development activities, nor is any such expense allocable to the segment, therefore it does not incur research and development related expenses.

 

Sales and Marketing

 

Sales and marketing expenses consist primarily of personnel costs, including salaries, commissions for sales, corporate marketing and travel related costs.

 

Total Sales and Marketing Expenses

 

Sales and marketing expenses were $5.6 million in fiscal 2006 compared to $4.0 million in fiscal 2005. The increase in sales and marketing expense in absolute dollars and as a percentage of revenue in the fiscal 2006 was

 

36


Table of Contents

primarily the result of an increase in payroll-related expenses related to the hiring of new executives in April 2005, near the end of first quarter of fiscal 2006, the net increase of two additional employees in the second quarter of fiscal 2006, one new employee in January 2006 and one employee transferred to the our marketing group as we increased our marketing efforts in the second quarter of fiscal 2006. In addition, there was an increase in sales commission resulting from the signing of new contracts in the third and fourth quarters of fiscal 2006 and an increase in marketing expenses related to a sales conference during the third quarter of fiscal 2006.

 

The software products and strategic consulting segments both have dedicated sales and marketing resources, as well as a shared pool of sales and marketing resources which are allocated to the segments based on each segment’s revenue as a relative percentage of total revenues. Inter-segment sales costs related to the shared pool of resources are estimated by management and used to compensate or charge each segment for such shared costs, and to incent shared efforts. Management will continually evaluate the alignment of sales and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.

 

Software Products Segment

 

Sales and marketing expenses for the Software Products segment were $3.3 million in fiscal 2006 compared to $2.5 million in fiscal 2005. The increase in sales and marketing expense in absolute dollars in the fiscal 2006 was primarily due to an increase in payroll and payroll related costs, which includes employment placement fees associated with the hiring of new executives in first quarter of fiscal 2006, additional employees hired in the second quarter of fiscal 2006, a new employee hired as software trainer to service clients in the third quarter of fiscal 2006, increased commission expenses and marketing expenses related to the sales conference that took place in the third quarter of fiscal 2006. The increase in sales and marketing expenses as a percentage of revenue was also a result of higher growth in expenses relative to the growth in revenue.

 

Strategic Consulting Segment

 

Sales and marketing expenses for the Strategic Consulting segment were $2.3 million in fiscal 2006 compared to $1.5 million in fiscal 2005. The increase in absolute dollars and as a percentage of revenue was primarily due to the result of an increase in payroll and payroll related expenses of $800,000 resulted from hiring two new executives hired in the first quarter of fiscal 2006 and two new sales personnel hired in second and third quarter of fiscal 2006. The increase in expense was also due to $29,000 related to the inside sales conference that took place in the third quarter of fiscal 2006.

 

General and Administrative

 

General and administrative expenses consist primarily of personnel costs of executive officers and support personnel, facilities, investor relations, legal and accounting fees.

 

Total General and Administrative Expenses

 

General and administrative expenses were $5.3 million in fiscal 2006 compared to $4.9 million in fiscal 2005. The increase during fiscal 2006 as compared to fiscal 2005 was primarily the result of an increase of approximately $368,000 due to an increase in depreciation related expense associated with the implementation of a new ERP system, additional facility-related expenses associated with moving to new facilities, a $202,000 increase in investor relations costs and a $279,000 increase in consultant fees, offset by a decrease of approximately $140,000 in bad debt expense and a decrease of approximately $353,000 in legal fees and employee benefits. General and administrative expenses not specifically associated with corporate initiatives are allocated based on each segment’s revenues as a relative percentage of total revenues. In fiscal 2006, $19,000 of general and administrative expenses were associated with corporate initiatives and not allocated to the segments, compared to $115,000 in fiscal 2005.

 

37


Table of Contents

Software Products Segment

 

General and administrative expenses for the Software Products segment were $3.0 million in fiscal 2006 compared to $2.5 million in fiscal 2005. The increase in general and administrative expense in absolute dollars in fiscal 2006 was primarily the result of an increase in professional service fees and other general business expenses, such as insurance, and an increase in the allocation of facility-related expenses. General and administrative costs for the Software Product segment also increased as the result of a higher relative percentage of Software Product segment revenues to total revenue. The increase in general and administrative expenses as a percentage of revenue was also a result of higher growth in expense relative to the growth in revenue.

 

Strategic Consulting Segment

 

General and administrative expenses for the Strategic Consulting segment were $2.2 million in fiscal 2006 compared to $2.3 million in fiscal 2005. The decrease in general and administrative expense in fiscal 2006 was primarily the result of a decrease in the allocation of general and administrative costs to the Strategic Consulting segment as the result of a lower relative percentage of Strategic Consulting segment revenues to total revenues, as well as lower professional fees related to international entities.

 

Year Ended March 31, 2005 and 2004

 

Research and Development

 

Software Products Segment

 

Research and development expenses did not change significantly in absolute dollars in fiscal 2005, as compared to fiscal 2004. The decrease as a percentage of total revenues for fiscal 2005 is primarily due to an increase in total revenue, while we continued our cost containment efforts.

 

Strategic Consulting Segment

 

The Strategic Consulting segment does not engage in research and development activities, nor is any such expense allocable to the segment, therefore it does not incur research and development related expenses.

 

Sales and Marketing

 

Total Sales and Marketing Expenses

 

Sales and marketing expenses did not change significantly in absolute dollars in fiscal 2005, as compared to fiscal 2004. Sales and marketing expenses as a percentage of revenues for fiscal 2005 decreased as a result of our ongoing cost containment efforts while revenues have increased. The Software Products and Strategic Consulting segments both have dedicated sales and marketing resources, as well as a shared pool of sales and marketing resources which are allocated to the segments based on each segment’s revenue as a relative percentage of total revenues. Inter-segment sales costs related to the shared pool of resources are estimated by management and used to compensate or charge each segment for such shared costs, and to incent shared efforts. Management will continually evaluate the alignment of sales and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.

 

Software Products Segment

 

Sales and marketing expenses for the Software Products segment were $2.5 million in fiscal 2005, compared to $2.2 million in fiscal 2004. The increase in sales and marketing expense in absolute dollars in fiscal 2005, as compared to fiscal 2004 was primarily the result of approximately $176,000 in payroll and payroll related expenses and $317,000 in the internal allocation of costs, partially offset by a reduction in facilities-related costs of approximately $207,000. The decrease in sales and marketing expenses as a percentage of revenue during fiscal 2005, as compared to fiscal 2004, was related to an increase in total revenue, while we continued our cost containment efforts.

 

38


Table of Contents

Strategic Consulting Segment

 

Sales and marketing expenses for the Strategic Consulting segment were $1.5 million in fiscal 2005, compared to $1.8 million in fiscal 2004. The decrease in expense in absolute dollars was primarily the result of a decrease in the total pool of sales and marketing expenses allocable to the Strategic Consulting segment.

 

General and Administrative

 

Total General and Administrative Expenses

 

General and administrative expenses were $4.9 million in fiscal 2005 compared to $4.6 million in fiscal 2004. The increase in absolute dollars during fiscal 2005 as compared to fiscal 2004, was primarily the result of an increase of approximately $249,000 in professional service fees, $213,000 in payroll and payroll related expenses and $140,000 in bad debt expense, offset by a decrease of approximately $176,000 in consulting expense and $143,000 in business insurance expense. General and administrative expenses decreased as a percentage of revenues compared to the same periods in fiscal 2004 as a result of our ongoing cost containment efforts in comparison to revenue growth. General and administrative expenses not specifically associated with corporate initiatives are allocated based on each segment’s revenues as a relative percentage of total revenues. In fiscal 2005, $115,000 of general and administrative expenses were associated with corporate initiatives and not allocated to the segments, compared to $72,000 in fiscal 2004.

 

Software Products Segment

 

General and administrative expenses for the Software Products segment were $2.5 million in fiscal 2005 compared to $2.4 million in fiscal 2004. The increase in general and administrative expense in absolute dollars in fiscal 2005 was primarily the result of professional service fees related to international entities. The allocable costs did not change significantly in absolute dollars or as a percentage mix of revenue for fiscal 2005 compared to fiscal 2004.

 

Strategic Consulting Segment

 

General and administrative expenses for the Strategic Consulting segment were $2.3 million in fiscal 2005 compared to $2.1 million in fiscal 2004. The decrease in general and administrative expense in absolute dollars in fiscal 2005 was primarily the result of a decrease in the allocation of general and administrative costs to the Strategic Consulting segment as the result of a lower relative percentage of Strategic Consulting segment revenues to total revenues, as well as lower professional fees related to international entities. The allocable costs did not change significantly in absolute dollars or as a percentage mix of revenue for fiscal 2006 compared to fiscal 2005.

 

Other Income (Expense), Net

 

Other income, net of expense, was $16,000 in fiscal 2006. Other expense, net of income, was $125,000 and $180,000 in fiscal 2005 and fiscal 2004, respectively. The increase in other income occurred primarily as a result of a higher interest income on a higher average cash balance in fiscal 2006.

 

Other income (expense), net, was $125,000 in fiscal 2005 compared to $180,000 in fiscal 2004. The decrease occurred primarily as a result of lower interest expense related to a lower outstanding balance on our term loan partially offset by higher interest income on a higher average cash balance in fiscal 2005. We paid off the outstanding balance of our obligations under capital leases in fiscal 2005.

 

Provision for Income Taxes

 

     Years ended

     2006

   2005

   2004

Provision for income taxes

   $ 68    $ 133    $ 81

 

39


Table of Contents

We recorded income tax provisions of $68,000 and $133,000 for fiscal 2006 and fiscal 2005, respectively, which were attributable to federal and state alternative minimum taxes, other state taxes and foreign income tax. The amounts provided were at rates less than the combined U.S. federal and state statutory rates due to the recognition of federal and state net operating loss carry forwards. As of March 31, 2006, we had federal and state net operating loss carryforwards of $24.8 million and $9.4 million respectively, which begin to expire in the years 2006 through 2024, if not utilized. We have recorded a valuation allowance against the entire net operating loss carry-forwards because of the uncertainty that we will be able to realize the benefit of the net operating loss carry-forwards before they expire. We have federal and state research and development tax credit carry-forwards of approximately $367,000 and $505,000, respectively. The federal research and development credits begin to expire in 2011 through 2024, and the state credits can be carried forward indefinitely.

 

Under the Tax Reform Act of 1986, the amounts of and benefits from net operating loss carryforwards and credit carryforwards may be impaired or limited in certain circumstances. Events which may restrict utilization of a company’s net operating loss and credit carryforwards include, but are not limited to, certain ownership change limitations as defined in Internal Revenue Code Section 382 and similar state provisions. In the year ended March 31, 2005, we completed a review of our historical ownership percentages and concluded that several ownership changes as defined in Internal Revenue Code Section 382 occurred in prior years. As a result of these ownership changes, our ability to utilize carryforwards may be restricted to an annual limitation. This annual limitation could result in the expiration of net operating loss carryforwards and credit carryforwards before utilization. Accordingly, we reduced our deferred tax assets and valuation allowance reported in our consolidated financial statements in the year ended March 31, 2005. We will continue to monitor changes in tax law and rulings from the Internal Revenue Service that may impact the annual limitation placed on our tax attribute carryforwards.

 

Off-Balance Sheet Arrangements

 

As of March 31, 2006, we did not have any off-balance sheet arrangements.

 

Liquidity and Capital Resources

 

From our inception through the initial public offering of our common stock, we funded operations through the private sale of preferred stock, with net proceeds of approximately $38 million, limited borrowings and equipment leases. In August 2000, we completed our initial public offering of 3,000,000 shares of common stock, at a price of $10.00 per share, all of which were issued and sold by us for net proceeds of $26.4 million, net of underwriting discounts and commissions of $2.1 million and expenses of $1.5 million. We paid $6.1 million to holders of our Series C preferred stock at the closing of the offering as required by the terms of the Series C preferred stock. After this payment, our net proceeds were $20.3 million. In June and September of fiscal 2003, we completed a private placement of preferred stock to several of our investors, raising additional net proceeds of $7.2 million, as further described below.

 

Summarized cash, working capital and cash flow information is as follows (dollars in thousands):

 

     Years Ended March 31,

    Percentage of
Dollar Change
Year Over
Year


 
           2006    

        2005      

    2006/2005

 

Cash and cash equivalents

   $ 10,832     $ 10,579     2 %
    


 


     

Working capital

   $ 2,610     $ 3,332     (22 )%
    


 


     

Cash flows from operating activities

   $ 2,894     $ 1,984     46 %
    


 


     

Cash flows from investing activities

   $ (1,982 )   $ (449 )   (341 )%
    


 


     

Cash flows from financing activities

   $ (669 )   $ (962 )   30 %
    


 


     

 

40


Table of Contents

Cash and Cash Equivalents. As of March 31, 2006, our cash and cash equivalents consisted primarily of demand deposits and money market funds. The increase in our cash and cash equivalents in fiscal 2006 was primarily due to cash provided from $2.9 million from operating activities, offset by $1.9 million decrease in cash from investing activities as well as $669,000 decrease in financing activities. In fiscal 2006, our revenue was relatively consistent compared with fiscal 2005, yet we have been able to also keep operating costs relatively consistent with fiscal 2005 during fiscal 2006, which resulted in the overall cash increase. Our working capital, defined as current assets less current liabilities, decreased primarily due to a combination of increase in accrued compensation and deferred revenue.

 

Cash Flows From Operating Activities. Cash flows provided by operating activities increased in fiscal 2006, compared to fiscal 2005, is primarily due to decreases in accounts receivable, prepaids, other assets, accounts payable, and increases in accrued expenses and compensation and deferred revenue.

 

Cash Flows From Investing Activities. Cash flows used in investing activities during fiscal 2006 primarily related to moving to a new corporate headquarters and investment in a new financial system that we began implementing and paying starting the fourth quarter of fiscal 2005 until the first quarter of 2006. We used approximately $550,000 of cash in connection with improvements made to our new corporate headquarters, which was offset by approximately $368,000 in tenant improvement credits received from the landlord. The reimbursement of tenant improvements is classified as deferred rent incentives, which is included as part of accrued liabilities. Cash flows used in investing in fiscal 2006 was related to purchases of capital equipment necessary for our ongoing operations, including computers, computer server equipments, and furniture related to the relocation of the Cary, North Carolina office in the first quarter of fiscal 2006 and the relocation of the Mountain View, California headquarters in the second quarter of fiscal 2006. There was also additional data storage purchased for both the Mountain View headquarters and the Cary office in the third quarter of fiscal 2006.

 

Cash Flows From Financing Activities. Cash flows used in financing activities were primarily a result of payments against our outstanding loan facilities with Silicon Valley Bank and payments of dividends to our preferred stockholders. Cash flows provided by financing activities were from the loan proceeds of $600,000 received in the second quarter of fiscal 2006.

 

Credit Facilities. We have a secured term loan outstanding, payable over 48 months, with monthly payments having commenced in July 2002. The balance on the term loan as of March 31, 2006 was $219,000 due May 2006. In February 2005, we secured an additional $300,000 term loan for the purchase of a new financial system. The $300,000 term loan is payable over 36 months. The balance outstanding on this term loan as of March 31, 2006 was $192,000. In addition, we secured an equipment credit facility through June 2006 for up to $600,000. Each advance will be payable over 36 months. As of March 31, 2006, the current balance on this equipment credit facility was $500,000.

 

In December 2005, we extended our credit facilities with Silicon Valley Bank, providing for up to $3.0 million in borrowings, secured against 80% of eligible domestic accounts receivable. The current balance of this credit facility is $1.0 million as of March 31, 2006.

 

The following financial covenants apply to the Silicon Valley Bank loan facilities: net loss no greater than $200,000 in the first quarter of fiscal 2006; net income of at least $1.00 in the remaining three quarters of fiscal 2006; and a minimum modified quick ratio (defined as cash and cash equivalents plus accounts receivable, divided by total current liabilities, including all bank debt and not including deferred revenue) of 2:1 for the months of December 2004 and each month thereafter. We were in compliance with each of these covenants as of December 31, 2005. As of March 31, 2006, the company was in violation of its quarterly profitability covenant, to which the company received a waiver of compliance. Interest on our revolving lines of credit is accrued at 0.5% above prime and is payable monthly from the date of borrowing. Interest on our term loans is accrued at 1.25% above prime and is payable monthly from the date of borrowing. Certain of our assets, excluding intellectual property, secure both facilities.

 

41


Table of Contents

Preferred Stock Financing. On June 26, 2002 and September 11, 2002, we completed private placements of our securities to certain entities affiliated with Alloy Ventures, Inc. and the Sprout Group, both of which were among our existing stockholders, pursuant to a Preferred Stock and Warrant Purchase Agreement (the “Purchase Agreement”). Pursuant to the Purchase Agreement, we sold an aggregate of 1,814,662 units (each a “Unit,” and collectively the “Units”). Each Unit consisted of one share of our Series A redeemable convertible preferred stock (the “Series A Preferred”) and a warrant to purchase one share of our common stock. The purchase price for each Unit was $4.133, which is the sum of $4.008 (four times the underlying average closing price of $1.002 for our common stock over the five trading days prior to the initial closing (i.e., $1.002)) and $0.125 for each share of Series A Preferred and warrant, respectively. The Second Closing, which occurred on September 11, 2002, was subject to stockholder approval, which was obtained on September 6, 2002.

 

The Series A Preferred is redeemable at any time after five years from the date of issuance upon the affirmative vote of at least 75% of the holders of Series A Preferred, at a price of $4.008 per share plus any unpaid dividends. Each share of Series A Preferred is convertible into four shares of our common stock at the election of the holder or upon the occurrence of certain other events. The holders of Series A Preferred are entitled to receive, but only out of legally available funds, quarterly cumulative dividends at the rate of 8% per year commencing in September 2002, which are payable in cash or shares of Series B redeemable convertible preferred stock (the “Series B Preferred” and, together with the Series A Preferred, the “Preferred Stock”), at the election of the holder. The terms of the Series B Preferred are identical to the Series A Preferred, except that the Series B Preferred is not entitled to receive the 8% dividends. In the event of any liquidation or winding up of the company, the holders of the Series A Preferred and Series B Preferred shall be entitled to receive in preference to the holders of the common stock a per share amount equal to the greater of (a) the original issue price, plus any accrued but unpaid dividends and (b) the amount that such shares would receive if converted to common stock immediately prior thereto (the “Liquidation Preference”). After the payment of the Liquidation Preference to the holders of Preferred Stock, the remaining assets shall be distributed ratably to the holders of the common stock. A merger, acquisition, sale of voting control of the company in which our stockholders do not own a majority of the outstanding shares of the surviving corporation, or a sale of all or substantially all of our assets, shall be deemed to be a liquidation.

 

The holders of Series A Preferred and Series B Preferred are entitled to vote together with the common stock. Each share of Preferred Stock has a number of votes equal to the number of shares of common stock then issuable upon conversion of such share of Preferred Stock. In addition, consent of the holders of at least 75% of the then outstanding Preferred Stock is required for certain actions, including any action that amends our charter documents so as to adversely affect the Preferred Stock.

 

The warrants are exercisable for a period of five years from issuance with an exercise price of $1.15 per share.

 

Pursuant to the Purchase Agreement, we filed a registration statement on Form S-3 (File No. 333-98095) for the resale of the shares of Common Stock issuable to the investors upon conversion of the shares of Preferred Stock and exercise of the warrants. The registration statement became effective on October 31, 2002. In the event that we fail to keep the Registration Statement effective (other than pursuant to the permissible suspension periods or waivers granted by the holders of the Preferred Stock), we are obligated to pay to the holders of Preferred Stock as liquidated damages, the amount of 1% per month of the aggregate purchase price for the shares remaining to be sold pursuant to the registration statement. The holders of the Preferred Stock waived the right to receive liquidated damages that resulted from the delayed date of effectiveness through November 30, 2002.

 

We did not file a Registration Statement covering the shares of Series B preferred stock to be issued as a dividend with respect to the Series A Preferred Stock, and therefore, the holders of Preferred Stock accrued additional liquidated damages following November 30, 2002. In February 2003, the holders of the Preferred Stock waived the right to receive the foregoing liquidated damages.

 

42


Table of Contents

In May 2003, the holders of the Preferred Stock waived the requirement that we file a post-effective amendment on Form S-1 in the event that we are no longer eligible to use Form S-3. The holders of Preferred Stock also waived the right to receive liquidated damages as a result of the failure to file a post-effective amendment on Form S-1. Notwithstanding the foregoing, the holders of Preferred Stock are entitled to terminate the May 2003 waivers and, as a result, require us to file a post-effective amendment on Form S-1 within thirty (30) days from the our receipt of such waiver termination and to cause such post-effective amendment to become effective within ninety (90) days from receipt of such waiver termination, or otherwise incur liquidated damages under the terms of the Purchase Agreement. On June 10, 2003, the Registration Statement ceased to be available for resale of the shares registered thereunder.

 

The Series A Preferred Stock is entitled to receive an annual dividend of 8% payable quarterly in cash or shares of Series B Preferred Stock, at the election of the holder of the Series A Preferred Stock. The Series B Preferred Stock has identical rights, preferences and privileges to the Series A Preferred Stock except that the Series B Preferred Stock is not entitled to 8% dividends. These quarterly dividends commenced in September 2002. During fiscal 2006, we paid $363,000 in cash dividends to the Series A Preferred stockholders and we recorded an additional $48,000 in accrued dividends payable as of March 31, 2006. On June 1, 2004 (the “Valuation Date”), at the election of a Series A Preferred stockholder, instead of cash we issued a dividend in the form of 18,142 shares of Series B Preferred Stock to a Series A Preferred stockholder. During fiscal 2006, the Company also issued dividends in the form of 54,426 shares, of Series B Preferred Stock to its Series A holders, at the election of the Series A holders. The Series B Preferred has identical rights, preferences and privileges as the Series A Preferred, except that the Series B Preferred is not entitled to the dividend payment right. Due to the nature of the redemption features of the Series B Preferred, the Company has excluded the Series B Preferred from stockholders’ equity in its financial statements.

 

Contractual Commitments. During fiscal 2006, we recorded rent expense related to these arrangements of $513,000.

 

The following is a summary of our contractual commitments associated with our debt and lease obligations as of March 31, 2006 (in thousands):

 

     Payments Due by Period

Contractual Obligations


   Total

  

Less Than 1

Year


   1-3 Years

   3-5 Years

  

More Than 5

Years


Redeemable convertible preferred stock (1)

   $ 727    $ 582    $ 145    $ —      $ —  

Notes payable

     1,911      1,519      392      —        —  

Operating leases

     2,172      422      900      830      20
    

  

  

  

  

Total commitments

   $ 4,810    $ 2,523    $ 1,437    $ 830    $ 20
    

  

  

  

  


(1) The holders of the preferred stock may elect to have us redeem the preferred stock immediately after it becomes redeemable in June 2007. However, if this does not occur then we will continue to pay dividends in the aggregate amount of approximately $582,000 per year. Further, the terms of the preferred stock provide that it will automatically convert to common stock in the event of a public offering meeting certain minimum conditions, and if this were to occur, our obligation to pay dividends or redeem the preferred stock would cease at that time. Any of these outcomes cannot be readily determined. The amounts presented in the table above reflect only our contractual obligations related to dividend payments to the holders of the preferred stock up to June 2007, at which point the stock may or may not redeem. We also refer the reader to the discussion of the redeemable convertible preferred stock in Note 8 of the Notes to Consolidated Financial Statements.

 

Short Term and Long Term Liquidity. We believe that the combination of our cash and cash equivalents and currently anticipated cash flow from operations should be adequate to sustain operations through the next 12 months. We are managing the business to achieve positive cash flow utilizing existing assets. Although operating

 

43


Table of Contents

expenses have increased, which is consistent with the growth of the Company over the past several fiscal years, we generated positive operating cash flow for fiscal 2006 and 2005. There is no assurance that we can continue to maintain positive cash flow. We are committed to the successful execution of our operating plan and we will take continued actions as necessary to ensure our cash resources are sufficient to fund our working capital requirements at least through fiscal 2007.

 

Our long-term liquidity and capital requirements will depend on numerous factors including our future revenues and expenses, growth or contraction of operations and general economic pressures. We may not be able to maintain our current market share, or continue to expand our business, without investing in our operations, technology, or product and service offerings. In order to do so, we may need to raise additional funds through public or private financings or other sources to fund our operations. However, our common stock is not listed on an exchange or the Nasdaq National Market, and until it is listed it will be difficult for us to make sales of our equity stock. In addition, the terms of our preferred stock may prevent us from issuing additional shares of preferred stock on terms that investors would require in order to invest in our preferred stock. The necessity of raising additional funds could require us to incur debt on terms that could restrict our ability to make capital expenditures and incur additional indebtedness. As a result, we may not be able to obtain additional funds on commercially reasonable terms, or at all. In addition, beginning in June 2007, the holders of our preferred stock can force us to redeem the shares of our preferred stock, and if we were required to redeem all of the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $7.7 million.

 

Impact of Inflation

 

The effects of inflation and changing prices on our operations were not significant during the periods presented.

 

SFAS 123R

 

On December 16, 2004, the Financial Accounting Standards Board, or FASB issued Statement of Accounting Standards No. 123R, “Share-Based Payment”, or SFAS 123R, which is a revision of Statement of Accounting Standards No. 123, “Accounting for Stock-Based Compensation”. SFAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends Statement of Accounting Standards No. 95, “Statement of Cash Flows”. SFAS 123R requires all companies to measure compensation expense for all share-based payments (including employee stock options and options issued pursuant to employee stock purchase plans) based upon the fair value of the stock-based awards at the date of grant. SFAS 123R is effective for all public companies for annual periods beginning after June 15, 2005 – April 1, 2006 for Pharsight.

 

We will adopt SFAS 123R under the modified-prospective method. As permitted by SFAS 123R, we currently account for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123R’s fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123R cannot be predicted at this time because it will depend on, among other things, levels of share-based payments granted in the future.

 

44


Table of Contents

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

 

We have considered the provisions of Financial Reporting Release No. 48, “Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments, and Disclosure of Quantitative and Qualitative Information about Market Risk Inherent In Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments.” We have no holdings of derivative financial or commodity-based instruments at March 31, 2006.

 

At March 31, 2006, we performed sensitivity analyses to assess the potential effect of these risks and concluded that near-term changes in interest rates and foreign currency exchange rates would not materially affect our financial position, results of operations or cash flows.

 

We have operated primarily in the United States and all funding activities and sales have been denominated in U.S. dollars. Accordingly, we have no material exposure to foreign currency rate fluctuations.

 

Our interest income is sensitive to changes in the general level of United States interest rates. As of March 31, 2006, we did not hold any short-term investments and therefore we believe that there is no material market risk exposure. As of March 31, 2006, our cash and cash equivalents consisted primarily of demand deposits and money market funds.

 

45


Table of Contents

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Supplementary Data

 

The following tables set forth unaudited quarterly supplementary data for each of the years in the two-year period ended March 31, 2006.

 

     Quarter Ended

 
     June 30

    September 30

   December 31

   March 31

 
     (In thousands, except per share amounts)  

FISCAL 2006

                              

Revenues

   $ 5,694     $ 5,920    $ 5,757    $ 5,371  

Cost of revenues

     1,887       2,054      1,829      1,929  

Gross profit

     3,807       3,866      3,928      3,442  

Income (loss) from operations

     287       281      292      (278 )

Net income (loss) attributable to common stockholders

     109       49      84      (450 )

Net income (loss) per common share attributable to common stockholders, basic

   $ 0.01     $ 0.00    $ 0.00    $ (0.02 )

Net income (loss) per common share attributable to common stockholders, diluted

   $ 0.00     $ 0.00    $ 0.00    $ (0.02 )

FISCAL 2005

                              

Revenues

   $ 5,034     $ 5,072    $ 6,462    $ 6,025  

Cost of revenues

     1,844       1,814      1,948      2,155  

Gross profit

     3,190       3,258      4,514      3,870  

Income from operations

     134       487      1,490      880  

Net income (loss) attributable to common stockholders

     (81 )     276      1,266      662  

Net income per common share attributable to common stockholders, basic

   $ 0.00     $ 0.01    $ 0.07    $ 0.03  

Net income per common share attributable to common stockholders, diluted

   $ 0.00     $ 0.01    $ 0.05    $ 0.03  

 

46


Table of Contents

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Pharsight Corporation

    

Report of Ernst & Young LLP, Independent Registered Public Accounting Firm

   48

Consolidated Balance Sheets

   49

Consolidated Statements of Operations

   50

Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders’ Deficit

   51

Consolidated Statements of Cash Flows

   53

Notes to the Consolidated Financial Statements

   54

 

47


Table of Contents

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders

Pharsight Corporation

 

We have audited the accompanying consolidated balance sheets of Pharsight Corporation as of March 31, 2006 and 2005, and the related consolidated statements of operations, redeemable convertible preferred stock and stockholders’ equity (deficit), and cash flows for each of the three years in the period ended March 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pharsight Corporation at March 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended March 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

San Jose, California

May 5, 2006

except for Note 14, as to which the date is June 12, 2006

 

48


Table of Contents

PHARSIGHT CORPORATION

 

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

 

     March 31,

 
     2006

    2005

 
ASSETS                 

Current assets:

                

Cash and cash equivalents

   $ 10,832     $ 10,579  

Accounts receivable, net of allowance for doubtful accounts of $20 and $94 at March 31, 2006 and 2005, respectively

     4,585       4,809  

Prepaids and other current assets

     298       594  
    


 


Total current assets

     15,715       15,982  

Property and equipment, net

     2,025       604  

Other assets

     46       236  
    


 


Total assets

   $ 17,786     $ 16,822  
    


 


LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ DEFICIT                 

Current liabilities:

                

Accounts payable

   $ 794     $ 862  

Accrued expenses

     1,035       754  

Accrued compensation

     2,152       1,881  

Deferred revenue

     7,605       7,178  

Current portion of notes payable

     1,519       1,975  
    


 


Total current liabilities

     13,105       12,650  

Deferred revenue, long term portion

     54       126  

Notes payable, less current portion

     392       410  

Other long term liabilities

     253       —    

Redeemable convertible preferred stock, $0.001 par value:

                

Authorized shares—3,200,000 (2,000,000 designated as Series A and 1,200,000 designated as Series B) at March 31, 2006 and 2005

                

Issued and outstanding shares—1,923,511 and 1,869,085 at March 31, 2006 and 2005, respectively (1,814,662 designated as Series A at March 31, 2006 and 2005, 108,849 and 54,423 designated as Series B at March 31, 2006 and 2005, respectively)—Aggregate redemption and liquidation value—$7,709

     6,641       6,266  

Commitments and contingencies

     —         —    

Stockholders’ deficit:

                

Preferred stock, $0.001 par value:

                

Authorized shares—1,800,000 at March 31, 2006 and 2005

                

Issued and outstanding shares—none at March 31, 2006 and 2005

                

Common stock, $0.001 par value:

                

Authorized shares—120,000,000 at March 31, 2006 and 2005

                

Issued and outstanding shares—19,594,684 and 19,332,939 at March 31, 2006 and 2005, respectively

     19       19  

Additional paid-in capital

     73,790       74,360  

Accumulated other comprehensive loss

     (13 )     (24 )

Accumulated deficit

     (76,455 )     (76,985 )
    


 


Total stockholders’ deficit

     (2,659 )     (2,630 )
    


 


Total liabilities, redeemable convertible preferred stock, and stockholders’ deficit

   $ 17,786     $ 16,822  
    


 


 

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

 

49


Table of Contents

PHARSIGHT CORPORATION

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

 

     Years Ended March 31,

 
     2006

    2005

    2004

 

Revenues:

                        

License

   $ 4,864     $ 4,874     $ 3,833  

Renewal

     4,928       4,618       4,183  

Maintenance

     977       298       129  

Services

     11,973       12,803       9,585  
    


 


 


Total revenues

     22,742       22,593       17,730  

Costs of revenues

                        

License, renewal, maintenance

     295       379       759  

Services

     7,404       7,382       7,034  
    


 


 


Total costs of revenues

     7,699       7,761       7,793  
    


 


 


Gross profit

     15,043       14,832       9,937  

Operating expenses:

                        

Research and development

     3,497       2,932       2,899  

Sales and marketing

     5,638       3,983       3,986  

General and administrative

     5,326       4,926       4,590  

Amortization of deferred stock compensation

     —         —         198  
    


 


 


Total operating expenses

     14,461       11,841       11,673  
    


 


 


Income (loss) from operations

     582       2,991       (1,736 )

Other income (expense):

                        

Interest income

     255       59       38  

Interest expense

     (167 )     (150 )     (202 )

Other expense

     (72 )     (34 )     (16 )
    


 


 


Total other income (expense)

     16       (125 )     (180 )
    


 


 


Income (loss) before income taxes

     598       2,866       (1,916 )

Provision for income taxes

     (68 )     (133 )     (81 )
    


 


 


Net income (loss)

     530       2,733       (1,997 )

Preferred stock dividends

     (738 )     (610 )     (654 )

Deemed dividend to preferred stockholders

     —         —         (339 )
    


 


 


Net income (loss) attributable to common stockholders

   $ (208 )   $ 2,123     $ (2,990 )
    


 


 


Earnings per share attributable to common stockholders:

                        

Basic

   $ (0.01 )   $ 0.11     $ (0.16 )
    


 


 


Diluted

   $ (0.01 )   $ 0.10     $ (0.16 )
    


 


 


Shares used to compute earnings per share attributable to common stockholders:

                        

Basic

     19,421       19,122       19,051  
    


 


 


Diluted

     19,421       28,509       19,051  
    


 


 


 

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

 

50


Table of Contents

PHARSIGHT CORPORATION

 

CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK

AND STOCKHOLDERS’ DEFICIT

(In thousands)

 

     Redeemable
Convertible
Preferred Stock


    Common Stock

   Additional
Paid-In
Capital


    Deferred
Stock
Compensation


    Accumulated
Other
Compre-
hensive
Income (Loss)


   Notes
Receivable
from
Stockholders


   Accumu-
lated
Deficit


    Total

 
   Shares

   Amount

    Shares

   Amount

              

Balance at March 31, 2003

   1,815    $ 5,608     19,053    $ 19    75,927     $ (352 )   $ —      —      $ (77,721 )   $ (2,127 )
    
  


 
  

  

 


 

  
  


 


Issuance of common stock under employee benefit plans, net of repurchases

   —        —       5      —      4       —         —      —        —         4  

Issuance of Series B redeemable convertible preferred stock

   36      217     —        —      (217 )     —         —      —        —         (217 )

Deemed dividend to Series A redeemable convertible preferred stockholders

   —        339     —        —      (339 )     —         —      —        —         (339 )

Accrued dividends on Series A redeemable convertible preferred stock

   —        —       —        —      (437 )     —         —      —        —         (437 )

Amortization of deferred stock compensation

   —        —       —        —      —         198       —      —        —         198  

Reversal of deferred stock compensation upon cancellation of unvested options

   —        —       —        —      (154 )     154       —      —        —         —    

Net loss and comprehensive loss

   —        —       —        —      —         —         —      —        (1,997 )     (1,997 )
    
  


 
  

  

 


 

  
  


 


Balance at March 31, 2004

   1,851    $ 6,164         19,058    $ 19    74,784     $ —       $ —      —      $ (79,718 )   $ (4,915 )
    
  


 
  

  

 


 

  
  


 


 

51


Table of Contents

PHARSIGHT CORPORATION

 

CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK

AND STOCKHOLDERS’ EQUITY (DEFICIT) (Continued)

(In thousands)

 

     Redeemable
Convertible
Preferred Stock


    Common Stock

   Additional
Paid-In
Capital


    Deferred
Stock
Compensation


   Accumulated
Other
Compre-
hensive
Income (Loss)


    Notes
Receivable
from
Stockholders


   Accumu-
lated
Deficit


    Total

 
   Shares

   Amount

    Shares

   Amount

              

Balance at March 31, 2004

   1,851    $ 6,164        19,058    $ 19    $ 74,784       —        —       —      $ (79,718 )   $ (4,915 )
    
  


 
  

  


 

  


 
  


 


Issuance of common stock under employee benefit plans, net of repurchases

   —        —       275      —        186       —        —       —        —         186  

Issuance of Series B redeemable convertible preferred stock

   18      102     —        —        (102 )     —        —       —        —         (102 )

Accrued dividends on Series A redeemable convertible preferred stock

   —        —       —        —        (508 )     —        —       —        —         (508 )

Comprehensive income:

                                                                     

Unrealized loss on foreign currency exchange

   —        —       —        —        —         —        (24 )   —        —         (24 )

Net income

   —        —       —        —        —         —        —       —        2,733       2,733  

Total comprehensive income

                                                                  2,709  
    
  


 
  

  


 

  


 
  


 


Balance at March 31, 2005

   1,869    $ 6,266     19,333    $ 19    $ 74,360     $ —      $ (24 )   —      $ (76,985 )   $ (2,630 )
    
  


 
  

  


 

  


 
  


 


Issuance of common stock under employee benefit plans, net of repurchases

   —        —       262      —        168       —        —       —        —         168  

Issuance of Series B redeemable convertible preferred stock

   54      375     —        —        (375 )     —        —       —        —         (375 )

Accrued dividends on Series A redeemable convertible preferred stock

   —        —       —        —        (363 )     —        —       —        —         (363 )

Comprehensive income:

                                                                     

Unrealized gain on foreign currency exchange

   —        —       —        —        —         —        11     —        —         11  

Net income

   —        —       —        —        —         —        —       —        530       530  

Total comprehensive income

                                                                  541  
    
  


 
  

  


 

  


 
  


 


Balance at March 31, 2006

   1,923    $ 6,641     19,595    $ 19    $ 73,790     $ —      $ (13 )   —      $ (76,455 )   $ (2,659 )
    
  


 
  

  


 

  


 
  


 


 

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

 

52


Table of Contents

PHARSIGHT CORPORATION

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 

     Years Ended March 31,

 
     2006

    2005

    2004

 

Cash Flows From Operating Activities:

                        

Net income (loss)

   $ 530     $ 2,733     $ (1,997 )

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

                        

Amortization of deferred stock compensation

     —         —         198  

Depreciation and amortization

     561       338       919  

Changes in operating assets and liabilities:

                        

Accounts receivable, net

     224       (1,039 )     (1,659 )

Unbilled accounts receivable

     —         50       142  

Prepaids and other current assets

     486       122       305  

Other assets

     —         —         (38 )

Accounts payable

     (68 )     455       (228 )

Accrued expenses and other long term liabilities

     535       232       (564 )

Accrued compensation

     271       292       391  

Deferred revenue

     355       (1,199 )     3,523  
    


 


 


Net cash provided by operating activities

     2,894       1,984       992  

Cash Flows From Investing Activities:

                        

Purchases of property and equipment

     (1,982 )     (449 )     (237 )
    


 


 


Net cash used in investing activities

     (1,982 )     (449 )     (237 )

Cash Flows From Financing Activities:

                        

Proceeds from issuance of notes payable

     600       300       —    

Principal payments on notes payable

     (1,075 )     (884 )     (875 )

Principal payments on capital lease obligations

     —         (55 )     (295 )

Proceeds from the issuance of common stock

     169       185       4  

Dividends paid to preferred stockholders

     (363 )     (508 )     (437 )
    


 


 


Net cash used in financing activities

     (669 )     (962 )     (1,603 )
    


 


 


Effect of exchange rate changes on cash and cash equivalents

     10       (21 )     —    
    


 


 


Net increase (decrease) in cash and cash equivalents

     253       552       (848 )

Cash and cash equivalents at the beginning of the year

     10,579       10,027       10,875  
    


 


 


Cash and cash equivalents at the end of the year

   $ 10,832     $ 10,579     $ 10,027  
    


 


 


Supplemental disclosures of non cash activities

                        

Reversal of deferred stock compensation upon cancellation of unvested stock options

   $ —       $ —       $ 154  
    


 


 


Amortization of deemed dividend to preferred stockholders

   $ —       $ —       $ 339  
    


 


 


Issuance of dividend to preferred stockholders in form of stock

   $ 375     $ 102     $ 217  
    


 


 


Accrued preferred stock dividend

   $ 48     $ 48     $ 48  
    


 


 


Supplemental disclosure of cash flow information

                        

Cash paid for interest

   $ 167     $ 150     $ 202  
    


 


 


Cash paid for income taxes

   $ 146     $ 41     $ 152  
    


 


 


 

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

 

53


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

 

1. Description of Business

 

Pharsight Corporation (“Pharsight” or the “Company”) develops and markets software and provides strategic consulting services that help pharmaceutical and biotechnology companies improve the efficiency of the drug development decision making process, by reducing the costs and time requirements of their drug discovery, development, and commercialization efforts. Pharsight’s products include proprietary software for clinical trial simulation and computer-aided trial design, for the statistical analysis and mathematical modeling of data, and for the storage, management, and regulatory reporting of derived data and models in data repositories. The Company’s software products and services leverage expertise in the sciences of pharmacology, drug and disease modeling, human genetics, biostatistics and strategic decision-making. Pharsight Corporation was incorporated in California in April 1995 and reincorporated in Delaware in June 2000.

 

Pharsight operates in two operating segments, which are also its reportable segments: Software Products and Strategic Consulting. These segments were determined based on how management and the Company’s Chief Operating Decision Maker, CODM, who is the Company’s chief executive officer, view and evaluate the business.

 

2. Summary of Significant Accounting Policies

 

Basis of Consolidation

 

The consolidated financial statements include the accounts of Pharsight and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated.

 

Use of Estimates

 

Pharsight’s financial statements are prepared in accordance with U.S. generally accepted accounting principles, or GAAP. These accounting principles require the Company to make certain estimates, judgments and assumptions. The Company believes that the estimates, judgments and assumptions upon which they rely are reasonable based upon information available to them at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, the Company’s financial statements will be affected.

 

Cash and Cash Equivalents

 

Cash and cash equivalents are comprised of highly liquid financial instruments consisting primarily of investments in money market funds, commercial paper, corporate notes and obligations issued by or fully collateralized by the U.S. government or federal agencies with insignificant interest rate risk and with original maturities of three months or less at the time of acquisition.

 

Fair Value of Financial Instruments

 

The carrying values of Pharsight’s cash and cash equivalents, accounts receivable and payable, and accrued liabilities approximate their fair values due to their short-term nature. The fair values of notes payable are estimated based on current interest rates available to Pharsight for debt instruments with similar terms, degrees of risk, and remaining maturities. The carrying values of these obligations approximate their respective fair values.

 

54


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Foreign Currency Translation

 

For foreign subsidiaries using the local currency as their functional currency, assets and liabilities are translated at exchange rates in effect at the balance sheet date and income and expenses are translated at average exchange rates. The effects of these translation adjustments are reported as a separate component of stockholders’ equity. Remeasurement adjustments for non-functional currency monetary assets and liabilities are included in other income (expense) in the accompanying consolidated statements of operations.

 

Allowance for Doubtful Accounts

 

We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than the full payment on our currently outstanding receivables. We make judgments as to our ability to collect receivables and provide allowances for the portion of receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding invoices. In determining our allowances, we analyze our historical collection experience and current economic trends. The Company reduced its allowance for doubtful accounts during the year ended March 31, 2006 by $37,000 through a reduction in sales and marketing expense due to management’s change in estimate of those accounts receivable at risk of not being collected and $37,000 in write offs.

 

Property and Equipment

 

Property and equipment are carried at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of three to five years. Property under capital leases is amortized over the lesser of the useful lives of the assets or the lease term. Amortization expense related to these assets is included in depreciation expense.

 

Internal Use Software

 

Pharsight accounts for internal use software costs, in accordance with Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” (“SOP 98-1”). In accordance with SOP 98-1, Pharsight capitalizes costs to develop software for internal use when preliminary development efforts are successfully completed and management has authorized and committed project funding and it is probable that the project will be completed and the software will be used as intended. Costs incurred prior to meeting these criteria, together with costs incurred for training and maintenance, are expensed. Costs incurred for upgrades and enhancements that are probable to result in additional functionality are also capitalized. All capitalized costs are included in property, plant and equipment and are amortized to expense over their expected useful lives.

 

Income Taxes

 

Pharsight accounts for income taxes under the liability method whereby deferred tax asset or liability account balances are calculated at the balance sheet date using current tax laws and rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

 

Revenue Recognition

 

Our revenues are derived from two primary sources: (1) initial and renewal fees for term-based and perpetual product licenses, and post-contract customer support (PCS), and (2) services related to scientific and training consulting and software deployment.

 

55


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Our revenue recognition policy is in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” or SOP 97-2, as amended. For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, collection is probable, and no significant post-delivery obligations remain unfulfilled. If any of these criteria are not met, we defer revenue recognition until such time as all of the criteria are met. We do not currently offer, have not offered in the past, and do not expect to offer in the future, extended payment term arrangements. If we do not consider collectability to be probable, we defer recognition of revenue until the fee is collected.

 

We enter into arrangements for one-year software licenses (initial and renewal fees) bundled with post-contract support services, or PCS, from which we receive solely license and renewal fees. We do not have vendor specific objective evidence to allocate the fee to the separate elements, as we do not sell PCS separately. Therefore, we do not present PCS revenue separately, and we do not believe other allocation methodologies, namely allocation based on relative costs, provide a meaningful and supportable allocation between license and PCS revenues. We recognize each of the initial and renewal license fees ratably over the one-year period of the license during which the PCS is expected to be provided as required by paragraph 12 of SOP 97-2.

 

We enter into arrangements consisting of perpetual or one-year licenses, one-year PCS, implementation/installation services and optional scientific consulting services. We recognize revenue attributable to license, PCS and implementation/installation ratably over the remaining period of the PCS term once the implementation and installation services are completed and accepted by the customer. The optional scientific consulting services meet the criteria of paragraph 65 of SOP 97-2 for separate accounting, as they are not essential to the functionality of the delivered software, are described and priced separately in the arrangement and are sold separately. We recognize fees from optional scientific consulting services (equal to the amounts set in the contracts) as revenue as these services are provided or upon their acceptance, as applicable.

 

We also enter into arrangements that consist of perpetual and term-based licenses, PCS and implementation/installation services. For arrangements involving a significant amount of services related to installation and implementation of our software products, we recognize revenue for the entire arrangement ratably over the remaining period of the PCS term once the implementation and installation services are completed and accepted by the customer. We currently do not have vendor specific objective evidence for PCS, however revenues from maintenance renewals on perpetual licenses are classified as maintenance revenue and deferred revenue on our income statement and notes.

 

For arrangements consisting solely of services, we recognize revenue as consulting services are performed. Arrangements for consulting services may be charged at daily rates for different levels of consultants and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee contracts, with payments based on milestones or acceptance criteria, we recognize revenue as such milestones are achieved, or if customer acceptance of the milestone’s completion is required, upon such customer acceptance, which approximates the level of services provided. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.

 

We have one international distributor. There is no right of return or price protection for sales to the international distributor. Revenue on sales to this distributor is recognized ratably over the license term when the software is delivered to the distributor and other revenue recognition criteria are met.

 

Judgments affecting revenue recognition. Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to

 

56


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

quarter. We recognize revenue in accordance with GAAP rules that have been prescribed for the software industry. The accounting rules related to revenue recognition are complex and are affected by interpretations of the rules and an understanding of industry practices, both of which are subject to change. Consequently, the revenue recognition accounting rules require management to make significant judgments

 

We do not record revenue on sales to customers whose ability to pay is in doubt at the time of sale. Rather, we recognize revenue from these customers as cash is collected. The determination of a customer’s ability to pay requires significant judgment. In this regard, management considers the international region of the customer and the financial viability of the customer in assessing a customer’s ability to pay.

 

We generally do not consider revenue arrangements with extended payment terms to be fixed or determinable and, accordingly, we do not generally recognize revenue on these arrangements until the customer payments become due. The determination of whether extended payment terms are fixed or determinable requires management to exercise significant judgment, including assessing such factors as the past payment history with the individual customer and evaluating the risk of concessions over an extended payment period. The determinations that we make can materially impact the timing of recognition of revenues. Our normal payment terms currently range from “net 30 days” to “net 60 days,” which are not considered by us to be extended payment terms.

 

The majority of our PKS software arrangements include software deployment services. We defer revenue for software deployment services, along with the associated license revenue, until the services are completed. If there is significant uncertainty about the project completion or receipt of payment for the professional services, we defer revenue until the uncertainty is sufficiently resolved.

 

Additionally, for fixed fee strategic consulting contracts, with payments based on milestones or acceptance criteria, we recognize revenue as such milestones are achieved, or if customer acceptance is required, upon customer acceptance, which approximates the level of services provided. Management makes a number of estimates related to recognizing revenue for such contracts, as discussed further above. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.

 

Deferred Revenue

 

Deferred revenue is comprised of license fees (initial and renewal), which are recognized ratably over the one-year period of the license. In addition, deferred revenue includes services and training revenue, which will be recognized as services are performed. Deferred revenue also includes license and service fees for arrangements that include significant implementation services, which have not yet been completed. Long term deferred revenue represents amounts received for maintenance and support services to be provided beginning in periods on or after April 1, 2006.

 

57


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The principal components of deferred revenue at March 31, 2006 and 2005 were as follows (in thousands):

 

     2006

   2005

License fees

   $ 3,078    $ 2,625

Renewals

     3,473      2,975

Training

     4      29

Maintenance

     557      524

Services

     547      1,151
    

  

Total deferred revenue

   $ 7,659    $ 7,304
    

  

Short term deferred revenue

   $ 7,605    $ 7,178

Long term deferred revenue

     54      126
    

  

Total deferred revenue

   $ 7,659    $ 7,304
    

  

 

Shipping Costs

 

Shipping and handling costs are included under cost of license and renewal for all periods presented. These costs were insignificant in all periods presented.

 

Research and Development

 

Pharsight capitalizes eligible computer software costs as products achieve technological feasibility, subject to net realizable value considerations. Pharsight has defined technological feasibility as completion of a working model. As of March 31, 2006 and 2005, there were no such internal capitalizable costs. Accordingly, Pharsight has charged all such internal costs to research and development expenses in the accompanying statements of operations.

 

Advertising

 

Pharsight expenses the cost of advertising as incurred. These costs were insignificant in all periods presented.

 

Net Income (Loss) per Share

 

Basic net income (loss) per share attributable to common stock is computed by dividing net income or loss attributable to common stockholders for the period by the weighted-average number of shares of vested common stock (i.e. not subject to a right of repurchase) outstanding during the period.

 

Diluted net income (loss) per share attributable to common stockholders is computed by dividing net income attributable to common stockholders for the period by the weighted-average number of shares of vested common stock outstanding and, where dilutive, weighted average number of shares of unvested common stock outstanding. Diluted net income (loss) per common share attributable to common stock also gives effect, as applicable, to the potential dilutive effect of outstanding stock options and warrants to purchase common stock using the treasury stock method, and convertible preferred stock using the as-if-converted method, as of the beginning of the period presented or the original issuance date, if later.

 

58


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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

 

     Years Ended March 31,

 
     2006

    2005

    2004

 

Net income (loss)

   $ 530     $ 2,733     $ (1,997 )

Preferred stock dividend

     (738 )     (610 )     (654 )

Deemed dividend to preferred stockholders

     —         —         (339 )
    


 


 


Net income (loss) attributable to common stockholders for basic computation

   $ (208 )   $ 2,123     $ (2,990 )
    


 


 


Dilutive effect of preferred stock dividends

     738       610       —    

Net income (loss) attributable to common stockholders after assumed conversions for diluted computation

   $ 530     $ 2,733     $ (2,990 )
    


 


 


Weighted average common shares outstanding

     19,421       19,122       19,054  

Less weighted average common shares subject to repurchase

     —         —         (3 )
    


 


 


Weighted-average common shares used to compute net income (loss) per share attributable to common stockholders for basic computation

     19,421       19,122       19,051  
    


 


 


Dilutive effect of:

                        

Stock options and stock-based awards

     —         1,922       —    

As if converted preferred stock

     —         7,465       —    
    


 


 


Dilutive weighted-average common shares outstanding

     19,421       28,509       19,051  
    


 


 


Net income (loss) per share attributable to common stockholders

                        

Basic

   $ (0.01 )   $ 0.11     $ (0.16 )
    


 


 


Diluted

   $ (0.01 )   $ 0.10     $ (0.16 )
    


 


 


 

All potential common equivalent shares including preferred stock (on an as-if-converted basis), have been excluded from the computation of diluted earnings per share in 2006 because they are antidilutive because their inclusion increases earnings per share. Therefore, basic and dilutive earnings per share are the same. All potential common equivalent shares including preferred stock (on an as-if-converted basis), have been excluded from the computation of diluted earings per share and 2004 as the effect of including such shares would be antidilutive due to the net loss recorded.

 

The number of potential common shares excluded from the calculation of net income (loss) per share attributable to common stockholders at March 31, 2006, 2005 and 2004 is detailed in the following table (in thousands):

 

     March 31,

     2006

   2005

   2004

Outstanding options

   2,357    2,244    3,531

Warrants

   682    155    2,091

Redeemable convertible preferred stock

   7,549    —      7,404
    
  
  
     10,588    2,399    13,026
    
  
  

 

59


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Stock-Based Compensation

 

The Company generally grants stock options to its employees for a fixed number of shares with an exercise price equal to the fair market value of the stock on the date of grant. As permitted under the Statement of Financial Accounting Standard (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”) and SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” (“FAS 148”), the Company has elected to follow the intrinsic value method of accounting as defined by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations in accounting for stock awards to employees. Accordingly, no compensation expense is recognized in the Company’s financial statements in connection with employee stock awards where the exercise price of the award is equal to the fair market value of the stock at the date of the award. When stock options are granted with an exercise price that is lower than the fair market value of the stock on the date of grant, the difference is recorded as deferred compensation and amortized to expense on a graded basis over the vesting term of the stock options.

 

As required by FAS 148, the following table illustrates the effect on net income (loss) per share if the Company had accounted for its stock option and stock purchase plans under the fair value method of accounting (in thousands, except per share amounts):

 

     Years Ended March 31,

 
     2006

    2005

    2004

 

Net income (loss) attributable to common stockholders, as reported

   $ (208 )   $ 2,123     $ (2,990 )

Add back:

                        

Stock-based employee compensation included in reported net income (loss)

     —         —         198  

Less:

                        

Total stock-based employee compensation expense determined under the fair value method for all awards

     (927 )     (670 )     (755 )
    


 


 


Pro forma net income (loss) attributable to common stockholders

   $ (1,135 )   $ 1,453     $ (3,547 )
    


 


 


Basic net income (loss) per share attributable to common stockholders

                        

As reported

   $ (0.01 )   $ 0.11     $ (0.16 )
    


 


 


Pro forma

   $ (0.06 )   $ 0.08     $ (0.19 )
    


 


 


Diluted net income (loss) per share attributable to common stockholders

                        

As reported

   $ (0.01 )   $ 0.10     $ (0.16 )
    


 


 


Pro forma

   $ (0.06 )   $ 0.07     $ (0.19 )
    


 


 


 

60


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The Company estimates the fair value of its options using the Black-Scholes option value model, which was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. The Company’s employee stock options have characteristics significantly different than those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimates. In management’s opinion, therefore, the existing models do not necessarily provide a reliable single measure of the fair value of the Company’s employee stock options. The fair value of options granted and the option component of the employee purchase plan shares were estimated at the date of grant, assuming no expected dividends, and with the following weighted average assumptions:

 

    

ESPP

Years Ended March 31,


   

Options

Years Ended March 31,


 
       2006  

      2005  

      2004  

      2006  

      2005  

      2004  

 

Expected life (years)

   0.49     0.50     0.49     3.14     3.25     3.77  

Expected stock price volatility

   90.3 %   122 %   200.0 %   200.8 %   204.8 %   210.8 %

Risk-free interest rate

   4.11 %   3.13 %   1.00 %   3.81 %   3.96 %   1.82 %

 

In conjunction with the transfer of its securities from the Nasdaq National Market to the Over-The-Counter Bulletin Board system and in accordance with the terms of the Employee Stock Purchase Plan, the Company suspended new offerings under the Employee Stock Purchase Plan from January 2003 until February 2004, at which time the shares could be issued pursuant to a permit under applicable state laws.

 

Comprehensive Income (Loss)

 

Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” (“SFAS 130”), requires Pharsight to display comprehensive income (loss) and its components as part of the financial statements. Comprehensive income (loss) includes certain changes in equity that are excluded from net income (loss). Pharsight’s comprehensive income (loss) consists of net income (loss) adjusted for the effect of unrealized foreign exchange gains or losses.

 

SFAS 123R

 

On December 16, 2004, the Financial Accounting Standards Board, or FASB issued Statement of Accounting Standards No. 123R, “Share-Based Payment”, or SFAS 123R, which is a revision of Statement of Accounting Standards No. 123, “Accounting for Stock-Based Compensation”. SFAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends Statement of Accounting Standards No. 95, “Statement of Cash Flows”. SFAS 123R requires all companies to measure compensation expense for all share-based payments (including employee stock options and options issued pursuant to employee stock purchase plans) based upon the fair value of the stock-based awards at the date of grant. SFAS 123R is effective for all public companies for annual periods beginning after June 15, 2005 – April 1, 2006 for Pharsight.

 

We will adopt SFAS 123R under the modified-prospective method. As permitted by SFAS 123R, we currently account for share-based payments to employees using APB 25’s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123R’s fair value method will have a significant impact on our results of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123R cannot be predicted at this time because it will depend on, among other things, levels of share-based payments granted in the future.

 

61


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

3. Property and Equipment

 

Property and equipment are stated at cost and consist of the following (in thousands):

 

     March 31,

 
     2006

    2005

 

Furniture and fixtures

   $ 339     $ 227  

Computers and equipment

     6,762       5,811  

Leasehold improvements

     709       161  
    


 


       7,810       6,199  

Accumulated depreciation and amortization

     (5,785 )     (5,595 )
    


 


     $ 2,025     $ 604  
    


 


 

4. Concentrations of Credit Risk

 

Financial instruments that potentially subject Pharsight to concentrations of credit risk consist primarily of cash and cash equivalents, and trade receivables. Pharsight generally invests its excess cash in money market funds, commercial paper, corporate notes and obligations issued by or fully collateralized by the U.S. government or federal agencies. Pharsight places its investments with high-credit quality counterparties and, by policy, limits the amount of credit exposure to any one counterparty.

 

Pharsight sells its products and services primarily to major pharmaceutical and biotechnology companies. Pharsight evaluates its customers’ financial condition when necessary and routinely receives a deposit for services contracts at the time of sale. Pharsight generally requires no collateral from its customers. To date, Pharsight has not experienced any significant losses with respect to these balances. For the year ended March 31, 2006, Pharsight wrote-off $37,000 against the allowance for doubtful accounts. For the year ended March 31, 2005, Pharsight wrote-off $120,000 against the allowance for doubtful accounts. For the year ended March 31, 2004, Pharsight wrote off $11,000 against the allowance for doubtful accounts.

 

The Company receives majority of its revenue from a limited number of customers. For fiscal 2006, 2005 and 2004, sales to its top two customers accounted for 42%, 45% and 28% of total revenue, respectively and sales to its top five customers accounted for 52%, 62% and 50%. In fiscal 2006, Pfizer Inc., or Pfizer, the Company’s largest customer, accounted for 25% of its total revenue, and Eli Lilly and Company, or Eli Lilly, accounted for 17% of its total revenue. In fiscal 2005, Pfizer accounted for 25% and Eli Lilly accounted for 20% of the Company’s total revenue. In fiscal 2004, Pfizer accounted for 16% and Eli Lilly accounted for 11% of the Company’s total revenue.

 

Three customers comprised 23%, 14% and 10% of accounts receivable at March 31, 2006. Three customers comprised 35%, 15% and 10% of accounts receivable at March 31, 2005.

 

5. Debt

 

Credit Facilities.

 

We have a secured term loan outstanding, payable over 48 months, with monthly payments having commenced in July 2002. The balance on the term loan as of March 31, 2006 was $219,000 due May 2006. In February 2005, we secured an additional $300,000 term loan for the purchase of a new financial system, which was added to the existing term loan. The $300,000 term loan is payable over 36 months. The balance outstanding on this term loan as of March 31, 2006 was $192,000. In addition, we secured an equipment credit facility

 

62


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

through June 2006 for up to $600,000. Each advance will be payable over 36 months. As of March 31, 2006, the current balance on this equipment credit facility was $500,000.

 

In December 2005, we extended our credit facilities with Silicon Valley Bank, providing for up to $3.0 million in borrowings, secured against 80% of eligible domestic accounts receivable. The current balance of this credit facility is $1.0 million as of March 31, 2006.

 

On June 12, 2006, Pharsight Corporation (the “Company”) and Silicon Valley Bank (the “Bank”) entered into the Fifth Amendment to the Loan and Security Agreement (the “Loan Amendment”), effective as of May 24, 2004 by and between Silicon Valley Bank and Pharsight Corporation, as amended (the “Loan and Security Agreement”). The Loan Modification amends in part Section 2.4 of the Loan and Security Agreement to provide that interest due on the Committed Revolving Line is payable on the 25th day of each month and amends Section 13.1 of the Loan and Security Agreement by changing the “Revolving Maturity Date” to May 26, 2007. In addition, the Loan and Security Agreement amends in part Section 6.7 by replacing the profitability/loss financial covenant with a covenant requiring the Company to maintain a minimum tangible net worth in the amount not less than $3,000,000. Furthermore, the Loan Amendment also provides for additional representations and warranties by the Company to induce the Bank to enter into the Loan Amendment.

 

The following financial covenants apply to the extended Silicon Valley Bank loan facilities: net loss no greater than $200,000 in the first quarter of fiscal 2006; net income of at least $1.00 in the remaining three quarters of fiscal 2006; and a minimum modified quick ratio (defined as cash and cash equivalents plus accounts receivable, divided by total current liabilities, including all bank debt and not including deferred revenue) of 2:1 for the months of December 2004 and each month thereafter. As of March 31, 2006, the company was in violation of its quarterly profitability covenant, to which the company received a waiver of compliance from the bank. Interest on our revolving lines of credit is accrued at 0.5% above prime and is payable monthly from the date of borrowing. Interest on our term loans is accrued at 1.25% above prime and is payable monthly from the date of borrowing. Certain of our assets, excluding intellectual property, secure both facilities.

 

Future minimum payments under the Company’s term loans at March 31, 2006 are as follows (in thousands):

 

     Notes
Payable


 

2007

   $ 1,531  

2008

     294  

2009

     100  
    


Total minimum payments

     1,925  

Less amounts representing interest

     (14 )
    


Present value of minimum payments

     1,911  

Less current portion

     (1,519 )
    


Long-term portion

   $ 392  
    


 

63


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

6. Commitments and Contingencies

 

Operating Leases

 

Pharsight leases its office facilities under noncancelable operating leases expiring through 2011. Minimum annual rental commitments at March 31, 2006 are as follows (in thousands):

 

     Cash
Commitments


2007

   $ 422

2008

     438

2009

     462

2010

     485

2011 and thereafter

     365
    

Total minimum payments

   $ 2,172
    

 

Rent expense was $513,000, $595,000 and $598,000 for the years ended March 31, 2006, 2005, and 2004, respectively.

 

Contingencies

 

From time to time and in the ordinary course of business, the Company may be subject to various claims, charges, and litigation. In the opinion of management, final judgments from such pending claims, charges, and litigation, if any, against the Company, would not have a material adverse effect on the Company’s financial position, result of operations, or cash flows.

 

Guarantees

 

From time to time, the Company enters into certain types of contracts that contingently require it to indemnify parties against third party claims. These obligations relate to certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationship. Other obligations relate to certain commercial agreements with its customers, under which the Company may be required to indemnify such parties against liabilities and damages arising out of claims of patent, copyright, trademark or trade secret infringement by its software. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. Because the obligated amounts of these types of agreements often are not explicitly stated, the overall maximum amount of the obligations cannot be reasonably estimated. Historically, the Company has not had to make any payments for these obligations, and no liabilities have been recorded for these obligations on the Company’s balance sheets as of March 31, 2006 and 2005.

 

7. Preferred Stock

 

As of March 31, 2006 Pharsight is authorized to issue up to 5,000,000 shares of preferred stock. The Board of Directors designated 2,000,000 shares as Series A preferred stock and 1,200,000 shares as Series B preferred stock. The Board of Directors may determine the rights and preferences of the remaining 1,800,000 shares of preferred stock, subject to limitations provided pursuant to the terms of the Series A and Series B preferred stock.

 

Series A Redeemable Convertible Preferred Stock and Common Stock Warrants

 

On June 26, 2002 and September 11, 2002, the Company completed a private placement of 1,814,662 units (each a “Unit,” and, collectively, the “Units”) for an aggregate purchase price of $7.5 million to certain investors.

 

64


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The sale and issuance of the Units were made pursuant to a Preferred Stock and Warrant Purchase Agreement (the “Purchase Agreement”) and closed in two phases. The first phase was completed on June 26, 2002, pursuant to which the Company sold an aggregate of 761,920 Units for an aggregate purchase price of $3.15 million. The second phase was completed on September 11, 2002, pursuant to which the Company sold an aggregate of 1,052,742 Units for an aggregate purchase price of $4.35 million. Each Unit consists of one share of the Company’s Series A redeemable convertible preferred stock (the “Series A Preferred”) and a warrant to purchase one share of common stock (each a “Warrant,” and, collectively, the “Warrants”).

 

Dividends

 

The holders of the Series A Preferred are entitled to receive cumulative dividends in preference to any dividend on the common stock, payable quarterly at the rate of 8% per annum, either in cash or in shares of Series B redeemable convertible preferred stock (the “Series B Preferred” and, together with the Series A Preferred, the “Preferred Stock”) at the election of the holder. The Series B Preferred has identical rights, preferences and privileges as the Series A Preferred, except that the Series B Preferred is not entitled to the dividend payment right. During fiscal 2006, at the election of the Series A holders, the Company issued dividends of 54,426 shares of Series B Preferred Stock to Series A holders.

 

Conversion

 

The holders of the Preferred Stock have the right to convert the Preferred Stock at any time into shares of common stock. The initial conversion rate is four to one, subject to proportional adjustments for stock splits, stock dividends, recapitalizations and the like.

 

The Preferred Stock shall be automatically converted into common stock, at the then applicable conversion price, (i) in the event that the holders of at least 75% of the outstanding Preferred Stock consent to such conversion or (ii) upon the closing of a firmly underwritten public offering of shares of common stock of Pharsight for a public offering price of at least $3.006 per share and with gross proceeds to the Company of not less than $40,000,000 (before deduction of underwriters commissions and expenses).

 

Liquidation Preference

 

In the event of any liquidation or winding up of Pharsight, the holders of the Preferred Stock shall be entitled to receive in preference to the holders of the common stock a per share amount equal to the greater of (a) the original issue price, plus any accrued but unpaid dividends or (b) the amount that such shares would receive if converted to common stock immediately prior thereto (the “Liquidation Preference”). After the payment of the Liquidation Preference to the holders of the Preferred Stock, the remaining assets shall be distributed ratably to the holders of the common stock. A merger, acquisition, sale of voting control of Pharsight in which the Company’s stockholders do not own a majority of the outstanding shares of the surviving corporation, or a sale of all or substantially all of the Company’s assets, shall be deemed to be a liquidation.

 

Voting Rights

 

The holders of Preferred Stock are entitled to vote together with the common stock. Each share of Preferred Stock has that number of votes equal to the number of shares of common stock then issuable upon conversion of such share of Preferred Stock. In addition, consent of the holders of at least 75% of the then outstanding Preferred Stock shall be required for certain actions, including any action that amends the Company’s charter documents so as to adversely affect the Preferred Stock.

 

65


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Redemption

 

At the election of the holders of at least 75% of the Preferred Stock, to the extent that the Company may legally do so, the Company shall redeem the outstanding Preferred Stock after the fifth anniversary of the initial issuance of Preferred Stock. Such redemption shall be at a price of $4.008 per share plus accrued and unpaid dividends. If the holders of Preferred Stock shall not have elected to have Pharsight redeem the Preferred Stock at or after the fifth anniversary of the date of issuance, the Company shall have the option to redeem the Preferred Stock on the same terms as the optional redemption by the holders of Preferred Stock.

 

Registration Rights

 

Pursuant to the Purchase Agreement, within 55 days following the initial closing, the Company agreed to use its best efforts to prepare and file a registration statement on Form S-3 (the “Registration Statement”) for the resale of the shares of common stock issuable to the purchasers upon conversion of the Preferred Stock and exercise of the Warrants (the “Shares”), and to use commercially reasonable efforts to cause the Registration Statement to become effective within 105 days after the initial closing. In addition, in the event that the Company failed to cause the Registration Statement to be timely filed, timely declared effective, or to be kept effective (other than pursuant to the permissible suspension periods), the Company was obligated to pay to the holders of Preferred Stock as liquidated damages the amount of 1% per month of the aggregate purchase price for the shares remaining to be sold pursuant to the Registration Statement.

 

The Registration Statement covering the shares of common stock issuable upon conversion of the Series A Preferred, the shares of common stock issuable upon exercise of the Warrants sold pursuant to the Purchase Agreement and other shares of common stock held by such stockholders was declared effective on October 31, 2002. The holders of the Preferred Stock waived the right to receive liquidated damages that resulted from the delayed date of effectiveness through November 30, 2002.

 

The Company has not filed a Registration Statement covering the shares of Series B preferred stock to be issued as a dividend with respect to the Series A Preferred Stock, and therefore, the holders of Preferred Stock accrued additional liquidated damages following November 30, 2002. In February 2003, the holders of the Preferred Stock waived the right to receive the foregoing liquidated damages.

 

In May 2003, the holders of the Preferred Stock waived the requirement that the Company file a post-effective amendment on Form S-1 in the event that the Company is no longer eligible to use Form S-3. The holders of Preferred Stock also waived the right to receive liquidated damages as a result of the failure to file a post-effective amendment on Form S-1. Notwithstanding the foregoing, the holders of Preferred Stock are entitled to terminate the May 2003 waivers and, as a result, require the Company to file a post-effective amendment on Form S-1 within thirty (30) days from the Company’s receipt of such waiver termination and to cause such post-effective amendment to become effective within ninety (90) days from receipt of such waiver termination, or otherwise incur liquidated damages under the terms of the Purchase Agreement. On June 10, 2003, the Registration Statement ceased to be available for resale of the shares registered thereunder.

 

Warrants

 

The Warrants are exercisable for a period of five years from the date of issuance at a per share price equal to $1.15, subject to proportional adjustments for stock splits, stock dividends, recapitalizations and the like. If not exercised after five years, the right to purchase the common stock will terminate. The Warrants contain a cashless exercise feature. The common stock issuable upon exercise of the Warrants are entitled to the benefits and subject to the terms of the Registration Rights described above.

 

66


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Summary of Certain Preferred Stock and Warrant Accounting

 

Due to the nature of the redemption features of the Series A Preferred, the Company has excluded the Series A Preferred from stockholders’ equity in its financial statements.

 

The amount representing the Series A Preferred with total gross proceeds of $7.5 million was discounted by a total of $2.1 million, including $1.3 million representing the value assigned to the Warrants, $585,000 representing the related beneficial conversion feature of the Series A Preferred, and $268,000 representing issuance costs. The amounts allocated in determining the discount were computed on a relative fair value basis. After reducing the proceeds by the value of the Warrants, the remaining proceeds were used to compute a discounted conversion price in accordance with EITF 00-27, “Application of EITF Issue No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios to Certain Convertible Instruments.” The discounted conversion price for each of the two closings was compared to the fair market value of the Company’s common stock on June 26, 2002 (the date of issuance of the Series A Preferred) and September 6, 2002 (the date of the stockholder vote approving the second closing) that resulted in a total beneficial conversion feature of $585,000, which represents the difference between the fair market value of its common stock and the deemed conversion price.

 

The net discounted value for the Series A Preferred of $5.6 million was recorded as a long-term liability as of March 31, 2003 with the corresponding aggregate value of the Warrants and the beneficial conversion feature of $1.9 million ($1.3 million plus $585,000) recorded as additional-paid-in-capital within equity.

 

There were no deemed dividends recorded by the Company for the year ended March 31, 2006 and 2005. Deemed dividends were recorded by the Company for the year ended March 31, 2004 totaling approximately $339,000, representing accretion of the discount resulting from the value of the beneficial conversion feature. The aggregate deemed dividends recorded were charged against additional-paid-in-capital and included in the calculation of net loss applicable to common stockholders.

 

Dividends on the Preferred Stock, calculated at the rate of 8% per annum, were approximately $738,000 and $610,000 for the years ended March 31, 2006 and 2005. The dividends were charged against additional-paid-in-capital and included in the calculation of net loss applicable to common stockholders.

 

During the three months ended June 30, 2003, the Company recorded a $96,000 deemed dividend, for a cumulative amount of $342,000 in total deemed dividends for the Series A Preferred. During the three months ended September 30, 2003, the Company recorded a $243,000 deemed dividend, representing the balance of the $585,000 beneficial conversion feature of the Series A Preferred. The increase in the deemed dividend in the second quarter of fiscal 2004 reflected an adjustment to recognize the remaining amount of the $585,000 beneficial conversion feature. The adjustment for the beneficial conversion feature was initiated by the Company’s reevaluation of the various complex rules surrounding the accounting for the Series A Preferred and the related interpretations under EITF 00-27 for redeemable preferred stock. The amounts of deemed dividends related to the beneficial conversion feature that should have been originally recorded were $484,000 and $101,000 for the three months ended June 30, 2002 and September 30, 2002, respectively. No other amounts representing deemed dividends should have been recorded in other periods. The Company does not believe that the $96,000 and $243,000 amounts recorded as deemed dividends in the three months ended June 30, 2003 and September 30, 2003, respectively, and the $339,000 total amount recorded as deemed dividends in the year ended March 31, 2004, are material to the periods in which they should have been recorded.

 

The Company will recognize the remaining $1.6 million value of the warrants when and if it becomes probable the warrants will be exercised and will recognized the $268,000 of issuance costs only if it becomes probable that the Series A Preferred will be redeemed.

 

67


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Series B Redeemable Convertible Preferred Stock

 

The following table depicts activities for Series B Preferred Stock for two years ended March 31, 2006:

 

 

     Number of shares
of Series B


Balance at March 31, 2004

   36,281

Preferred Series B issued June 1, 2004

   18,142
    

Balance at March 31, 2005

   54,423

Preferred Series B issued September 1, 2005

   18,142

Preferred Series B issued December 1, 2005

   18,142

Preferred Series B issued March 1, 2006

   18,142
    

Balance at March 31, 2006

   108,849
    

 

The Series B Preferred has identical rights, preferences and privileges as the Series A Preferred, except that the Series B Preferred is not entitled to the dividend payment right. Due to the nature of the redemption features of the Series B Preferred, the Company has excluded the Series B Preferred from stockholders’ equity in its financial statements.

 

The amount of the Series B Preferred dividend was determined based on the estimated per share fair value of the Series B Preferred Stock. To record the fair value of the Series B Preferred Stock, the Company performed a valuation based on its 5-day average stock price leading up to and including the Valuation Date. Various factors including, but not limited to, deemed time to liquidity and form of dividend payment were considered in the valuation of the Series B Preferred.

 

The following table depicts the estimated fair value of Series B Preferred Stock is as follows:

 

Date of Stocks Issued


   Number
of Shares
of Series B


   Price
per
Share


   Total
Estimated
Fair Value


March 31, 2004

   36,281    6.00    $ 217,686

June 1, 2004

   18,142    5.61      101,777

September 1, 2005

   18,142    7.80      141,508

December 1, 2005

   18,142    6.47      117,379

March 1, 2006

   18,142    6.38      115,746
    
       

     108,849         $ 694,096
    
       

 

8. Common Stock

 

Pharsight is authorized to issue up to 120,000,000 shares of common stock. At March 31, 2006, common stock was reserved for future issuance as follows (in thousands):

 

Warrants outstanding

   2,091

Stock option plans

   7,332

Employee stock purchase plan

   403

Redeemable convertible preferred stock

   8,420
    
     18,246
    

 

68


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Pharsight has sold common stock pursuant to restricted stock purchase agreements containing provisions established by the Board of Directors. Pharsight has a right to repurchase the shares at the original sale price, which generally expires at the rate of 25% after one year and 2.0833% per month thereafter.

 

At March 31, 2006 and at March 31, 2005, there were no shares subject to repurchase.

 

Warrants

 

No warrants have been granted during fiscal 2004, 2005 and 2006. The number of warrants outstanding was 2,091,000 for fiscal 2004, 2005 and 2006.

 

9. Stock-Based Benefit Plans

 

Stock Option Plans

 

In April 2001 the Board of Directors adopted, and in May 2000 the stockholders approved, the 2000 Equity Incentive Plan (“Incentive Plan”). The Incentive Plan became effective upon Pharsight’s initial public offering in August 2000. The Incentive Plan provides for the granting of stock awards, including incentive stock options, nonstatutory stock options, stock bonuses and rights to acquire restricted stock, to Pharsight’s employees and consultants. In addition, the Incentive Plan provides for non-discretionary grants of nonstatutory stock options to Pharsight’s non-employee directors.

 

Under the Incentive Plan, the Board of Directors determines the term of each award and the award price. In the case of incentive stock options, the exercise price may not be less than the fair market value on the date of grant, while nonstatutory options and restricted stock awards have exercise prices of not less than 85% of fair market value on the date of grant. Stock bonuses may be granted with a zero exercise price in consideration of past services rendered. In general, stock options vest over a four-year period, 25% on the first anniversary of the grant and ratably on a monthly basis thereafter.

 

Non-employee directors are eligible to receive nonstatutory stock options with an exercise price equal to fair market value on the date of grant under the Incentive Plan. Each newly appointed director of Pharsight who is (i) not an employee of Pharsight, (ii) is not acting in the capacity of a consultant to Pharsight, and (iii) cannot exercise, individually or in affiliation with any entity or group of entities that exercises voting control over more than 20% of Pharsight’s voting stock (an “Independent Director”), receives a one-time grant of options to purchase 100,000 shares of common stock under the Incentive Plan, which vest monthly over a two-year period and have a maximum term of 10 years (the “Initial Grant”). A director, who was not independent when appointed who later becomes an Independent Director, will receive the Initial Grant at that time. In addition, each eligible director is also granted an option to purchase 10,000 shares of common stock on the day after each Annual Meeting of Stockholders, which vest in full on the first anniversary of the date of grant and have a maximum term of 10 years.

 

Pharsight has reserved 7,198,387 shares for grant under the Incentive Plan as of March 31, 2006. In 2003, the Board of Directors reduced the number of shares available for grant under the Incentive Plan to comply with certain provisions of the California Code of Regulations. Each January 1, the number of shares reserved will increase automatically by the least of (i) 5% of the total number of common shares outstanding on that date, (ii) 2,000,000 shares, (iii) such fewer number of shares as determined by the Board of Directors, or (iv) so long as Pharsight is subject to certain provisions of the California Code of Regulations, such fewer number of shares such that the Incentive Plan will be in compliance with such provisions. On January 1, 2006, the number of shares reserved for issuance under the Incentive Plan increased by 785,630 shares.

 

69


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

In April 2001, the Board of Directors approved the UK Company Share Option Plan (“UK Plan”). The UK Plan became effective upon approval of its terms by the Inland Revenue of the United Kingdom (“Inland Revenue”). The UK Plan provides for the granting of stock options to Eligible Employees (as defined in the UK Plan). Pharsight has reserved 200,000 shares for grant under the UK Plan.

 

Under the UK Plan, the Board of Directors determines the term of each award and the award price (subject to the approval of Inland Revenue). The exercise price of all options may not be less than the fair market value on the date of the grant. In general, stock options vest over a four-year period, 25% on the first anniversary of the grant and ratably on a monthly basis.

 

Under the UK Plan, any option granted to an eligible employee shall be limited and take effect so that, immediately following such grant, the aggregate market value of all the shares which he or she may acquire upon the exercise in full of all unexercised options then held by him under the UK Plan and any share option plan (other than a savings-related share option plan) approved by the Inland Revenue under Schedule 9 and adopted by the Company or any Associated Company (as defined in the Plan) of the Company, shall not exceed 30,000 English Pounds.

 

A summary of Pharsight’s stock option activity and related information for the three fiscal years ended March 31, 2006, is as follows (in thousands, except per share amounts):

 

     Number of
Options
Outstanding


    Weighted
Average
Exercise Price
per Share


Balance at March 31, 2003

   3,113     $ 2.91

Options granted

   1,899       0.19

Options exercised

   (5 )     0.91

Options canceled

   (1,476 )     3.51
    

     

Balance at March 31, 2004

   3,531       1.20

Options granted

   1,195       1.28

Options exercised

   (204 )     0.67

Options canceled

   (515 )     2.05
    

     

Balance at March 31, 2005

   4,007       1.11

Options granted

   1,105       1.57

Options exercised

   (218 )     1.63

Options canceled

   (509 )     1.59
    

     

Balance at March 31, 2006

   4,385     $ 1.20
    

     

 

At March 31, 2006, 2005, and 2004, there were 2,946,938, 2,819,654 and 1,650,531 shares available for future option grants, respectively.

 

70


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table summarizes information about stock options outstanding and exercisable at March 31, 2006 (in thousands, except per share amounts):

 

    

Number
Outstanding


   Options Outstanding

   Options Exercisable

Range of Exercise Prices
         per Share


      Weighted
Average
Remaining
Contractual
Life (years)


   Weighted
Average
Exercise
Price
per Share


   Number
Exercisable


   Weighted
Average
Exercise
Price
per Share


$ 0.06 - $0.06

   950,000    7.07    $ 0.06    773,957    $ 0.06

$ 0.19 - $0.65

   535,689    6.01      0.43    450,244      0.45

$ 0.70 - $0.92

   648,166    7.55      0.87    457,163      0.86

$ 1.00 - $1.42

   182,900    7.30      1.12    130,460      1.15

$ 1.47 - $1.47

   677,000    9.13      1.47    0      0.00

$ 1.50 - $1.63

   547,582    8.03      1.56    278,297      1.56

$ 1.67 - $1.80

   477,500    7.90      1.74    185,000      1.79

$ 1.95 - $8.00

   346,167    5.42      3.93    281,167      4.37

$ 8.25 - $8.25

   10,000    4.48      8.25    10,000      8.25

$10.00 - $10.00

   10,000    4.36      10.00    10,000      10.00
    
              
      

$ 0.06 - $10.00

   4,385,004    7.41    $ 1.20    2,576,288    $ 1.15
    
              
      

 

Employee Stock Purchase Plan

 

In April 2000 the Board of Directors adopted, and in May 2000 the stockholders approved, the 2000 Employee Stock Purchase Plan (“Purchase Plan”). The Purchase Plan became effective upon Pharsight’s initial public offering in August 2000.

 

Pharsight has reserved 600,000 shares for issuance under the Purchase Plan as of March 31, 2006. In 2003, the Board of Directors reduced the number of shares available for grant under the Purchase Plan to comply with certain provisions of the California Code of Regulations. Each January 1, the number of shares reserved will be increased automatically by the least of (i) 1.5% of the number of shares of common stock outstanding on that date, (ii) 600,000 shares, (iii) a fewer number as determined by the Board of Directors, or (iv) so long as Pharsight is subject to certain provisions of the California Code of Regulations, such fewer number of shares such that the Incentive Plan will be in compliance with such provisions. On January 1, 2006, the number of shares reserved for issuance under the Purchase Plan did not increase.

 

Eligible employees may purchase common stock through payroll deductions by electing to have up to 20% of their compensation withheld. Each participant is granted an option to purchase common stock on the first day of each six-month offering period and this option is automatically exercised on the last day of the offering period. The purchase price for the common stock under the Purchase Plan is 85% of the lesser of the fair market value of the common stock on the first day and the last day of the offering period. Offering periods begin on February 1 and August 1 of each year. Shares of common stock issued under the Purchase Plan totaled 43,917 and 70,779 in fiscal 2006 and fiscal 2005, respectively.

 

In April 2001, the Board of Directors adopted the 2001 UK Employee Stock Purchase Plan (“UK Purchase Plan”). The UK Purchase Plan became effective immediately. Pharsight has reserved 130,000 shares for issuance under the UK Purchase Plan. Each January 1, the number of shares reserved will be increased automatically by the lesser of 1.5% of the number of shares of common stock outstanding on that date, 130,000 shares or a fewer number as determined by the Board of Directors. On January 1, 2006, 2005 and 2004 the number of shares reserved for issuance under the UK Purchase Plan did not increase.

 

71


Table of Contents

PHARSIGHT CORPORATION

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Eligible employees may purchase common stock through payroll deductions by electing to have up to 20% of their compensation withheld. Each participant is granted an option to purchase common stock on the first day of each six-month offering period and this option is automatically exercised on the last day of the offering period. The purchase price for the common stock under the UK Purchase Plan is 85% of the lesser of the fair market value of the common stock on the first day and the last day of the offering period. Offering periods begin on February 1 and August 1 of each year. Shares of common stock issued under the Purchase Plan totaled 1,620 in fiscal 2006. There were no shares of common stock issued under the UK Purchase Plan in fiscal 2006, 2005 and 2004.

 

The weighted average grant date fair value of stock options, as calculated using the Black-Scholes model under FAS 123, was as follows:

 

     ESPP
Years Ended March 31,


   Options
Years Ended March 31,


     2006

   2005

   2004

   2006

   2005

   2004

Weighted average fair value

   $ 0.72    $ 0.48    $ 0.47    $ 1.47    $ 1.21    $ 0.18

 

10. Income Taxes

 

Significant components of provision for income taxes are as follows (in thousands):

 

     Years Ended March 31,

     2006

   2005

   2004

Current:

                    

Federal

   $ —      $ 44    $ —  

State