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DETERMINE, INC. 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-32.1
  4. Ex-32.1
e10vq
Table of Contents

 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
COMMISSION FILE NUMBER 000-29637
SELECTICA, INC.
(Exact Name of Registrant as Specified in Its Charter)
     
DELAWARE   77-0432030
(State of Incorporation)   (IRS Employer Identification No.)
3 WEST PLUMERIA DRIVE, SAN JOSE, CA 95134
(Address of Principal Executive Offices)
(408) 570-9700
(Registrant’s Telephone Number, Including Area Code)
     Indicate by a check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o
     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b of the Exchange Act. (Check one):
Large accelerated filer o       Accelerated filer þ       Non-accelerated filer o
     Indicate by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. YES o NO þ
     The number of shares outstanding of the registrant’s common stock, par value $0.0001 per share, as of July 31, 2006, was 30,561,353.
 
 

 


 

FORM 10-Q
SELECTICA, INC.
INDEX
         
       
 
       
       
 
       
    3  
 
       
    4  
 
       
    5  
 
       
    6  
 
       
    19  
 
       
    27  
 
       
    28  
 
       
       
 
       
    29  
 
       
    31  
 
       
    43  
 
       
    44  
 
       
    44  
 
       
    44  
 
       
    44  
 
       
    45  
 EXHIBIT 31.1
 EXHIBIT 32.1

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PART I: FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
SELECTICA, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
                 
    June 30,     March 31,  
    2006     2006 *  
    (unaudited)          
Assets
               
Current assets:
               
Cash and cash equivalents
  $ 19,530     $ 12,628  
Short-term investments
    51,375       61,377  
Accounts receivable, net of allowance for doubtful accounts of $85 and $167, respectively
    3,174       3,243  
Prepaid expenses and other current assets
    2,237       2,259  
 
           
Total current assets
    76,316       79,507  
 
               
Property and equipment, net
    2,437       2,407  
Intangible assets
    464       516  
Other assets
    548       511  
Long-term investments
    946       2,929  
 
           
Total assets
  $ 80,711     $ 85,870  
 
           
 
               
Liabilities and Stockholders’ Equity
               
Current liabilities:
               
Accounts payable
  $ 1,057     $ 1,651  
Accrued payroll and related liabilities
    1,376       1,431  
Other accrued liabilities
    1,049       1,330  
Deferred revenues
    3,053       2,052  
 
           
Total current liabilities
    6,535       6,464  
 
           
 
               
Other long term liabilities
    1,019       1,091  
 
           
 
               
Contingencies (see Note 9)
               
 
               
Stockholders’ equity:
               
Common stock
    3       4  
Additional paid-in capital
    293,926       293,383  
Deferred compensation
    (17 )     (20 )
Accumulated deficit
    (192,734 )     (190,136 )
Accumulated other comprehensive loss
    (98 )     (107 )
Treasury stock
    (27,923 )     (24,809 )
 
           
Total stockholders’ equity
    73,157       78,315  
 
           
Total liabilities and stockholders’ equity
  $ 80,711     $ 85,870  
 
           
See accompanying notes.
 
*   Derived from audited consolidated financial statements

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SELECTICA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
                 
    Three Months Ended  
    June 30,  
    2006     2005  
Revenues:
               
License
  $ 468     $ 2,034  
Services
    4,748       5,045  
 
           
Total revenues
    5,216       7,079  
Cost of revenues:
               
License
    115       132  
Services
    2,564       2,587  
 
           
Total cost of revenues
    2,679       2,719  
 
           
Gross profit
    2,537       4,360  
Operating expenses:
               
Research and development
    2,107       2,565  
Sales and marketing
    1,835       1,737  
General and administrative
    1,882       3,302  
 
           
Total operating expenses
    5,824       7,604  
 
             
Loss from operations
    (3,287 )     (3,244 )
Interest and other income, net
    718       545  
 
           
Loss before provision for income taxes
    (2,569 )     (2,699 )
Provision for income taxes
    29       30  
 
           
Net loss
  $ (2,598 )   $ (2,729 )
 
           
Basic and diluted net loss per share
  $ (0.08 )   $ (0.08 )
 
           
Weighted-average shares of common stock used in computing basic and diluted net loss per share
    31,441       32,821  
 
           
See accompanying notes.

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SELECTICA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
                 
    Three Months Ended  
    June 30,  
    2006     2005  
Operating activities
               
Net loss
  $ (2,598 )   $ (2,729 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation
    81       304  
Amortization
    52        
Loss (gain) on disposition of property and equipment
    (34 )     24  
Amortization of deferred compensation
    3       22  
Compensation expenses related to modification of options
          58  
Changes in assets and liabilities:
               
Accounts receivable (net)
    69       690  
Prepaid expenses and other current assets
    23       (6 )
Other assets
    (37 )     (7 )
Accounts payable
    (594 )     (313 )
Accrued payroll and related liabilities
    (55 )     (615 )
Other accrued liabilities and long term liabilities
    (353 )     117  
Deferred revenues
    1,001       431  
 
           
Net cash used in operating activities
    (2,442 )     (2,024 )
 
           
 
               
Investing activities
               
Purchase of capital assets
    (111 )     (66 )
Purchase of short-term investments
    (3,435 )     (10,171 )
Purchase of long term investments
    (4,800 )     (15,712 )
Proceeds from maturities of short-term investments
    13,447       4,897  
Proceeds from maturities of long-term investments
    6,782       15,300  
Acquisition cost paid
          (892 )
Proceeds from disposal of fixed assets
    33       6  
 
           
Net cash provided by (used in) investing activities
    11,916       (6,638 )
 
               
Financing activities
               
Purchase of treasury stock
    (3,114 )      
Proceeds from issuance of common stock
    542       186  
 
           
Net cash provided by (used in) financing activities
    (2,572 )     186  
 
           
 
               
Net increase (decrease) in cash and cash equivalents
    6,902       (8,476 )
Cash and cash equivalents at beginning of the period
    12,628       29,360  
 
           
Cash and cash equivalents at end of the period
  $ 19,530     $ 20,884  
 
           
See accompanying notes.

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SELECTICA, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. Basis of Presentation
     The condensed consolidated balance sheet as of June 30, 2006, the condensed consolidated statements of operations for the three months ended June 30, 2006 and 2005, and the condensed consolidated statement of cash flows for the three months ended June 30, 2006 and 2005 have been prepared by the Company and are unaudited. In the opinion of management, all necessary adjustments (which include normal recurring adjustments) have been made to present fairly the financial position at June 30, 2006, and the results of operations for the three months ended June 30, 2006 and 2005 and cash flows for the three months ended June 30, 2006 and 2005. Interim results are not necessarily indicative of the results for a full fiscal year. The consolidated balance sheet as of March 31, 2006 has been derived from the audited consolidated financial statements at that date.
     Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended March 31, 2006.
2. Summary of Significant Accounting Policies
  Principles of Consolidation
     The consolidated financial statements include all accounts of the Company and those of its wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated.
  Use of Estimates
     The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
  Foreign Currency Transactions
     Foreign currency transactions at foreign operations are measured using the U.S. dollar as the functional currency. Accordingly, monetary accounts (principally cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities) are remeasured into U.S. dollar using the foreign exchange rate at the balance sheet date. Operational accounts and non-monetary balance sheet accounts are remeasured at the rate in effect at the date of a transaction. The effects of foreign currency remeasurement are reported in current operations and were immaterial for all periods presented.
  Concentrations of Credit Risk
     Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash, cash equivalents, short-term investments, long-term investments, restricted investments, and accounts receivable. The Company places its short-term, long-term and restricted investments in high-credit quality financial institutions. The Company is exposed to credit risk in the event of default by these institutions to the extent of the amount recorded on the balance sheet. The Company’s cash balances periodically exceed the FDIC insured amounts. Investments are not protected by FDIC insurance. As of June 30, 2006, the Company has invested in short-term and long-term investments including commercial paper, corporate notes/bonds, and government agency notes/bonds. Restricted investments include corporate bonds and term deposits. Accounts receivable are derived from revenue earned from customers primarily located in the United States and Europe. The Company performs ongoing credit evaluations of its customers’ financial condition and generally does not require collateral. The Company maintains reserves for potential credit losses, and historically, such losses have been immaterial.

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  Cash Equivalents and Short-term Investments
     The Company considers all highly liquid investments purchased with a remaining maturity of three months or less to be cash equivalents. The Company’s cash equivalents consist of money market funds, certificates of deposits, U.S. Agency, asset backed securities and commercial paper. Debt securities with maturities less than one year are available-for-sale and are classified as short-term investments. All of the Company’s short-term investments were classified as available-for-sale as of the balance sheet dates presented and, accordingly, are reported at fair value with unrealized gains and losses recorded net of tax as a component of accumulated other comprehensive loss in stockholders’ equity. Fair values of cash equivalents approximated original cost due to the short period of time to maturity. The cost of securities sold is based on the specific identification method. The investments policy limits the amount of credit exposure to any one issuer of debt securities.
     The Company monitors its investments for impairment on a quarterly basis and determines whether a decline in fair value is other-than-temporary by considering factors such as current economic and market conditions, the credit rating of the issuers, the length of time an investment has been below the Company’s carrying value, and the Company’s ability and intent to hold the investment to maturity. If a decline in fair value, caused by factors other than changes in interest rates, is determined to be other-than-temporary, an adjustment is recorded and charged to operations.
  Accounts Receivable and Allowance for Doubtful Accounts
     The Company evaluates the collectibility of its accounts receivable based on a combination of factors. When the Company believes a collectibility issue exists with respect to a specific receivable, the Company records an allowance to reduce that receivable to the amount that it believes to be collectible. In making the evaluations, the Company will consider the collection history with the customer, the customer’s credit rating, communications with the customer as to reasons for the delay in payment, disputes or claims filed by the customer, warranty claims, non-responsiveness of customers to collection calls, and feedback from the responsible sales contact. In addition, the Company will also consider general economic conditions, the age of the receivable and the quality of the collection efforts.
  Property and Equipment
     Property and equipment are stated at cost. Depreciation is computed using the straight-line method based on estimated useful lives. The estimated useful lives for computer software and equipment is three years, furniture and fixtures is five years, and leasehold improvements is the shorter of the applicable lease term or estimated useful life. The estimated life for the Company’s building in Pune, India is 25 years and land is not depreciated.
  Revenue Recognition
     The Company enters into arrangements for the sale of: (1) licenses of software products and related maintenance contracts; (2) bundled license, maintenance, and services; (3) services; and (4) subscription for on-demand services. In instances where maintenance is bundled with a license of software products, such maintenance term is typically one year.
     For each arrangement, the Company determines whether evidence of an arrangement exists, delivery has occurred, the fees are fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all of the criteria are met.
     Arrangements consisting of license and maintenance only. For those contracts that consist solely of license and maintenance, the Company recognizes license revenues based upon the residual method after all elements other than maintenance have been delivered as prescribed by Statement of Position 98-9 “Modification of SOP No. 97-2 Software Revenue Recognition, with Respect to Certain Transactions.” The Company recognizes maintenance revenues over the term of the maintenance contract because vendor-specific objective evidence of fair value for maintenance exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If vendor specific objective evidence does not exist to allocate the total fee to all undelivered elements of the arrangement, revenue is deferred until the earlier of

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the time at which (1) such evidence does exist for the undelivered elements, or (2) all elements are delivered. If unspecified future products are given over a specified term, the Company recognizes license revenue ratably over the applicable period. The Company recognizes license fees from resellers as revenue when the above criteria have been met and the reseller has sold the subject licenses through to the end-user.
     Arrangements consisting of license, maintenance and other services. Services revenues can consist of maintenance, training and/or consulting services. Consulting services include a range of services including installation of off-the-shelf software, customization of the software for the customer’s specific application, data conversion and building of interfaces to allow the software to operate in customized environments.
     In all cases, the Company assesses whether the service element of the arrangement is essential to the functionality of the other elements of the arrangement. In this determination the Company focuses on whether the software is off-the-shelf software, whether the services include significant alterations to the features and functionality of the software, whether the services involve the building of complex interfaces, the timing of payments and the existence of milestones. Often the installation of the software requires the building of interfaces to the customer’s existing applications or customization of the software for specific applications. As a result, judgment is required in the determination of whether such services constitute “complex” interfaces. In making this determination the Company considers the following: (1) the relative fair value of the services compared to the software; (2) the amount of time and effort subsequent to delivery of the software until the interfaces or other modifications are completed; (3) the degree of technical difficulty in building of the interface and uniqueness of the application; (4) the degree of involvement of customer personnel; and (5) any contractual cancellation, acceptance, or termination provisions for failure to complete the interfaces. The Company also considers the likelihood of refunds, forfeitures and concessions when determining the significance of such services.
     In those instances where the Company determines that the service elements are essential to the other elements of the arrangement, the Company accounts for the entire arrangement under the percentage of completion contract method in accordance with the provisions of SOP 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts.” The Company follows the percentage of completion method if reasonably dependable estimates of progress toward completion of a contract can be made. The Company estimates the percentage of completion on contracts utilizing hours and costs incurred to date as a percentage of the total estimated hours and costs to complete the project. Recognized revenues and profits are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. The Company also accounts for certain arrangements under the completed contract method, when the terms of acceptance and warranty commitments preclude revenue recognition until all uncertainties expire. To date, when the Company has been primarily responsible for the implementation of the software, services have been considered essential to the functionality of the software products, and therefore license and services revenues have been recognized pursuant to SOP 81-1.
     For those contracts that include contract milestones or acceptance criteria, the Company recognizes revenue as such milestones are achieved or as such acceptance occurs.
     For those contracts with unspecified future products and services which are not essential to the functionality of the other elements of the arrangement, license revenue is recognized by the subscription method over the length of time that the unspecified future product is available to the customer.
     In some instances the acceptance criteria in the contract require acceptance after all services are complete and all other elements have been delivered. In these instances the Company recognizes revenue based upon the completed contract method after such acceptance has occurred.
     For those arrangements for which the Company has concluded that the service element is not essential to the other elements of the arrangement, the Company determines whether the services are available from other vendors, do not involve a significant degree of risk or unique acceptance criteria, and whether the Company has sufficient experience in providing the service to be able to separately account for the service. When services qualify for separate accounting, the Company uses vendor-specific objective evidence of fair value for the services and the maintenance to account for the arrangement using the residual method, regardless of any separate prices stated within the contract for each element.

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     Vendor-specific objective evidence of fair value of services is based upon hourly rates. As previously noted, the Company enters into contracts for services alone, and such contracts are based upon time and material basis. Such hourly rates are used to assess the vendor-specific objective evidence of fair value in multiple element arrangements.
     In accordance with Statement of Position 97-2, “Software Revenue Recognition,” vendor-specific objective evidence of fair value of maintenance is determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate). Each license agreement offers additional maintenance renewal periods at a stated price. Maintenance contracts are typically one year in duration.
     Arrangements consisting of consulting services. Consulting services consist of a range of services including installation of off-the-shelf software, customization of the software for the customer’s specific application, data conversion and building of interfaces to allow the software to operate in customized environments. Consulting services may be recognized based on customer acceptance in the form of customer-signed timesheets, invoices, cash received, or customer-signed acceptance as defined in the master service agreement.
  Customer Concentrations
     A limited number of customers have historically accounted for a substantial portion of the Company’s revenues.
     Customers who accounted for at least 10% of total revenues were as follows:
                 
    Three Months Ended
    June 30,
    2006   2005
Customer A
    25 %     29 %
Customer B
    11 %     *  
Customer C
    *       24 %
Customer D
    *       13 %
 
*   Customer account was less than 10% of total revenues.
     Customers who accounted for at least 10% of net accounts receivable were as follows:
                 
    June 30,   March 31,
    2006   2006
Customer A
    17 %     24 %
Customer B
    14 %     *  
Customer C
    11 %     24 %
Customer D
    11 %     11 %
 
*   Customer account was less than 10% of net accounts receivable.
  Warranties and Indemnifications
     The Company generally provides a warranty for its software product to its customers and accounts for its warranties under Statement of Financial Accounting Standards No. 5 (“SFAS 5”), “Accounting for Contingencies”. The Company’s products are generally warranted to perform substantially in accordance with the functional specifications set forth in the associated product documentation for a period of 90 days. In the event there is a failure of such warranties, the Company generally is obligated to correct the product to conform to the product documentation or, if the Company is unable to do so, the customer is entitled to seek a refund of the purchase price of the product or service. The Company has not provided for a warranty accrual as of June 30, 2006 and March 31, 2006. To date, the Company has not refunded any amounts in relation to the warranty.

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     The Company generally agrees to indemnify its customers against legal claims that the Company’s software infringes certain third-party intellectual property rights and accounts for its indemnification under SFAS 5. In the event of such a claim, the Company is obligated to defend its customer against the claim and to either settle the claim at the Company’s expense or pay damages that the customer is legally required to pay to the third-party claimant. In addition, in the event of the infringement, the Company agrees to modify or replace the infringing product, or, if those options are not reasonably possible, to refund the purchase price of the software. To date, the Company has not been required to make any payment resulting from infringement claims asserted against its customers. As such, the Company has not provided for an indemnification accrual as of June 30, 2006 and March 31, 2006.
  Development Costs
     Software development costs incurred prior to the establishment of technological feasibility are included in research and development expenses. The Company defines establishment of technological feasibility as the completion of a working model. Software development costs incurred subsequent to the establishment of technological feasibility through the period of general market availability of the products are capitalized, if material, after consideration of various factors, including net realizable value. To date, software development costs that are eligible for capitalization have not been material and have been expensed.
  Intangible Assets
     The Company purchased intangible assets at fair value as determined by a third party as part of its acquisition of the assets of Determine Software, Inc. (see Note 10). The original cost is amortized on a straight-line basis over the estimated life of each asset as determined by management. The Company regularly performs reviews to determine if the carrying value of the intangible asset is impaired. If and when indicators of impairment exist, the Company assesses the need to record an impairment loss. Intangible assets represent acquired customer backlog, customer relationships as well as developed technology. The intangible assets are being amortized using the straight-line basis over their estimated useful lives, which range from 1-4 years.
  Accumulated and Other Comprehensive Loss
     SFAS 130 establishes standards for reporting and displaying comprehensive net income or loss and its components in stockholders’ equity. However, it has no impact on the net loss as presented in the Company’s financial statements. Accumulated other comprehensive loss is comprised of net unrealized losses on available for sale securities of approximately $98,000 and approximately $107,000 at June 30, 2006 and March 31, 2006, respectively.
     The components of comprehensive loss, net of related income tax, for the three months ended June 30, 2006 and 2005 are as follows:
                 
    Three Months Ended  
    June 30,  
    2006     2005  
    (In thousands)  
Net loss
  $ (2,598 )   $ (2,729 )
Change in unrealized gain on securities
    9       172  
 
           
Comprehensive loss
  $ (2,589 )   $ (2,557 )
 
           
  Stock-Based Compensation
     Beginning April 1, 2006, the Company adopted the provisions of, and accounts for stock-based compensation in accordance with, (“SFAS”) No. 123 (revised 2004) “Share-Based Payment” (“SFAS No. 123R”) and Securities and Exchange Commission Staff Accounting Bulletin (“SAB”) No. 107. The Company elected the modified-prospective method, under which prior periods are not revised for comparative purposes. The Company currently uses the Black-Scholes option-pricing model to determine the fair value of stock options and employee stock purchase plan shares and compensation cost is recognized as expense over the requisite service period.

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     The Company previously applied Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations and provided the required pro forma disclosures of SFAS No. 123, “Accounting for Stock-Based Compensation” as amended by SFAS No. 148. See Note 7.
  Segment Information
     International revenues are attributable to countries based on the location of the customers. For the three months ended June 30, 2006, sales to international locations were derived primarily from the United Kingdom, Canada, India, Japan and New Zealand. For the fiscal year ended March 31, 2006, sales to international locations were derived primarily from Canada, India, Japan, New Zealand, Sweden and the United Kingdom.
                 
    Three Months Ended
    June 30,
    2006   2005
International revenues
    18 %     26 %
Domestic revenues
    82 %     74 %
 
               
Total revenues
    100 %     100 %
 
               
     For the three months ended June 30, 2006, there were no sales to any international customer that accounted for 10% of the total revenue. For the three months ended June 30, 2005, sales to one specific international customer accounted for 24% of total revenue.
     As of June 30, 2006 and March 31, 2006, the Company held long-lived assets outside of the United States with a net book value of approximately $1.0 million, which were primarily in India.
3. Concurrent Transaction
     In May 2006, the Company entered into a swap contract with Azul, whereby Azul would receive two years of the Company’s on-demand products, Contract Management and Fastraq, installation, training and other services and the Company would receive, in exchange, two high-speed servers and the required power systems. The value of the transaction was $208,454. There was no monetary exchange. The Company utilized its list price to establish the value of the assets received, which included a 5% discount. The Company accounted for this transaction in accordance with APB No.29, “Accounting for Nonmonetary Transactions” and SFAS No. 153, “Exchanges of Nonmonetary Transactions – an amendment to APB 29”. As of June 30, 2006, the Company had received the two servers, but had not placed them into service. The Company does not plan to resell the servers. Azul had not implemented the product nor had any of the negotiated services begun as of June 30, 2006.
     The Company expects to place the servers into service in the second quarter of fiscal 2007, and will depreciate the servers over a period of three years. The Company will recognize the service work when all required elements for revenue recognition are satisfied and will recognize the subscription revenue prorata over the 2-year term of the agreement.
     The Company, from time to time, purchases professional services from a value-added reseller. The Company records the cost of the professional services purchased as a reduction of license or services revenue recorded from the reseller. For the three months ended June 30, 2006, the Company recognized approximately $40,000 of revenue from the value-added reseller and did not purchase any professional services from the value- added reseller. For the three months ended June 30, 2005, the Company recognized approximately $585,000 of revenue from the value-added reseller and did not purchase any professional services from the value- added reseller.
4. Related Party Transaction
     In connection with the resignation of Dr. Sanjay Mittal, as Chief Executive Officer in September 2003, the Company agreed to have him continue as Chief Technical Advisor (“CTA”). Pursuant to this arrangement, Dr. Mittal received $20,000 per month for his services and this arrangement would continue until either party terminated the CTA service.

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     In March 2005, Dr. Mittal’s role as CTA was terminated and he received a lump-sum severance payment of $412,500 in addition to the amount paid for outside services. In July 2005, Dr. Mittal agreed to provide hourly consulting services relating to the Company’s patent litigation, which was settled in February 2006. As a result, his consulting services agreement terminated. Dr. Mittal was not paid any fees for consulting services for the three months ended June 30, 2006 and June 30, 2005. Dr. Mittal was a member of the Board of Directors until July 21, 2006.
     On July 21, 2006, Dr. Sanjay Mittal resigned as a member of the Board of Directors. Also on July 21, 2006, the Company entered into a new consulting agreement with Dr. Mittal. Under the terms of the consulting agreement, Dr. Mittal will serve as a consultant to the Company for a period of at least 12 months, subject to earlier termination under certain specified circumstances, and will receive $500 per hour for services rendered, with a minimum payment of 10 hours per calendar month.
5. Stockholders’ Equity
  Deferred Compensation
     Prior to the adoption of SFAS No. 123R on April 1, 2006, the Company had recorded deferred stock compensation and related amortization expense in connection with certain stock options to employees representing the difference between the fair market value of the stock at the grant date and the exercise price, as prescribed in APB 25. During the three months ending June 30, 2006 and June 30, 2005, no options were granted to employees with exercise prices that were less than fair value. During the three months ended June 30, 2005, the Company recorded amortization of deferred compensation of approximately $22,000, of which approximately $13,000 was charged to general and administrative expense and $9,000 to cost of revenue. Additionally, in the three months ended June 30, 2006, the Company recorded $396,907 of stock related compensation in accordance with SFAS 123R. See Note 7.
  Stock Repurchase
     In December 2005, the Board of Directors approved a stock buyback program to repurchase up to $25.0 million worth of stock in the open market subject to certain criteria as determined by the Board. As of June 30, 2006, approximately $18.7 million remains available to be used under this program. The Board also dissolved the previous stock buyback program initiated in May 2003. Pursuant to the plan, the Company expects to repurchase shares in the open market from time to time based on market conditions. During the three months ended June 30, 2006, the Company repurchased 1,206,431 shares of its common stock. During the three months ended June 30, 2005, the Company did not repurchase any shares of its common stock.
6. Income Taxes
     The Company recorded a provision for income taxes of approximately $29,000 and $30,000 for the three months ended June 30, 2006 and June 30, 2005, respectively. The provision related to state franchise taxes in the U.S. and foreign taxes on interest income in India.
     Statement of Financial Accounting Standards No. 109 provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes the Company’s historical operating performance and the reported cumulative net losses in all prior years, the Company has provided a full valuation allowance against its net deferred tax assets. The Company evaluates the realizability of the deferred tax assets on a quarterly basis.
7. Stock-Based Compensation
     Effective April 1, 2006, the Company adopted the provisions of SFAS No. 123R. SFAS No. 123R establishes accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as expense over the requisite service period, which is the vesting period. All of the Company’s stock compensation is accounted for as an equity

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instrument. The Company previously applied APB No. 25 and related interpretations and provided the required pro forma disclosures of SFAS No. 123.
  Prior to the Adoption of SFAS No. 123R
     Prior to the adoption of SFAS No. 123R, the Company provided the disclosures required under SFAS No. 123, as amended by SFAS No. 148.
     The pro-forma information for the three months ended June 30, 2005 was as follows (in thousands, except per share data):
         
    Three months ended  
    June 30, 2005  
Net loss, as reported
  $ (2,729 )
Add: Stock-based employee compensation expense included in reported net loss
    80  
Deduct: Stock-based employee compensation expense determined under the fair value based method for all awards
    (766 )
 
     
Net loss, pro forma
  $ (3,415 )
 
     
Basic and diluted net loss per share, as reported
  $ (0.08 )
 
     
Basic and diluted net loss per share, pro forma
  $ (0.10 )
 
     
  Equity Incentive Program
     The Company’s equity incentive program is a broad-based, retention program comprised of stock option plans and an employee stock purchase plan designed to align stockholder and employee interests. For a description of the Company’s equity plans, see the notes to consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended March 31, 2006.
  Valuation Assumptions
     The Company estimates the fair value of each stock option on the date of grant using a Black-Scholes option-pricing model, consistent with the provisions of SFAS No. 123R, SAB No. 107 and the Company’s prior period pro forma disclosures of net loss, including stock-based compensation (determined under a fair value method as prescribed by SFAS No. 123) to determine the fair value of stock options and employee stock purchase plan shares. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by the stock price as well as assumptions regarding a number of complex and subjective variables. These variables include expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.
     The Company estimates the expected term of options granted by calculating the average term from the Company’s historical stock option exercise experience. The Company estimates the volatility of its stock options by using historical volatility in accordance with SAB No. 107. The Company believes its historical volatility is representative of its estimate of expectations of the expected term of its equity instruments. The Company bases the risk-free interest rate that is use in the option-pricing model on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore uses an expected dividend yield of zero in the option-pricing model. The Company is required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company uses predicted data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. All share based payment awards are amortized on a straight-line basis over the requisite service periods of the awards, which are the vesting periods.

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     If factors change and the Company employs different assumptions for estimating stock-based compensation expense in future periods or if it decides to use a different option-pricing model, the future periods may differ significantly from what has been recorded in the current period and could materially affect operating income (loss), net income (loss) and net income (loss) per share.
     The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable, characteristics not present in our option grants and employee stock purchase plan shares. Existing option-pricing models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair values of our stock-based compensation. Consequently, there is a risk that the Company’s estimates of the fair values of its stock-based compensation awards on the grant dates may bear little resemblance to the actual values realized upon the exercise, expiration, early termination or forfeiture of those stock-based payments in the future. Certain stock-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, value may be realized from these instruments that are significantly higher than the fair values originally estimated on the grant date and reported in the Company’s financial statements. There currently is no market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these option-pricing models, nor is there a means to compare and adjust the estimates to actual values.
     Information regarding net loss had the Company accounted for its employee stock options granted during the three months ended June 30, 2006 and 2005 under the fair value method was estimated at the date of grant with the following weighted average assumptions:
                 
    Three Months Ended June 30,
    2006   2005
Risk-free interest rate
    5.09 %     3.59 %
Dividend yield
    0.00 %     0.00 %
Expected volatility
    43.66 %     66.35 %
Expected option life in years
    4.0       3.97  
Weighted average fair value at grant date
  $ 1.13     $ 1.69  
     Information regarding net loss had the Company accounted for its employee stock purchase during the three months ended June 30, 2006 and 2005 under the fair value method was estimated at the date of grant with the following weighted average assumptions:
                 
    Three Months Ended June 30,
    2006   2005
Risk-free interest rate
    5.14 %     3.01 %
Dividend yield
    0.00 %     0.00 %
Expected volatility
    43.66 %     65.16 %
Expected option life in years
    1.25       1.20  
Weighted average fair value at grant date
  $ 1.02     $ 1.53  
     The following table summarizes activity under the equity incentive plans for the indicated periods:
                         
            Options Outstanding
    Shares available           Weighted-average
    for grant   Number of shares   exercise price
    (in thousands)        
Outstanding at March 31, 2006
    8,432       6,929     $ 3.68  
Options granted
    (40 )     40     $ 2.79  
Options exercised
          (41 )   $ 2.56  
Options cancelled
    462       (462 )   $ 4.77  
Options expired
    (39 )            
 
                       
Outstanding at June 30, 2006
    8,815       6,466     $ 3.60  
 
                       

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     The intrinsic value is calculated as the difference between the market value as of June 30, 2006 and the exercise price of the shares. The market value of the Company’s common stock as of June 30, 2006 was $2.50 as reported by the NASDAQ National Market. The aggregate intrinsic value of stock options outstanding at June 30, 2006 was $56,041, of which $56,014 was related to exercisable options. The aggregate intrinsic value of stock options outstanding at June 30, 2005 was $991,000, of which $891,000 was related to exercisable options.
     The options outstanding and exercisable at June 30, 2006 were in the following exercise price ranges:
                                         
            Options Outstanding   Options Vested
                    Weighted-            
            Number of   Average           Weighted-
            Outstanding   Remaining           Average
    Shares as of   Contractual   Options Vested at   Exercise
Range of   June 30, 2006   Life   June 30, 2006   Price
Exercise Prices   (in thousands except for per share amount)
$ 0.50 —
  $ 2.56       1,426,229       6.06       1,388,780       2.50  
$ 2.65 —
  $ 3.39       1,168,863       8.37       381,110       3.02  
$ 3.40 —
  $ 3.40       2,427,395       8.53       996,031       3.40  
$ 3.44 —
  $ 4.94       1,294,835       6.42       1,182,379       4.17  
$ 5.30 —
  $ 63.48       148,680       5.12       132,013       18.25  
 
                                       
$ 0.50 —
  $ 63.48       6,466,002       7.45       4,080,313       3.76  
 
                                       
     The following table summarizes the Company’s outstanding weighted average options for the indicated periods:
                 
    Three Months Ended June 30,
    2006   2005
Weighted average options with strike price below FMV
    509,770       1,850,129  
Weighted average options with strike price at FMV
    9,209       5,750  
Weighted average options with strike price above FMV
    5,947,023       6,469,730  
  1999 Employee Stock Purchase Plan (“ESPP”)
     The price paid for the Company’s common stock purchased under the ESPP is equal to 85% of the lower of the fair market value of the Company’s common stock at the beginning of each offering period or at the end of each offering period. The compensation expense in connection with the ESPP for the three months ended June 30, 2006 was $51,573. The compensation cost in connection with the ESPP for the three months ended June 30, 2005 was $37,138. During the three months ended June 30, 2006, there were 18,289 shares issued under the ESPP at a weighted average purchase price of $2.30 per share. During the three months ended June 30, 2005, there were 36,360 shares issued under the ESPP at a weighted average purchase price of $2.77 per share. At June 30, 2006, 3,017,213 shares were available for purchase under the ESPP.
  Impact of the Adoption of SFAS No. 123R
     The Company elected to adopt the modified prospective application method as provided by SFAS No. 123R under which prior periods are not revised for comparative purposes. The effect of recording stock-based compensation for the three months ended June 30, 2006 was as follows:
         
    Three Months Ended  
    June 30, 2006  
Stock-based compensation expense by caption:
       
Cost of revenues
  $ 49,563  
Research and development
    57,118  
Selling and marketing
    38,240  
General and administrative
    251,986  
 
     
Impact on net loss per share
  $ 396,907  
 
     

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    Three Months Ended  
    June 30, 2006  
Stock-based compensation expense by type of award:
       
Stock options
  $ 345,334  
Employee stock purchase plan
    51,573  
 
     
Impact on net loss per share
  $ 396,907  
 
     
     As of June 30, 2006, the Company had an unrecorded deferred stock-based compensation balance related to stock options of approximately $3,222,208 before estimated forfeitures, which will be recognized over an estimate weighted average amortization period through June 1, 2010. The weighted average remaining contractual term of all options exercisable at June 30, 2006 is 6.7 years. In the Company’s pro forma disclosures prior to the adoption of SFAS No. 123R, the Company accounted for forfeitures upon occurrence. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised if necessary in subsequent periods if actual forfeitures differ from those estimates. Based on the Company’s estimates of future forfeiture rates, the Company has assumed an annualized forfeiture rate of 20% for its options.
     During the three months ended June 30, 2006, the Company granted 40,000 stock options with an estimated total grant-date fair value of $45,159. Of this amount, the Company estimated that the stock-based compensation for the awards not expected to vest was $9,032. During the three months ended June 30, 2006, the Company recorded stock-based compensation related to all stock options of $345,334.
8. Computation of Basic and Diluted Net Loss Per Share
     Basic and diluted net loss per common share is presented in conformity with SFAS No. 128, “Earnings Per Share” (“SFAS 128”), for all periods presented. In accordance with SFAS 128, basic and diluted net loss per share has been computed using the weighted-average number of shares of common stock outstanding during the period.
     The following table presents the computation of basic and diluted net loss per share:
                 
    Three Months  
    Ended  
    June 30,  
    2006     2005  
    (In thousands)  
Net loss
  $ (2,598 )   $ (2,729 )
 
           
Basic and diluted:
               
Weighted-average shares used in computing basic and diluted net loss per share
    31,441       32,821  
 
           
Basic and diluted, net loss per share
  $ (0.08 )   $ (0.08 )
 
           
     The Company excludes potentially dilutive securities from its diluted net loss per share computation when their effect would be antidilutive to net loss per share amounts. The following common stock equivalents were excluded from the net loss per share computation:
                 
    Three Months Ended June 30,  
    2006     2005  
    (In thousands)  
Options excluded due to the exercise price exceeding the average fair market value of the Company’s common stock during the period
    5,947       6,470  
Options excluded for which the exercise price was at or less than the average fair market value of the Company’s common stock during the period but were excluded as inclusion would decrease the Company’s net loss per share
    519       1,850  
 
           
Total common stock equivalents excluded from diluted net loss per common share
    6,466       8,320  
 
           

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9. Litigation
     The Company is subject to certain routine legal proceedings, as well as demands, claims and threatened litigation, that arise in the normal course of its business. The Company believes that the ultimate amount of liability, if any, for any pending claims of any type, except for the items described in the Company’s Annual Report on Form 10-K for the year ended March 31, 2006, (either alone or combined) will not materially affect its financial position, results of operations or liquidity.
10. Acquisition
     In May 2005, the Company entered into an agreement to purchase certain assets and products of Determine Software, Inc. (“Determine”) for approximately $892,000. The transaction closed in the first quarter of fiscal 2006 and has been accounted for in accordance with SFAS 141 “Business Combinations”. Determine was a provider of enterprise contract management software. Determine’s solutions include: the ability to aggregate and analyze enterprise-wide contract information, automate and accelerate contract related business processes, enforce contract and relationship-wide contract and relationship compliance. The addition of Determine’s software capabilities and customers will allow the Company to extend its offerings to include contract management solutions. The Company allocated the purchase price of the acquisition to tangible and intangible assets acquired based on several factors, including valuations, estimates and assumptions.
     The total purchase price is allocated as follows (in thousands of dollars):
                 
    Amount     Amortization life  
    (in thousands)     (years)  
Accounts Receivable
  $ 74        
Fixed Assets
    17        
Intangible assets:
               
Developed technology
    367       3  
Customer relationship
    338       4  
Customer backlog
    96       1  
 
             
Total purchase price
  $ 892          
 
             
     The results of Determine’s operations effective May 3, 2005 has been included in the condensed consolidated financial statements.
     As of June 30, 2006, the intangible assets associated with Determine are included in Other Assets as follows:
         
    Amount  
    (in thousands)  
Cost
  $ 801  
Accumulated amortization
    (337 )
 
     
Net
  $ 464  
 
     
     These intangible assets will be amortized on a straight-line basis over their estimated lives:
                                 
    Nine        
    months                    
    ended     Fiscal Years Ended June 30,  
    2007     2008     2009     2010  
            (in thousands)          
Amortization by fiscal year
  $ 155     $ 207     $ 95     $ 7  
 
                       
     Amortization for the three months ended June 30, 2006 and June 30, 2005, was approximately $52,000 for each respective period.

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11. Restructuring
     In May 2005, the Company reduced headcount by 42 employees. Headcount reduction consisted of 11 in general and administrative, 12 in sales and marketing, 8 in research and development and 11 in professional service. These reductions resulted in charges of approximately $688,000 during the three months ended June 30, 2005, consisting principally of severance payments and benefits, of which $115,000 was included in cost of revenues, $131,000 included in research and development expense, $126,000 included in sales and marketing expense, and $316,000 included in general and administrative expense. The charges for this reduction in staff have been accounted for in accordance with SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities.” All amounts associated with this reduction have been paid as of June 30, 2006.
12. Recent Accounting Pronouncements
     In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). FIN 48 requires the use of a two-step approach for recognizing and measuring tax benefits taken or expected to be taken in a tax return and disclosures regarding uncertainties in income tax positions. The Company is required to adopt FIN 48 effective January 1, 2007. The cumulative effect of initially adopting FIN 48 will be recorded as an adjustment to opening retained earnings in the year of adoption and will be presented separately. Only tax positions that meet the more likely than not recognition threshold at the effective date may be recognized upon adoption of FIN 48. The Company does not believe this new standard will have a material impact on its future results of operations or financial position.
13. Subsequent Events
  Resignation of a Director and Consulting Agreement
     On July 21, 2006, Dr. Sanjay Mittal resigned as a member of the Board of Directors. Also on July 21, 2006, the Company entered into a consulting agreement with Dr. Mittal. Under the terms of the consulting agreement, Dr. Mittal will serve as a consultant to the Company for a period of at least 12 months, subject to earlier termination under certain specified circumstances, and will receive $500 per hour for services rendered, with a minimum payment of 10 hours per calendar month for a minimum total monthly commitment of $5,000.
  Resignation of the Chief Executive Officer
     On August 9, 2006, the Company announced that its board of directors had named Stephen Bennion as its new Chairman and Chief Executive Officer. Mr. Bennion had served as the Company’s Chief Financial Officer since 1999. Mr. Bennion replaced Vince Ostrosky, who had stepped down from the Chief Executive Officer position following a mutual decision reached with the Company’s board of directors that the Company would be better served by a more streamlined management structure. Mr. Ostrosky will continue to serve on the Company’s board of directors. Mr. Bennion will also serve as Interim Chief Financial Officer. The Company will commence a search for a new Chief Financial Officer.

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ITEM 2:   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
     In addition to historical information, this quarterly report contains forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those projected. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the section entitled “Management’s Discussion and Analysis” as well as in Part II Item 1A “Risk Factors.” Actual results could differ materially. Important factors that could cause actual results to differ materially include, but are not limited to; the level of demand for Selectica’s products and services; the intensity of competition; Selectica’s ability to effectively manage product transitions and to continue to expand and improve internal infrastructure; risks associated with potential acquisitions; and adverse financial, customer and employee consequences that might result to us if litigation were to be resolved in an adverse manner to us. For a more detailed discussion of the risks relating to our business, readers should refer to Part II Item 1A found later in this report entitled “Risks Factors.” Readers are cautioned not to place undue reliance on the forward-looking statements, including statements regarding our expectations, beliefs, intentions or strategies regarding the future, which speak only as of the date of this quarterly report. We assume no obligation to update these forward-looking statements.
Overview
     We develop, market, sell and support software that helps companies with multiple product lines and channels of distribution to effectively configure, price, quote new business and manage the contracting process for their products and services. Our products enable customers to increase revenue and profit margins and reduce costs through seamless, web-enabled automation of the “quote to contract” business processes, which reside between legacy CRM and ERP systems. Businesses that deploy our products are able to empower business managers to quickly and easily modify and synchronize product, service and price information enterprise-wide to ensure proper margins and to stay ahead of changing market conditions. Over the past number of years, our solutions have been successfully implemented at a number of companies such as IBM, Cisco Systems, Dell, Rockwell and GE Healthcare. However, these types of large system sales have declined significantly over the past several quarters due, we believe, to reduced IT spending, reluctance of customers to undertake large, custom project implementations, our target customers’ growing preference for smaller scale, more focused system implementations and increased competition from suite vendors such as Oracle, SAP and Ariba and from point application software vendors like Comergent Technologies, Firepond, Trilogy, iMany, Upside Software, and Dicarta/Emptoris.
     In response to this market shift, we developed and introduced a new generation of application offerings including the On Demand/hosted software as a service product called Fastraq. These products utilize our state-of-the-art configuration and pricing technologies. These applications incorporate industry specific domain knowledge and offer high levels of capability in more flexible ways. We have also been focused on expanding our product footprint and value proposition by extending into the growing contract management and compliance market. We began to achieve this objective shortly after the close of fiscal 2005 with the acquisition of certain of the assets of Determine. Determine Contract Management products along with Fastraq extend our business model by permitting us to offer a broader range of on-demand solutions for our customers. The new Telecom and Insurance products, developed with a partner, are targeted at large and mid-sized customers. The Fastraq and Contract Management products are targeted at small to large businesses interested in using application software to manage configurable product and service offerings, though automated pricing management, contract management, and compliance. Concurrent with the development, marketing and sales of these new products, we will continue to develop, sell and support our existing platform products.
     Also in response to these business developments, we have worked to reduce our operating costs through the reduction of personnel and other costs. During fiscal 2006, we continued to face significant challenges as bookings of platform products underperformed and sales of the new generation products were minimal, as they were not released until the latter part of the calendar year. However, bookings of our Contract Management products have increased significantly since the business was acquired. Following the anticipated relocation of our corporate headquarters, we believe our breakeven level will be reduced to approximately $6.2 million in quarterly revenues in the second half of fiscal 2007. Based on our expectation that new bookings will begin improving, combined with our ongoing cost reduction initiatives, we currently expect to achieve profitability in the second half of fiscal year 2007.
     On August 9, 2006, we announced that our board of directors had named Stephen Bennion as our new Chairman and Chief Executive Officer. Mr. Bennion had served as our Chief Financial Officer since 1999. Mr. Bennion replaced Vince Ostrosky, who had stepped down from the Chief Executive Officer position following a mutual decision reached with our board of directors that we would be better served by a more streamlined management structure. Mr. Ostrosky will continue to serve on our board of directors. Mr. Bennion will also serve as Interim Chief Financial Officer. We will commence a search for a new Chief Financial Officer.

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Quarterly Financial Overview
     For the three months ended June 30, 2006, our revenues were approximately $5.2 million with license revenues representing 9% and services revenues representing 91% of total revenues. In addition, approximately 36% of our quarterly revenue came from two customers. License margins for the quarter were 75% and services margins were 46%. While we anticipate entering into more time and material based services contracts, we still have some existing contracts, which have fixed fee terms and may lower services margins in the future. Net loss for the quarter was approximately $2.6 million or $(0.08) per share.
     Our bookings this quarter increased in comparison to the prior quarter, particularly in Contract Management and Fastraq. In addition, we will need to continue to increase our level of overall bookings on a quarterly basis in order to increase our reported revenues. We may reduce quarterly operating expense levels depending on the level of bookings achieved.
     Additionally, as part of our continuing expense reduction efforts, we will relocate our corporate headquarters to a lower cost facility in the San Jose area. We expect this relocation to occur in the second half of fiscal 2007. Accordingly, we expect to record a one-time charge of approximately $6.5 million in the second half of fiscal 2007 related to these relocation efforts.
Critical Accounting Policies and Estimates
     There have been no material changes to any of our critical accounting policies and estimates as disclosed in our report on Form 10-K for the year ended March 31, 2006.
     The following table shows how our revenues have been recognized:
                 
    Three Months Ended
    June 30,
As a Percentage of Total Revenues:   2006   2005
Contract accounting
    73 %     74 %
Residual method
    %     %
Subscription method (includes maintenance)
    27 %     26 %
 
               
Total revenues
    100 %     100 %
 
               
     Customer billing occurs in accordance with contract terms. Customer advances and amounts billed to customers in excess of revenue recognized are recorded as deferred revenues. The majority of our contracts have been accounted for on the completed contract method upon achievement of milestones or final acceptance from the customer.
  Related Party Transaction and Severance Agreement
     In connection with the resignation of Dr. Sanjay Mittal, as Chief Executive Officer in September 2003, we agreed to have him continue as Chief Technical Advisor (“CTA”). Pursuant to this arrangement, Dr. Mittal received $20,000 per month for his services and this arrangement would continue until either party terminated the CTA service.
     In March 2005, Dr. Mittal’s role as CTA was terminated and he received a lump-sum severance payment of $412,500 in addition to the amount paid for outside services. In July 2005, Dr. Mittal agreed to provide hourly consulting services relating to our patent litigation, which was settled in February 2006. As a result, his consulting services agreement terminated. Dr. Mittal was not paid any fees for consulting services for the three months ended June 30, 2006 and June 30, 2005. Dr. Mittal was a member of the Board of Directors until July 21, 2006.

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     On July 21, 2006, Dr. Sanjay Mittal resigned as a member of the Board of Directors. Also on July 21, 2006, we entered into a new consulting agreement with Dr. Mittal. Under the terms of the consulting agreement, Dr. Mittal will serve as a consultant to us for a period of at least 12 months, subject to earlier termination under certain specified circumstances, and will receive $500 per hour for services rendered, with a minimum payment of 10 hours per calendar month. See Note 13 for additional information regarding Dr. Mittal.
  Factors Affecting Operating Results
     A small number of customers account for a significant portion of our total revenues. We expect that our revenue will continue to depend upon a limited number of customers. If we were to lose a customer, it would have a significant impact upon future revenue. Customers who accounted for at least 10% of total revenues were as follows:
                 
    Three Months Ended
    June 30,
    2006   2005
Customer A
    25 %     29 %
Customer B
    11 %     *  
Customer C
    *       24 %
Customer D
    *       13 %
 
*   Customer account was less than 10% of total revenues.
     To date, we have foreign activities in India, Canada and some European countries because we believe international markets represent an avenue for growth. We anticipate that our exposure to foreign currency fluctuations will continue since we have not adopted a hedging program to protect us from risks associated with foreign currency fluctuations.
     We have incurred significant losses since inception and, as of June 30, 2006, we had an accumulated deficit of approximately $192.7 million. We believe our success depends on the growth of our customer base and the development of the emerging configuration, pricing management, quoting solutions and the contract management and compliance market. In the early 2000’s, we underwent certain restructuring activities and did so again during the fiscal years of 2006 and 2005.
     In view of the rapidly changing nature of our business, we believe that period-to-period comparisons of revenues and operating results are not necessarily meaningful and should not be relied upon as indications of future performance. Our operating history has been volatile and makes it difficult to forecast future operating results. This was evidenced by the decline in revenue in fiscal 2006 and 2005.
     Because our services tend to be specific to each customer and how that customer will use our products, and because each customer sets different acceptance criteria, it is difficult for us to accurately forecast the amount of revenue that will be recognized on any particular customer contract during any quarter or fiscal year. As a result, we base our revenue estimates, and our determination of associated expense levels, on our analysis of the likely revenue recognition events under each contract during a particular period. Although the value of customer contracts signed during any particular quarter or fiscal year is not an accurate indicator of revenues that will be recognized during any particular quarter or fiscal year, in general, if the value of customer contracts signed in any particular quarter or fiscal year is lower than expected, revenue recognized in future quarters and fiscal years will likely be negatively effected.

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Results of Operations:
Revenues
                         
    Three Months Ended    
    June 30,    
    2006   2005   Change
    (in thousands except percentages)
License
  $ 468     $ 2,034       (77 )%
Percentage of total revenues
    9 %     29 %        
Services
  $ 4,748     $ 5,045       (6 )%
Percentage of total revenues
    91 %     71 %        
Total revenues
  $ 5,216     $ 7,079       (26 )%
     License. For the three months ending June 30, 2006, license revenues decreased on a quarterly basis by approximately $1.5 million compared to the three months ending June 30, 2005.
     Our inability to increase bookings in the previous quarters was a significant factor in the decline of our revenues this quarter. Our license bookings have generally declined since the third quarter of fiscal 2005. We expect license revenues to continue to fluctuate in future periods as a percentage of total revenues and in absolute dollars depending on the number and size of new license contracts.
     Services. Services revenues are comprised of fees from consulting, maintenance, training, subscription revenue and out-of pocket reimbursement. During the three months ending June 30, 2006, services revenues decreased compared to the period ending June 30, 2005. The decrease primarily related to fewer service opportunities provided by new license agreements as bookings of license agreements has continued to decline, offset by our clients’ demand for additional services to expand their initial customized application and revenue generated by our on-demand offerings. Maintenance revenues represented 34% of total services revenues for the three months ended June 30, 2006 and June 30, 2005, respectively.
     We expect services revenues to continue to fluctuate in future periods as a percentage of total revenues and in absolute dollars. This will depend on the number and size of new software implementations and follow-on services to our existing customers. We expect maintenance revenue to fluctuate in absolute dollars and as a percentage of services revenues with respect to the number of maintenance renewals, and number and size of new contracts. In addition, maintenance renewals are extremely dependent upon customer satisfaction and the level of need to make changes or upgrade versions of our software by our customers. Fluctuations in services revenue are also due to timing of revenue recognition, achievement of milestones, customer acceptance, changes in scope or renegotiated terms, and additional services.
Cost of revenues
                         
    Three Months Ended        
    June 30,        
    2006     2005     Change  
    (in thousands, except percentages)  
Cost of license revenues
  $ 115     $ 132       (13 )%
 
                   
Percentage of license revenues
    25 %     6 %        
 
                       
Cost of services revenues, excluding stock-based compensation
  $ 2,514     $ 2,578       (2 )%
Stock-based compensation expense
    50       9       422 %
 
                   
Total cost of services revenues
  $ 2,564     $ 2,587       (1 )%
 
                   
Percentage of services revenues
    54 %     51 %        
     Cost of License Revenues. The cost of license revenues consists of a nominal allocation of research and development fees, royalty fees associated with third-party software, and data transmission costs. The decrease in costs of license revenue during the three months ended June 30, 2006 from the same period in 2005 was primarily due to a decrease in research and development expenses. We expect cost of license revenues to maintain a relatively consistent level in absolute dollars.
     Cost of Services Revenues. The cost of services revenues is comprised mainly of salaries and related expenses of our services organization plus certain allocated expenses. During the three months ended June 30, 2006, these costs

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decreased 1% while service revenue decreased 6% compared to the same period in 2005 primarily due to a decrease in salaries and facilities expenses offset by an increase of approximately $240,000 of consulting expense. Additionally, restructuring and severances costs resulted in a charge of $116,000 in the three months ended June 30, 2005. There were no severance charges in the three months ended June 20, 2006.
     Our cost of revenues included charges of $50,000 and $9,000 related to stock compensation expense in the three months ended June 30, 2006 and June 30, 2005, respectively. In the three months ended June 30, 2006, we adopted SFAS 123R, which accounted for this increase.
     We expect cost of services revenues to fluctuate as a percentage of service revenues and we plan to reduce our investment in cost of services revenues in absolute dollars over the next year as necessary to balance expense levels with projected revenues.
Gross Margins
     Gross margins percentages for services revenues and license revenues for the respective periods are as follows:
                 
    Three Months Ended
    June 30,
    2006   2005
License
    75 %     94 %
Services
    46 %     49 %
     Gross Margin — Licenses. Because we have certain license costs that are fixed, gross margins fluctuate until we have sufficient license revenues. License margins may also fluctuate due to embedded third-party software. When license software products are sold with royalty bearing software, margins are lower than when license software without such third party products are sold. Accordingly, margins will vary based on gross license revenue and product mix. Due to significantly lower license revenues to offset the fixed license costs, we experienced lower license gross margins during the three months ended June 30, 2006 compared to the three months ending June 30, 2005.
     Gross Margin — Services. During the three months ended June 30, 2006, revenues from services decreased by approximately $0.3 million and gross margin decreased to 46%. While services revenues decreased, we were unable to decrease our costs correspondingly in order to maintain the services margin compared to the three months ended June 30, 2005.
     We expect that our overall gross margins will continue to fluctuate due to the timing of services and license revenue recognition and will continue to be adversely affected by lower margins associated with services revenues. The impact on our gross margin will depend on the mix of services we provide, whether the services are performed by our in-house staff or third party consultants, and the overall utilization rates of our professional services organization.
Operating Expenses
Research and Development Expenses
                         
    Three Months Ended  
    June 30,  
    2006     2005     Change  
    (in thousands, except percentages)  
Research and development expense, excluding stock-based compensation
  $ 2,050     $ 2,562       (20 )%
Stock-based compensation expense
    57       3       1800 %
 
                   
Total research and development expense
  $ 2,107     $ 2,565       (18 )%
 
                   
Percentage of total revenues
    40 %     36 %        

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     Research and development expenses consist primarily of salaries and related costs of our engineering, quality assurance, technical publications efforts and certain allocated expenses. The decrease of approximately $450,000 in research and development expenses during the three months ending June 30, 2006 compared to the three months June 30, 2005 was primarily attributable to a staff reduction and decreases in costs for facilities, overhead and benefits. Restructuring and severances costs resulted in a charge of $131,000 in the three months ended June 30, 2005. There were no severance charges in the three months ended June 30, 2006. Headcount reductions lowered salaries and benefits by approximately $500,000. Additionally, we amortized $30,000 and $20,000 in the three months ended June 30, 2006 and June 30, 2005, respectively, of Determine intangible assets for customer relationships. The decrease in research and development expenses was offset by charges of $57,000 and $3,000 related to stock compensation expense in the three months ended June 30, 2006 and June 30, 2005. In the three months ended June 30, 2006, we adopted SFAS 123R, which accounted for this increase.
     We may reduce expenses in research and development in absolute dollars over the current year as necessary to balance total expenses.
Sales and Marketing
                         
    Three Months Ended  
    June 30,  
    2006     2005     Change  
    (in thousands, except percentages)  
Sales and marketing, excluding stock-based compensation
  $ 1,797     $ 1,737       3 %
Stock-based compensation expense
    38              
 
                   
Total sales and marketing
  $ 1,835     $ 1,737       6 %
 
                   
Percentage of total revenues
    35 %     25 %        
     Sales and marketing expenses consist primarily of salaries and related costs for our sales and marketing organization, sales commissions, expenses for travel and entertainment, trade shows, public relations, collateral sales materials, advertising and certain allocated expenses. For the three months ended June 30, 2006, sales and marketing expenses increased $100,000 when compared to the same period in 2005. Restructuring and severances costs resulted in a charge of $126,000 in the three months ended June 30, 2005. There were no severance charges in the three months ended June 30, 2006. Salaries, benefits, travel and consultants decreased by approximately $100,000, offset by increases in overall marketing expenses of approximately $200,000. Additionally, we incurred amortization of intangible assets of $21,000 and $31,000 in the three months ended June 30, 2006 and June 30, 2005, respectively, and charges of $38,000 related to stock compensation expense in the three months ended June 30, 2006 as we adopted SFAS 123R. There were no charges to sales and marketing expense related to stock compensation expense in the three months ended June 30, 2005.
     We may increase our sales and marketing expenses in absolute dollars over the next year as necessary to continue the business expansion.
General and Administrative
                         
    Three Months Ended  
    June 30,  
    2006     2005     Change  
    (in thousands, except percentages)  
General and administrative, excluding stock-based compensation
  $ 1,630     $ 3,234       (50 )%
Stock-based compensation expense
    252       68       271 %
 
                   
Total general and administrative
  $ 1,882     $ 3,302       (43 )%
 
                   
Percentage of total revenues
    36 %     47 %        
     General and administrative expenses consist mainly of personnel and related costs for general corporate functions, including finance, accounting, legal, human resources, bad debt expense and certain allocated expenses.

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The decrease of approximately $1.4 million in general and administrative expense during the three months ending June 30, 2006 compared to the three months ended June 30, 2005, was due primarily to decreases of approximately $1.1 million in legal and professional fees associated with patent litigation, which was settled in February 2006, offset by other charges. Restructuring and severances costs resulted in a charge of $316,000 in the three months ended June 30, 2005. There were no severance charges in the three months ended June 30, 2006. Additionally, we incurred charges of $252,000 and $68,000 related to stock compensation expense in the three months ended June 30, 2006 and June 30, 2005, respectively. In the three months ended June 30, 2006, we adopted SFAS 123R, which accounted for this increase.
     The decline in overall operating expenses reflects the impact of our efforts to reduce our cost structure, particularly general and administrative expenses. We may reduce general and administrative expenses in absolute dollars over the next year as necessary to balance total expenses.
Restructuring
     In May 2005, we implemented a reduction of 42 employees. This was accounted for under Summary of Statement No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities”, which replaced EITF 94-3 on January 1, 2003. The reduced headcounts were 11, 8, 12, and 11 for professional services, research and development, sales and marketing, and general and administrative, respectively. These reductions were offset by related severance costs of approximately $868,000 included in operating expenses, of which $688,000 was recorded in the three months ended June 30, 2005, and the use of outside services and consultants to assume certain tasks and ongoing projects.
     All severance and employee benefits have been paid as of June 30, 2006.
Interest and Other Income, Net
     Interest income consists primarily of interest earned on cash balances and short-term and long-term investments. During the three months ended June 30, 2006 and June 30, 2005, interest income totaled approximately $718,000 and $545,000, respectively. The increase was due primarily to higher interest rates on our cash and investments balances and offset by the reduction of cash and investments balances due to amounts used for the operation of our business and the repurchase of our shares.
Provision for Income Taxes
     During the three months ended June 30, 2006 and June 30, 2005, we recorded income tax provisions of approximately $29,000 and $30,000, respectively. These amounts related to taxes due in foreign jurisdictions and nominal tax amounts for federal and states taxes in the U.S.
     FASB Statement No. 109 provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes our historical operating performance and the reported cumulative net losses in all prior years, we have provided a full valuation allowance against our net deferred tax assets. We will continue to evaluate the realizability of the deferred tax assets on a quarterly basis.
Recent Accounting Pronouncements
     In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). FIN 48 requires the use of a two-step approach for recognizing and measuring tax benefits taken or expected to be taken in a tax return and disclosures regarding uncertainties in income tax positions. We are required to adopt FIN 48 effective January 1, 2007. The cumulative effect of initially adopting FIN 48 will be recorded as an adjustment to opening retained earnings in the year of adoption and will be presented separately. Only tax positions that meet the more likely than not recognition threshold at the effective date may be recognized upon adoption of FIN 48. We do not believe this new standard will have a material impact on our future results of operations or financial position.

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Liquidity and Capital Resources
                         
    June 30,   March 31,    
    2006   2006   Change
    (in thousands, except percentages)
Cash, cash equivalents and short-term investments
  $ 70,905     $ 74,005       (4 )%
Working capital
  $ 69,781     $ 73,043       (4 )%
                 
    Three Months Ended
    June 30,
    2006   2005
    (in thousands)
Net cash used in operating activities
  $ (2,442 )   $ (2,024 )
Net cash provided by (used in) investing activities
  $ 11,916     $ (6,638 )
Net cash provided by (used in) financing activities
  $ (2,572 )   $ 186  
     Our primary sources of liquidity consisted of approximately $70.9 million in cash, cash equivalents and short-term investments as of June 30, 2006 compared to approximately $74.0 million in cash, cash equivalents and short-term investments as of March 31, 2006. During the three months ending June 30, 2006, the increase in cash and cash equivalents was primarily related to approximately $2.4 million of cash used in operations and approximately $3.1 million of cash used to repurchase our stock, offset by net purchases of short and long-term investments and purchase of assets of approximately $12.0 million. During the three months ending June 30, 2005, the decrease in cash and cash equivalents was primarily related to approximately $2.0 million of cash used in operations and approximately $6.6 million net purchases of short and long-term investments and acquisition costs, offset by the issuance of common stock of approximately $186,000. We experienced a net decrease in working capital at June 30, 2006 as compared to March 31, 2006 primarily due to the cash used in operations and the cost of repurchasing our stock.
     The net cash provided by investing activities for the three months ending June 30, 2006 was due primarily to approximately $12.0 million of net maturity of available-for-sale investments as compared to approximately $5.7 million of net purchases of available-for-sale investments for the three months ending June 30, 2005.
     The net cash used in financing activities for the three months ended June 30, 2006, was primarily due to the cost of stock repurchased by us for approximately $3.1 million, offset by issuance of common stock through the exercise of options and employee stock purchase plans for approximately $0.5 million. The net cash provided by financing activities for the three months ending June 30, 2005 was due primarily to the proceeds from the issuance of common stock through the exercise of options and employee stock purchase plans for approximately $186,000.
     We had no significant commitments for capital expenditures as of June 30, 2006. We expect to fund our future capital expenditures, liquidity and strategic operating programs from a combination of available cash balances and internally generated funds. We have no outside debt and do not have any plans to enter into borrowing arrangements. Our cash, cash equivalents, and short-term investment balances as of June 30, 2006 are adequate to fund our operations through at least the next twelve months.
     We do not anticipate any significant capital expenditures, payments due on long-term obligations, or other contractual obligations. However, management is continuing to review our cost structure to minimize expenses and use of cash as we implement our planned business model changes. This activity may result in additional restructuring charges or severance and other benefits. Additionally, abandonment of excess leased facilities could result in significant one-time charges and use of cash, although such charges and use of cash are not assured. As part of our continuing expense reduction efforts, we will be attempting to relocate our corporate headquarters to a lower cost facility in the San Jose area. If this occurs, we expect to record a one-time charge of approximately $6.5 million in the second quarter of fiscal 2007 related to this relocation effort.

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     Our contractual obligations and commercial commitments at June 30, 2006, are summarized as follows:
                                         
    Payments Due By Period  
            Less Than     1-3     4-5     After 5  
Contractual Obligations:   Total     1 Year     Years     Years     Years  
    (in thousands)  
Operating Leases
  $ 8,710     $ 2,472     $ 6,238     $     $  
     We engage in global business operations and are therefore exposed to foreign currency fluctuations. As of June 30, 2006, the effects of the foreign currency fluctuations in Europe and India were insignificant.
     We have adopted a new stock repurchase program, which authorizes us to pay up to approximately $25.0 million. As of June 30, 2006, approximately $18.7 million remains available to be used under this program at June 30, 2006.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
     The following discusses our exposure to market risk related to changes in foreign currency exchange rates and interest rates. This discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors including those set forth in the Part II Item 1A entitled “Risk Factors” of this quarterly report on Form 10-Q.
Foreign Currency Exchange Rate Risk
     We develop products in the United States and India and sell them worldwide. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Since our sales are currently priced in U.S. dollars and are translated to local currency amounts, a strengthening of the dollar could make our products less competitive in foreign markets.
     Our exposure to fluctuation in the relative value of other currencies has been limited because substantially all of our assets are denominated in U.S. dollars. The impact to our financial statements has therefore not been material. To date, we have not entered into any foreign exchange hedges or other derivative financial instruments. We will continue to evaluate our exposure to foreign currency exchange rate risk on a regular basis.
Interest Rate Risk
     We established policies and business practices regarding our investment portfolio to preserve principal while obtaining reasonable rates of return without significantly increasing risk. This is accomplished by investing in widely diversified short-term and long-term investments, consisting primarily of investment grade securities. Our interest income is sensitive to changes in the general level of U.S. interest rates.
     During the three months ending June 30, 2006, a hypothetical 50 basis point increase in interest rates would have resulted in a reduction of approximately $49,000 (less than 0.1%) in the fair market value of our cash equivalents and investments. This potential change is based upon a sensitivity analysis performed on our financial positions at June 30, 2006. During the three months ending June 30, 2005, a hypothetical 50 basis point increase in interest rates would have resulted in a reduction of approximately $151,000 (less than 0.16%) in the fair market value of our cash equivalents and investments. This potential change is based upon a sensitivity analysis performed on our financial positions at June 30, 2005.
     Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted because of a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations because of changes in interest rates or we may suffer losses in principal if forced to sell securities that have seen a decline in market value because of changes in interest rates. Our investments are made in accordance with an investment policy approved by the Board of Directors. In general, our investment policy requires that our securities purchases be rated A1/P1, AA/Aa3 or better. No securities may have a maturity that exceeds 18 months and the average duration of our investment portfolio may not exceed 9 months. At any time, no more than 15% of the investment portfolio may be insured by a single insurer and no more than 25% of investments may be invested in any one industry other than the US government bonds, commercial paper and money market funds.

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     The following summarizes short-term and long-term investments at fair value, weighted average yields and expected maturity dates as of June 30, 2006 through the fiscal years ending:
                                         
    2007     2008     2009     2010     Total  
    (in thousands)  
Investment CD
  $ 1,153     $ 2,031     $ 1     $ 17     $ 3,202  
Weighted Average yield
    4.92 %     6.34 %     5.75 %     6.50 %     5.83 %
Commercial Paper
    1,088                         1,088  
Weighted Average yield
    4.86 %                       4.86 %
Auction rate securities
    29,459                         29,459  
Weighted Average yield
    5.17 %                       5.17 %
Corporate notes & bonds
    2,824       597                   3,421  
Weighted Average yield
    4.85 %     5.36 %                 4.94 %
Government agencies
    13,249       1,902                   15,151  
Weighted Average yield
    4.24 %     4.90 %                 4.32 %
 
                             
Total investments
  $ 47,773     $ 4,530     $ 1     $ 17     $ 52,321  
 
                             
ITEM 4: CONTROLS AND PROCEDURES
     (a) Evaluation of Disclosure Controls and Procedures. Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 (Exchange Act) Rules 13a-15(e) or 15d-15(e)) as of the end of the period covered by this quarterly report, have concluded that our disclosure controls and procedures are not effective because of the material weaknesses described below.
     (b) Changes in Internal Control over Financial Reporting. As previously disclosed in Item 9A of our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on June 14, 2006, for the fiscal year ended March 31, 2006, we determined that the following material weakness existed in our internal control over financial reporting related to controls maintained by us:
     We had insufficient controls over the External Reporting process related to the preparation, review and approval of the annual and the interim financial statements. Specifically, we had insufficient: a) review within the accounting and finance departments; b) preparation and review of footnote disclosures accompanying our financial statements; and c) technical accounting resources. As of March 31, 2006, we did not have sufficient personnel and technical accounting expertise within our accounting function to sufficiently address complex transactions and/or accounting and financial reporting issues that arise from time to time in the course of our operations. Although these deficiencies did not result in errors in the financial statements, there is however, more than a remote likelihood that a material misstatement of our annual or interim financial statements would not have been prevented or detected.
          Planned Remediation
     In June 2006, our management discussed the material weaknesses described above with our audit committee. We are implementing corrective actions that we believe will remediate the material weakness, however a material weakness may not be considered fully remediated until the instituted controls are operational for a period of time and have been tested by management.
     In fiscal year 2007, we are committed to hiring a sufficient number of technically qualified employees and/or consultants to ensure that all significant accounting issues, both routine and non-routine, are identified, researched and properly concluded upon. This will include preparation and review of the financial statements and related required supporting documentation.
     Because of the insufficient controls described in the preceding paragraphs, we concluded that our internal controls over financial reporting were not effective as of June 30, 2006. While management implemented new controls in the last fiscal year, we maintained our assessment as of June 30, 2006 to allow sufficient time to monitor our new controls and determine whether the new controls are effective and that our remediation plans are sufficient. We will continue to assess the effectiveness of our internal controls, including the controls implemented to correct

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the five material weaknesses identified in fiscal 2005 and the material weakness identified in fiscal 2006. Except for the remediation process implemented by management, there has been no change in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during the quarter ended June 30, 2006, which materially affected, or is reasonably likely to affect, our internal controls over financial reporting.
(c) Limitations on Effectiveness of Controls
     Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls or our internal controls over the financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system reflects the fact that there are resource constraints, and the benefit of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within have been detected. These inherent limitations include the realities that judgment in decision-making can be faulty and that simple error or mistakes can occur. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving it stated goals under all future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.
PART II: OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
  Patent Infringement
     On April 22, 2004, Trilogy Group (“Trilogy”) filed a complaint in the United States District Court for the Eastern District of Texas Marshall Division alleging patent infringement against us. On September 2, 2004, we filed counterclaims in the Eastern District of Texas Marshall Division action against Trilogy for infringement of our U.S. Patent Nos. 6,405,308, 6,675,294, 5,878,400 and 6,553,350 for willfully infringing, directly and indirectly, by making, using, licensing, selling, offering for sale, or importing products including configuration and ordering software.
     In January 2006 we reached a settlement with Trilogy resolving the patent dispute. Both parties agreed to grant each other cross-licenses to the asserted patents for the life of the patents, entered into mutual releases and dismissed with prejudice all outstanding patent infringement claims against each other. Under the terms of the settlement, we paid a one-time sum of $7.5 million to Trilogy on February 16, 2006.
  Class Action
     During 2001, a number of securities class action complaints were filed against us, certain of our officers and directors, and certain of the underwriters of our March 13, 2000 initial public offering (“IPO”). On August 9, 2001, these actions were consolidated before a single judge along with cases brought against numerous other issuers, their officers and directors and their underwriters that make similar allegations involving the allocation of shares in the IPOs of those issuers. The consolidation was for purposes of pretrial motions and discovery only. On April 19, 2002, plaintiffs filed a consolidated amended complaint asserting essentially the same claims as the original complaints.
     The amended complaint alleges that the officer and director defendants, the underwriter’s defendants and Selectica, Inc. violated federal securities laws by making material false and misleading statements in the prospectus incorporated in our registration statement on Form S-1 filed with the SEC in March 2000 in connection with our IPO. Specifically, the complaint alleges, among other things, that the underwriters solicited and received excessive and undisclosed commissions from several investors in exchange for which the underwriters allocated to those investors material portions of the restricted number of shares of common stock issued in our IPO. The complaint further alleges that the underwriters entered into agreements with its customers in which it agreed to allocate the

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common stock sold in our IPO to certain customers in exchange for which such customers agreed to purchase additional shares of our common stock in the after-market at pre-determined prices. The complaint also alleges that the underwriters offered to provide positive market analyst coverage for us after the IPO, which had the effect of manipulating the market for our stock.
     During the course of pre-trial proceedings, the plaintiffs dismissed their claims against the individual defendants without prejudice in return for the individual defendants’ execution of a tolling agreement. A motion to dismiss filed by us was denied by the Court on November 19, 2003.
     On June 25, 2003, our Special Committee of the Board of Directors approved a Memorandum of Understanding (the “MOU”) reflecting a settlement in which the plaintiffs agreed to dismiss the case against us with prejudice in return for our assignment of certain claims that we might have against its underwriters. The same offer of settlement was made to all the issuer defendants involved in the litigation. No payment to the plaintiffs by us is required under the MOU. After further negotiations, the essential terms of the MOU were formalized in a Stipulation and Agreement of Settlement (“Settlement”), which has been executed on behalf of us.
     The settling parties presented the proposed Settlement papers to the Court and filed formal motions seeking preliminary approval. The underwriter defendants, who are not parties to the proposed Settlement, filed objections to the Settlement. On February 15, 2005, the Court granted preliminary approval of the Settlement conditioned on the agreement of the parties to narrow one of a number of the provisions intended to protect the issuers against possible future claims by the underwriters. We re-approved the Settlement with the proposed modifications that were outlined by the Court in its February 15, 2005 Order granting preliminary approval. Approval of any settlement involves a three-step process in the district court: (i) a preliminary approval, (ii) determination of the appropriate notice of the settlement to be provided to the settlement class, and (iii) a final fairness hearing.
     On August 31, 2005, the Court entered a preliminary order approving the modifications to the Settlement and certifying the settlement classes. The Court also ordered that the mailing of the notices of pendency and proposed settlement of the class actions be completed by January 15, 2006. The deadline for class members to request exclusion from the settlement classes was March 24, 2006.
     As part of the Settlement, the settling issuers were required to assign to the plaintiffs certain claims they had against their underwriters (“Assigned Claims”). To preserve these claims while the proposed Settlement was pending the Court’s final approval, the settling issuers sought tolling agreements from the underwriters. In the event that an underwriting defendant would not enter a tolling agreement, under the terms of the proposed Settlement agreement, the settling issuer conditionally assigned the claims to a litigation trustee. Before the expiration of any relevant statutes of limitations, the litigation trustee filed lawsuits against the various issuers’ respective underwriters alleging the Assigned Claims. All of our underwriters entered into tolling agreements. On February 24, 2006, the Court dismissed, with prejudice, the Assigned Claims brought by the litigation trustee against the other issuers’ underwriters that had not entered into tolling agreements on statute of limitations grounds. After the Court’s ruling, three of our underwriters terminated their tolling agreements. Accordingly, we conditionally assigned their Assigned Claims to the litigation trustee. Because the Assigned Claims were part of the consideration contemplated under the Settlement, it is unclear how the Court’s February 24, 2006 decision will impact the Settlement and the Court’s final approval of it.
     On April 24, 2006, the Court held a hearing in connection with a motion for final approval of a proposed Settlement. The Court did not rule on the fairness of the Settlement at the hearing. It is uncertain when the Court will issue a ruling. Despite the preliminary approval of the Settlement, there can be no assurance that the Court will provide final approval of the Settlement.
     In the meantime, the plaintiffs and underwriters have continued to litigate the consolidated action. The litigation is proceeding through the class certification phase by focusing on six cases chosen by the plaintiffs and underwriters (“focus cases”). We are not a focus case. On October 13, 2004, the Court certified classes in each of the six focus cases. The underwriter defendants have appealed that decision. On June 6, 2006, the Court heard oral argument from the underwriters and the plaintiffs on the appeal. After the argument, the Court indicated that it would reserve its decision. It is uncertain when the Court of Appeals will rule on the appeal.

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     The plaintiffs’ money damage claims include prejudgment and post-judgment interest, attorneys’ and experts’ witness fees and other costs, as well as other relief to which the plaintiffs may be entitled should they prevail. We believe that the securities class action allegations against us and our officers and directors are without merit and, if settlement of the action is not finalized, we intend to contest the allegations vigorously. However, the class action litigation is in its preliminary stages, and we cannot predict its outcome.
ITEM 1A: RISK FACTORS
     In addition to other information in this Form 10-Q, the following risk factors should be carefully considered in evaluating our business because such factors currently may have a significant impact on our business, operating results and financial condition. As a result of the risk factors set forth below and elsewhere in this Form 10-Q, and the risks discussed in our other Securities and Exchange Commission filings including our Form 10-K for our fiscal year ended March 31, 2006, actual results could differ materially from those projected in any forward-looking statements.
We have a history of losses and expect to continue to incur net losses in the near-term.
     We have experienced operating losses in each quarterly and annual period since inception. We incurred net losses of approximately $2.6 million and $2.7 million for the three months ended June 30, 2006 and June 30, 2005, respectively. We have an accumulated deficit of approximately $192.7 million as of June 30, 2006. We plan to reduce our investment in research and development, sales and marketing, and general and administrative expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues. We will need to generate significant increases in our revenues to achieve and maintain profitability. If our revenue fails to grow or grows more slowly than we anticipate or our operating expenses exceed our expectations, our losses will significantly increase which would significantly harm our business and operating results.
The unpredictability of our quarterly revenues and results of operations makes it difficult to predict our financial performance and may cause volatility or a decline in the price of our common stock if we are unable to satisfy the expectations of investors or the market.
     We enter into arrangements for the sale of: (1) licenses of software products and related maintenance contracts; (2) bundled license, maintenance, and services; (3) services; and (4) subscription for on-demand services. In instances where maintenance is bundled with a license of software products, such maintenance term is typically one year.
     For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fees are fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all of the criteria are met.
     Our quarterly revenues may also fluctuate due to our ability to perform services, achieve specific milestones and obtain formal customer acceptance of specific elements of the overall completion of a project. As we provide such services and products, the timing of delivery and acceptance, changed conditions with the customers and projects could result in changes to the timing of our revenue recognition, and thus, our operating results.
     Likewise, if our customers do not renew maintenance services or purchase additional products, our operating results could suffer. Historically, we have derived and expect to continue to derive a significant portion of our total revenue from existing customers who purchase additional products or renew maintenance agreements. Our customers may not renew such maintenance agreements or expand the use of our products. In addition, as we introduce new products, our current customers may not require or desire the features of our new products. If our customers do not renew their subscriptions or maintenance agreements with us or choose not to purchase additional products, our operating results could suffer.
     Because we rely on a limited number of customers, the timing of customer acceptance or milestone achievement, or the amount of services we provide to a single customer can significantly affect our operating results or the failure to replace a significant customer. Because expenses are relatively fixed in the near term, any shortfall from anticipated revenues could cause our quarterly operating results to fall below anticipated levels.

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     We may also experience seasonality in revenues. For example, our quarterly results may fluctuate based upon our customers’ calendar year budgeting cycles. These seasonal variations may lead to fluctuations in our quarterly revenues and operating results.
     Based upon the foregoing, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and that such comparisons should not be relied upon as indications of future performance. In some future quarter, our operating results may be below the expectations of public market analysts and investors, which could cause volatility or a decline in the price of our common stock.
If our bookings do not improve, our results of operations could be significantly harmed.
     In any given period our revenues are dependent on customer contracts entered into, “booked” during earlier periods. Because we typically recognize revenue in periods after contracts are booked, a decline in the number of contracts booked during any particular period or the value of such contracts would cause a decrease in revenue in future periods. The number and value of our bookings has been lower than management expectations. Our inability to increase bookings in the previous quarters was a significant factor in the decline of our revenues in more recent quarters. If our bookings remain at current levels or if the value of such bookings decreases further, it will cause our revenues to decline in future periods and could significantly harm our business and operating results.
The loss of any of our key personnel would harm our competitiveness because of the time and effort that we would have to expend to replace such personnel.
     We believe that our success will depend on the continued employment of our management team and key technical personnel, including Stephen Bennion, our President, Chief Executive Officer, and Interim Chief Financial Officer, who has an employment agreement with us.
     If one or more members of our senior management team or key technical personnel were unable or unwilling to continue in their present positions, these individuals would be difficult to replace and our ability to manage day-to-day operations, including our operations in Pune, India, develop and deliver new technologies, attract and retain customers, attract and retain other employees and generate revenues would be significantly harmed.
Any mergers, acquisitions or joint ventures that we may make could disrupt our business and harm our operating results.
     On December 3, 2004, we announced that we entered into a definitive merger agreement with I-many, Inc., under which we agreed, subject to certain conditions, to pay $1.55 per share in cash for all outstanding shares of I-many common stock, for a total transaction value of $70 million. The transaction was not approved by the I-many stockholders, and the merger agreement was terminated in March 2005. In May 2005, we entered into an agreement to purchase certain assets and products of Determine for cash. The transaction closed in the first quarter of fiscal 2006.
     The attempt to acquire and merge I-many required a significant amount of management time, as well as significant consulting, legal and accounting expense that negatively affected our operating results. We may engage in acquisitions of other companies, products or technologies, such as the acquisition of Determine. If we fail to integrate successfully any future acquisitions (or technologies associated with such), the revenue and operating results of the combined companies could decline. The process of integrating an acquired business may result in unforeseen difficulties and expenditures. If we fail to complete any acquisitions of any other companies, it may also result in unforeseen difficulties and expenditures. Acquisitions may involve a number of other potential risks to our business and include, but are not limited to the following:
    potential adverse effects on our operating results, including unanticipated costs and liabilities, unforeseen accounting charges or fluctuations from failure to accurately forecast the financial impact of an acquisition;
 
    use of cash;

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    issuance of stock that would dilute our current stockholders’ percentage ownership;
 
    incurring debt;
 
    assumption of liabilities;
 
    amortization expenses related to other intangible assets;
 
    incurring large and immediate write-offs;
 
    incurring legal and professional fees;
 
    problems combining the purchased operations, technologies or products with ours;
 
    diversion of managements’ attention from our core business;
 
    adverse effects on existing business relationships with suppliers and customers; and
 
    potential loss of key employees, particularly those of the acquired organizations.
Any unsolicited proposals for the purchase of our Company could disrupt business and harm our operating results.
     In January 2005, Trilogy, a privately held company, conditionally proposed to purchase all of our outstanding common stock for $4.00 per share. This unsolicited proposal assumed that the I-many merger was not completed. On February 2, 2005, following consultation with our legal and financial advisors, we issued a press release announcing that our Board of Directors determined that Trilogy’s proposal was not in our best interests or those of our stockholders. For reasons unrelated to Trilogy’s proposal, I-many and Selectica terminated the I-many merger on March 31, 2005. On April 11, 2005, Trilogy filed a Statement of Beneficial Ownership on Schedule 13D with the Securities and Exchange Commission reporting that it owned 6.9% of our outstanding common stock as of that date. As described further in this annual report, Trilogy was also engaged in a patent infringement lawsuit against us, which has been settled.
     Uncertainty regarding Trilogy’s intentions toward us may cause disruption in our business, which could result in a material adverse effect on our financial condition and operating results. Additionally, as a consequence of the uncertainty surrounding our future, our key employees may be distracted and could seek other employment opportunities. If key employees leave, there could be a material adverse effect on our business and results of operations. Uncertainty surrounding Trilogy’s intentions and Trilogy’s patent infringement lawsuit against us could also be disruptive to our relations with our existing and potential customers as the proposal and/or the patent litigation may be viewed negatively by some customers. Responding to any proposals from Trilogy and the patent lawsuit has consumed, and may continue to consume, attention from our management and employees, and may require us to incur significant costs, which could adversely affect our financial and operating results.
If our new product marketing strategy is unsuccessful, it could significantly harm our business and operating results.
     We have recently revised our product marketing focus. We had previously positioned our company as a seller of Internet Selling Solutions, however, we now emphasize our products’ ability to bridge the gap that exists between CRM and ERP, which we refer to as the Opportunity to Order Gap. We have brought new products such as the Fastraq application to market, which are specifically tailored to address this gap in specific industries. If the market for products that address the Opportunity to Order Gap is smaller than we anticipated or if our products fail to gain widespread acceptance in this market, our results of operations would be adversely affected. In addition, if there is a delay in bringing our new products to market, it would delay our ability to derive revenues from such products and our business and operating results could be significantly harmed.

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We have relied and expect to continue to rely on a limited number of customers for a substantial portion of our revenues, and the loss of any of these customers would significantly harm our business and operating results.
     Our business and financial condition is dependent on a limited number of customers. Our five largest customers accounted for approximately 59% and 76% of our revenues for the three months ended June 30, 2006 and June 30, 2005, respectively, and our ten largest customers accounted for approximately 76% and 86% of our revenues for the three months ended June 30, 2006 and June 30, 2005, respectively. Revenues from significant customers greater than 10% of total revenues are as follows:
                 
    Three Months Ended
    June 30,
    2006   2005
Customer A
    25 %     29 %
Customer B
    11 %     *  
Customer C
    *       24 %
Customer D
    *       13 %
 
*   Customer account was less than 10% of total revenues.
     We expect that we will continue to depend upon a relatively small number of customers for a substantial portion of our revenues for the foreseeable future. As a result, if we fail to successfully sell our products and services to one or more customers in any particular period or a large customer purchases fewer of our products or services, defers or cancels orders, or terminates its relationship with us, our business and operating results would be harmed.
Our lengthy sales cycle for our large enterprise sales execution systems makes it difficult for us to forecast revenue and exacerbates the variability of quarterly fluctuations, which could cause our stock price to decline.
     The sales cycle of our large enterprise sales execution systems has historically averaged between nine to twelve months, and may sometimes be significantly longer. We are generally required to provide a significant level of education regarding the use and benefits of our products, and potential customers tend to engage in extensive internal reviews before making purchase decisions. In addition, the purchase of our products typically involves a significant commitment by our customers of capital and other resources, and is therefore subject to delays that are beyond our control, such as customers’ internal budgetary procedures and the testing and acceptance of new technologies that affect key operations. In addition, because we target large companies, our sales cycle can be lengthier due to the decision process in large organizations. As a result of our products’ long sales cycles, we face difficulty predicting the quarter in which sales to expected customers may occur. If anticipated sales from a specific customer for a particular quarter are not realized in that quarter, our operating results for that quarter could fall below the expectations of financial analysts and investors, which could cause our stock price to decline.
We have been subject to intellectual property litigation, and could be subject to additional such litigation in the future, in connection with which we may incur substantial costs, which would harm our operating results.
     On April 22, 2004, Trilogy Group (“Trilogy”) filed a complaint in the United States District Court for the Eastern District of Texas Marshall Division alleging patent infringement against us. On September 2, 2004, we filed counter claims in the Eastern District of Texas Marshall Division action against Trilogy for infringement of our U.S. Patent Nos. 6,405,308, 6,675,294, 5,878,400 and 6,533,350 for willfully infringing, directly and indirectly, by making, using, licensing, selling offering for sale, or importing products including configuration and ordering software.
     In January 2006, Trilogy and we reached a settlement resolving the patent dispute. Trilogy and us agreed to grant each other cross-licenses to the asserted patents for the life of the patents, entered into mutual releases and dismissed with prejudice all outstanding patent infringement claims against each other. Under the terms of the settlement, we paid a one-time sum of $7.5 million to Trilogy on February 16, 2006.

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     In addition, from time to time, we have received (and may receive in the future) correspondence from patent holders (including our competitors) recommending that we license their patents. We review and evaluate these patents (in light of the allegations from the patent holders). To date, we have informed these patent holders that it would not be necessary to license these patents. However, we may be required to license such patents or incur legal fees to defend our position that such licenses are not necessary (as was the case in the Trilogy litigation), and there can be no assurance that we would be able to obtain a license to use such patents on commercially reasonable terms, or at all.
     Any intellectual property litigation, such as the litigation with Trilogy, or any threat of such litigation could force us to do one or more of the following:
    cease selling, incorporating or using products or services that incorporate the challenged intellectual property;
 
    obtain from the holder of the infringed intellectual property right a license to sublicense or use the relevant intellectual property, which license may not be available on commercially reasonable terms or at all;
 
    redesign those products or services that incorporate such intellectual property; and/or
 
    pay money damages to the holder of the infringed intellectual property right.
     In the event of a successful claim of infringement against us and our failure or inability to license the infringed intellectual property on commercially reasonable terms (or at all) or license a substitute intellectual property or redesign our product to avoid infringement, our business and operating results would be significantly harmed. If we are forced to abandon use of our trademark, we may be forced to change our name and incur substantial expenses to build a new brand, which would significantly harm our business.
Developments in the market for enterprise software including configuration, pricing, contract management and quoting solutions may harm our operating results, which could cause a decline in the price of our common stock.
     The market for enterprise software including configuration, pricing, contract management and quoting solutions is evolving rapidly. In view of changing market trends including vendor consolidation, the competitive environment gross rate and potential size of the market are difficult to assess. The growth of the market is dependent upon the willingness of businesses and consumers to purchase complex goods and services over the Internet and the acceptance of the Internet as a platform for business applications. In addition, companies that have already invested substantial resources in other methods of Internet selling may be reluctant or slow to adopt a new approach or application that may replace, limit or compete with their existing systems.
     The rapid change in the marketplace poses a number of concerns. The decrease in technology infrastructure spending may reduce the size of the market for configuration, pricing management and quoting solutions. Our potential customers may decide to purchase more complete solutions offered by larger competitors instead of individual applications. If the market for configuration, pricing management, contract management and quoting solutions is slow to develop, or if our customers purchase more fully integrated products, our business and operating results would be significantly harmed.
We face intense competition, which could reduce our sales, prevent us from achieving or maintaining profitability and inhibit our future growth.
     The market for software and services that enable electronic commerce is intensely competitive and rapidly changing. We expect competition to persist and intensify, which could result in price reductions, reduced gross margins and loss of market share. Our principal competitors include publicly-traded companies such as Oracle Corporation, Ariba, and I-Many as well as privately held companies such as Comergent Technologies, Firepond, Upside Software, Nextance, DiCarta/Emptoris and Trilogy, all of which offer integrated solutions for electronic commerce incorporating some of the functionality of our configuration, pricing, contract management and quoting software.

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     Our competitors may intensify their efforts in our market. In addition, other enterprise software companies may offer competitive products in the future. Competitors vary in size, in the scope and breadth of the products and services offered. Although we believe we have advantages over our competitors including the comprehensiveness of our solution, our use of Java technology and our multi-threaded architecture, some of our competitors and potential competitors have significant advantages over us, including:
    a longer operating history;
 
    preferred vendor status with our customers;
 
    more extensive name recognition and marketing power; and
 
    significantly greater financial, technical, marketing and other resources, giving them the ability to respond more quickly to new or changing opportunities, technologies, and customer requirements.
     Our competitors may also bundle their products in a manner that may discourage users from purchasing our products. Current and potential competitors may establish cooperative relationships with each other or with third parties, or adopt aggressive pricing policies to gain market share. Competitive pressures may require us to reduce the prices of our products and services. We may not be able to maintain or expand our sales if competition increases, and we are unable to respond effectively.
A decline in general economic conditions or a decrease in information technology spending could harm our results of operations.
     A change in economic conditions could lead to revised budgetary constraints regarding information technology spending for our customers. We have had potential customers select our software, but decide to delay or not to implement any configuration system. Many companies have decided to reduce their expenditures for information technology by either delaying non-mission critical projects or abandoning them until their levels of business justify the expenses. Stagnation in information technology spending due to economic conditions or other factors could significantly harm our business and operating results.
If we do not keep pace with technological change, including maintaining interoperability of our products with the software and hardware platforms predominantly used by our customers, our products may be rendered obsolete, and our business may fail.
     Our industry is characterized by rapid technological change, changes in customer requirements, frequent new product and service introductions and enhancements and emerging industry standards. In order to achieve broad customer acceptance, our products must be compatible with major software and hardware platforms used by our customers. Our products currently operate on the Microsoft Windows NT, Sun Solaris, IBM AIX, J2EE, Linux and Microsoft Windows 2000 Operating Systems. In addition, our products are required to interoperate with electronic commerce applications and databases. We must continually modify and enhance our products to keep pace with changes in these operating systems, applications and databases. Our configuration, pricing and quoting products are complex, and new products and product enhancements can require long development and testing periods. If our products were to be incompatible with a popular new operating system, electronic commerce application or database, our business would be significantly harmed. In addition, the development of entirely new technologies to replace existing software could lead to new competitive products that have better performance or lower prices than our products and could render our products obsolete and unmarketable.
Our failure to meet customer expectations on deployment of our products could result in negative publicity and reduced sales, both of which would significantly harm our business and operating results.
     In the past, a small number of our customers have experienced difficulties or delays in completing implementation of our products. We may experience similar difficulties or delays in the future. Deploying our products typically involves integration with our customers’ legacy systems, such as existing databases and enterprise resource planning software as well adding their data to the system. Failing to meet customer expectations on

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deployment of our products could result in a loss of customers and negative publicity regarding us and our products, which could adversely affect our ability to attract new customers. In addition, time-consuming deployments may also increase the amount of professional services we must allocate to each customer, thereby increasing our costs and adversely affecting our business and operating results.
If we are unable to maintain our direct sales force, sales of our products and services may not meet our expectations, and our business and operating results will be significantly harmed.
     We depend on our direct sales force for a significant portion of our current sales, and our future growth depends in part on the ability of our direct sales force to develop customer relationships and increase sales to a level that will allow us to reach and maintain profitability. If we are unable to retain qualified sales personnel or if newly hired personnel fail to develop the necessary skills or to reach productivity when anticipated, we may not be able to increase sales of our products and services, and our results of operation could be significantly harmed.
If we are unable to manage our professional services organization, we will be unable to provide our customers with technical support for our products, which could significantly harm our business and operating results.
     Services revenues, which generated 91% and 71% of our revenues during the three months ended June 30, 2006 and June 30, 2005, respectively, are comprised primarily of revenues from consulting fees, maintenance contracts and training and are important to our business. Services revenues have lower gross margins than license revenues. During the three months ended June 30, 2006 and June 30, 2005, respectively, gross margins percentages for services revenues and license revenues are as follows:
                 
    Three Months Ended
    June 30,
    2006   2005
License
    75 %     94 %
Services
    46 %     49 %
     We intend to charge for our professional services on a time and materials rather than a fixed-fee basis. However, in current market conditions, many customers insist on services provided on a fixed-fee basis. To the extent that customers are unwilling to utilize third-party consultants or require us to provide professional services on a fixed-fee basis, our cost of services revenues could increase and could cause us to recognize a loss on a specific contract, either of which would adversely affect our operating results. In addition, if we are unable to provide these professional services, we may lose sales or incur customer dissatisfaction, and our business and operating results could be significantly harmed.
If new versions and releases of our products contain errors or defects, we could suffer losses and negative publicity, which would adversely affect our business and operating results.
     Complex software products such as ours often contain errors or defects, including errors relating to security, particularly when first introduced or when new versions or enhancements are released. In the past, we have discovered defects in our products and provided product updates to our customers to address such defects. Our products and other future products may contain defects or errors, that could result in lost revenues, a delay in market acceptance or negative publicity, each which would significantly harm our business and operating results.
A substantial portion of our operations are conducted by India-based personnel, and any change in the political and economic conditions of India or in immigration policies that adversely affects our ability to conduct our operations in India could significantly harm our business.
     We conduct development, quality assurance and professional services operations in India. As of June 30, 2006 we employed 81 persons in India. We are dependent on our India-based operations for these aspects of our business. As a result, we are directly influenced by the political and economic conditions affecting India. Operating expenses incurred by our operations in India are denominated in Indian currency, and accordingly, we are exposed to adverse movements in currency exchange rates. This, as well as any other political or economic problems or changes in India, could have a negative impact on our India-based operations, resulting in significant harm to our business and

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operating results. Furthermore, the intellectual property laws of India may not adequately protect our proprietary rights. We believe that it is particularly difficult to find quality management personnel in India, and we may not be able to timely replace our current India-based management team if any of them were to leave our Company.
     Our training program for some of our India-based employees includes an internship at our San Jose, California headquarters. Additionally, we provide services to some of our customers with India-based employees. We presently rely on a number of visa programs to enable these India-based employees to travel and work internationally. Any change in the immigration policies of India or the countries to which these employees travel and work could cause disruption or force the termination of these programs, which would harm our business.
Demand for our products and services will decline significantly if our software cannot support and manage a substantial number of users.
     Our strategy requires that our products be highly scalable. To date, only a limited number of our customers have deployed our products on a large scale. If our customers cannot successfully implement large-scale deployments, or if they determine that we cannot accommodate large-scale deployments, our business and operating results would be significantly harmed.
We may not be able to recruit or retain personnel, which could impact the development or sales of our products.
     Our success depends on our ability to attract and retain qualified management, engineering, sales and marketing and professional services personnel. We do not have employment agreements with most of our key personnel. If we are unable to retain our existing key personnel, or attract and train additional qualified personnel, our growth may be limited due to our lack of capacity to develop and market our products. Competition for such personnel has markedly intensified in India, where we have a large portion of our workforce. Many multinational corporations have expanded their operations into India, and there is an increased demand for individuals with relevant technology experience.
If we become subject to product liability litigation, it could be costly and time consuming to defend and could distract us from focusing on our business and operations.
     Since our products are company-wide, mission-critical computer applications with a potentially strong impact on our customers’ sales, errors, defects or other performance problems could result in financial or other damages to our customers. Although our license agreements generally contain provisions designed to limit our exposure to product liability claims, existing or future laws or unfavorable judicial decisions could negate such limitation of liability provisions. Product liability litigation, even if it were unsuccessful, would be time consuming and costly to defend.
Any reduction in expenses will place a significant strain on our management systems and resources, and if we fail to manage these changes, our business will be harmed.
     We may further reduce our operating expenses, and as a result, this would place increased demands on our managerial, administrative, operational, financial and other resources.
     Our rapid growth required us to manage a large number of relationships with customers, suppliers and employees, as well as a large number of complex contracts. Additional cost cutting measures would force us to handle these demands with a smaller number of employees. If we are unable to initiate procedures and controls to support our future operations in an efficient and timely manner, or if we are unable to otherwise manage these changes effectively, our business would be harmed.
Our future success depends on our proprietary intellectual property, and if we are unable to protect our intellectual property from potential competitors, our business may be significantly harmed.
     We rely on a combination of patent, trademark, trade secret and copyright law and contractual restrictions to protect the proprietary aspects of our technology. These legal protections afford only limited protection for our technology. We currently hold six patents in the United States. In addition, we have two trademarks registered in the

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United States, one trademark registered and one pending in South Korea, two trademarks registered in Canada and one trademark registered in European Community, and we have also applied to register another two trademarks in the United States. Our trademark applications might not result in the issuance of any trademarks. Our patents or any future issued trademarks might be invalidated or circumvented or otherwise fail to provide us any meaningful protection. We seek to protect the source code for our software, documentation and other written materials under trade secret and copyright laws. We license our software pursuant to license agreements, which impose certain restrictions on the licensee’s ability to utilize the software. We also seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In addition, the laws of many countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of the proprietary rights of others. Our failure to adequately protect our intellectual property could have a material adverse effect on our business and operating results.
Our results of operations will be reduced by charges associated with stock-based compensation, accelerated vesting associated with stock options issued to employees, charges associated with other securities issued by us, and charges related to variable accounting.
     We have in the past and expect in the future to incur a significant amount of charges related to securities issuances, which will negatively affect our operating results. During the three months ended June 30, 2006 and June 30, 2005, we recognized approximately $397,000 and $80,000, respectively, of such charges, which included the compensation expenses related to our recent adoption of SFAS 123R, as well as deferred compensation, option acceleration, option modification, and variable accounting.
     We adopted the provisions of SFAS 123R using a modified prospective application effective April 1, 2006. We use the Black-Scholes model to determine the fair value of our share-based payments and recognize compensation cost on a straight-line basis over the vesting periods. This pronouncement from the FASB provides for certain changes to the method for valuing stock-based compensation. Among other changes, SFAS 123R applies to new awards and to awards that are outstanding which are subsequently modified or cancelled. Upon adoption, compensation expense cost calculated under SFAS 123R will negatively impact our operating results.
Failure to improve and maintain relationships with systems integrators and consulting firms, which assist us with the sale and installation of our products, would impede the acceptance of our products and the growth of our revenues.
     Our strategy has been to rely in part upon systems integrators and consulting firms to recommend our products to their customers and to install and deploy our products. To date, we have had limited success in utilizing these firms as a sales channel or as a provider of professional services. To increase our revenues and implementation capabilities, we must continue to develop and expand our relationships with these systems integrators and consulting firms. If these systems integrators and consulting firms are unwilling to install and deploy our products, we may not have the resources to provide adequate implementation services to our customers, and our business and operating results could be significantly harmed.
We have entered into a joint sales and marketing arrangement with SalesTech, Pty. Ltd. Failure to achieve the mutual objectives of this partnership could damage our business.
     During fiscal 2006, we entered into non-exclusive joint sales and marketing agreement for Europe and certain vertical markets within North America with SalesTech, Pty. Ltd. (“SalesTech”) based in New Zealand. SalesTech is a relatively small company with limited financial resources that has been our reseller/partner for more than six years. Pursuant to this arrangement, both SalesTech and us will provide technology, personnel and management to further the sales and delivery of SalesTech applications for the telecom, banking and insurance industry vertical markets powered by our configuration and pricer engines. We have advanced approximately $1.8 million in expenses and prepaid royalties to SalesTech and the partnership since inception. We are entitled to receive repayment of pre-paid royalties and 50% of operating costs before net income from the partnership is distributed equally to the two

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companies. Failure to achieve sales and/or complete the delivery of solutions to customers could result in losses, write-offs and harm to our business.
Our on demand solutions are hosted by a third-party provider.
     Our Fastraq and Contract Management on demand solutions are hosted by a third party data-center provider. Failure of the data center provider to maintain service levels as contracted, could result in customer dissatisfaction, customer losses and potential product warranty or performance liabilities.
We are the target of several securities class action complaints and have been subject to patent infringement complaints and could be again, all of which could result in substantial costs and divert management attention and resources.
  Patent Infringement
     On April 22, 2004, Trilogy Group (“Trilogy”) filed a complaint in the United States District Court for the Eastern District of Texas Marshall Division alleging patent infringement against us. On September 2, 2004, we filed counterclaims in the Eastern District of Texas Marshall Division action against Trilogy for infringement of our U.S. Patent Nos. 6,405,308, 6,675,294, 5,878,400 and 6,553,350 for willfully infringing, directly and indirectly, by making, using, licensing, selling, offering for sale, or importing products including configuration and ordering software.
     In January 2006, we reached a settlement with Trilogy resolving the patent dispute. Both parties agreed to grant each other cross-licenses to the asserted patents for the life of the patents, entered into mutual releases and dismissed with prejudice all outstanding patent infringement claims against each other. Under the terms of the settlement, we paid a one-time sum of $7.5 million to Trilogy on February 16, 2006.
  Class Action
     During 2001, a number of securities class action complaints were filed in the United States District Court for the Southern District of New York against us, certain of its officers and directors, and certain of the underwriters of ours March 13, 2000 initial public offering (“IPO”). On August 9, 2001, these actions were consolidated before a single judge along with cases brought against numerous other issuers, their officers and directors and their underwriters that make similar allegations involving the allocation of shares in the IPOs of those issuers. The consolidation was for purposes of pretrial motions and discovery only. On April 19, 2002, plaintiffs filed a consolidated amended complaint asserting essentially the same claims as the original complaints.
     The amended complaint alleges that the officer and director defendants, the underwriter’s defendants and Selectica, Inc. violated federal securities laws by making material false and misleading statements in the prospectus incorporated in our registration statement on Form S-1 filed with the SEC in March 2000 in connection with our IPO. Specifically, the complaint alleges, among other things, that the underwriters solicited and received excessive and undisclosed commissions from several investors in exchange for which the underwriters allocated to those investors material portions of the restricted number of shares of common stock issued in our IPO. The complaint further alleges that the underwriters entered into agreements with its customers in which it agreed to allocate the common stock sold in our IPO to certain customers in exchange for which such customers agreed to purchase additional shares of our common stock in the after-market at pre-determined prices. The complaint also alleges that the underwriters offered to provide positive market analyst coverage for us after the IPO, which had the effect of manipulating the market for our stock.
     During the course of pre-trial proceedings, the plaintiffs dismissed their claims against the individual defendants without prejudice in return for the individual defendants’ execution of a tolling agreement. A motion to dismiss filed by us was denied by the Court on November 19, 2003.
     On June 25, 2003, a Special Committee of our Board of Directors approved a Memorandum of Understanding (the “MOU”) reflecting a settlement in which the plaintiffs agreed to dismiss the case against us with prejudice in return for our assignment of certain claims that we might have against its underwriters. The same offer of settlement was made to all the issuer defendants involved in the litigation. No payment to the plaintiffs by us is required under

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the MOU. After further negotiations, the essential terms of the MOU were formalized in a Stipulation and Agreement of Settlement (“Settlement”), which has been executed on behalf of us.
     The settling parties presented the proposed Settlement papers to the Court and filed formal motions seeking preliminary approval. The underwriter defendants, who are not parties to the proposed Settlement, filed objections to the Settlement. On February 15, 2005, the Court granted preliminary approval of the Settlement conditioned on the agreement of the parties to narrow one of a number of the provisions intended to protect the issuers against possible future claims by the underwriters. We re-approved the Settlement with the proposed modifications that were outlined by the Court in its February 15, 2005 Order granting preliminary approval. Approval of any settlement involves a three-step process in the district court: (i) a preliminary approval, (ii) determination of the appropriate notice of the settlement to be provided to the settlement class, and (iii) a final fairness hearing.
     On August 31, 2005, the Court entered a preliminary order approving the modifications to the Settlement and certifying the settlement classes. The Court also ordered that the mailing of the notices of pendency and proposed settlement of the class actions be completed by January 15, 2006. The deadline for class members to request exclusion from the settlement classes was March 24, 2006.
     As part of the Settlement, the settling issuers were required to assign to the plaintiffs certain claims they had against their underwriters (“Assigned Claims”). To preserve these claims while the proposed Settlement was pending the Court’s final approval, the settling issuers sought tolling agreements from the underwriters. In the event that an underwriting defendant would not enter a tolling agreement, under the terms of the proposed Settlement agreement, the settling issuer conditionally assigned the claims to a litigation trustee. Before the expiration of any relevant statutes of limitations, the litigation trustee filed lawsuits against the various issuers’ respective underwriters alleging the Assigned Claims. All of our underwriters entered into tolling agreements. On February 24, 2006, the Court dismissed, with prejudice, the Assigned Claims brought by the litigation trustee against the other issuers’ underwriters that had not entered into tolling agreements on statute of limitations grounds. After the Court’s ruling, two of our underwriters terminated their tolling agreements. Accordingly, we conditionally assigned their Assigned Claims to the litigation trustee. Because the Assigned Claims were part of the consideration contemplated under the Settlement, it is unclear how the Court’s February 24, 2006 decision will impact the Settlement and the Court’s final approval of it.
     On April 24, 2006, the Court held a hearing in connection with a motion for final approval of a proposed Settlement. The Court did not rule on the fairness of the Settlement at the hearing. It is uncertain when the Court will issue a ruling. Despite the preliminary approval of the Settlement, there can be no assurance that the Court will provide final approval of the Settlement.
     In the meantime, the plaintiffs and underwriters have continued to litigate the consolidated action. The litigation is proceeding through the class certification phase by focusing on six cases chosen by the plaintiffs and underwriters (“focus cases”). We are not a focus case. On October 13, 2004, the Court certified classes in each of the six focus cases. The underwriter defendants have appealed that decision to the United States Court of Appeals for the Second Circuit. On June 6, 2006, the Court heard oral argument from the underwriters and the plaintiffs on the appeal. After the argument, the Court indicated that it would reserve its decision. It is uncertain when the Court of Appeals will rule on the appeal.
     The plaintiffs’ money damage claims include prejudgment and post-judgment interest, attorneys’ and experts’ witness fees and other costs, as well as other relief to which the plaintiffs may be entitled should they prevail. We believe that the securities class action allegations against us and our officers and directors are without merit and, if settlement of the action is not finalized, we intend to contest the allegations vigorously. However, the class action litigation is in its preliminary stages, and we cannot predict its outcome.
Anti-takeover defenses that we have in place could prevent or frustrate attempts by stockholders to change our board of directors or the direction of us.
     Provisions of our amended and restated certificate of incorporation and amended and restated bylaws, Delaware law and the stockholder rights plan adopted by us on February 4, 2003 may make it more difficult for or prevent a third party from acquiring control of us without approval of our directors. These provisions include:

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    providing for a classified board of directors with staggered three-year terms;
 
    restricting the ability of stockholders to call special meetings of stockholders;
 
    prohibiting stockholder action by written consent;
 
    establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted on by stockholders at stockholder meetings; and
 
    granting our board of directors the ability to designate the terms of and issue new series of preferred stock without stockholder approval.
     These provisions may have the effect of entrenching our board of directors and may deprive or limit your strategic opportunities to sell your shares.
If we are unable to successfully address the material weaknesses in our disclosure controls and procedures, including our internal control over financial reporting, our ability to report our financial results on a timely and accurate basis may be adversely affected.
     We have evaluated our “disclosure controls and procedures” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as well as our internal control over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002. Our independent registered public accounting firm has performed a similar evaluation of our internal control over financial reporting. Effective controls are necessary for us to provide reliable financial reports and help identify and deter fraud. If we cannot provide reliable financial reports or prevent fraud, our operating results could be harmed. As of March 31, 2006, we concluded that we had deficiencies in our internal controls over financial reporting that constituted a material weakness, as further described in Item 9A, Report of Management on Internal Control over Financial Reporting. Our independent registered public accounting firm reached the same conclusion. As of June 30, 2006, we concluded we continue to have deficiencies. If we cannot establish and maintain effective internal controls over financial reporting, investors may lose confidence in our reported financial information, which could have a negative effect on the trading price of our common stock.
Compliance with new regulations dealing with corporate governance and public disclosure may result in additional expenses and require significant management attention.
     The Sarbanes-Oxley Act of 2002, as well as new rules implemented by the Securities Exchange Commission and the NASDAQ National Market, has required changes in corporate governance practices of public companies. These rules are increasing our legal and financial compliance costs and causing some management and accounting activities to become more time-consuming and costly. This includes increased levels of documentation, monitoring internal controls, and increased manpower and use of consultants to comply. We have and will continue to expend significant efforts and resources to comply with these rules and regulations and have implemented a comprehensive program of compliance with these requirements and high standards of corporate governance and public disclosure.
     These rules may also make it more difficult and more expensive us to obtain director and officer liability insurance, and may make us accept reduced coverage or incur substantially higher costs for such coverage. The rules and regulations may also make it more difficult for us to attract and retain qualified executive officers and members of our board of directors, particularly to serve on our audit committee.
Restrictions on export of encrypted technology could cause us to incur delays in international product sales, which would adversely impact the expansion and growth of our business.
     Our software utilizes encryption technology, the export of which is regulated by the United States government. If our export authority is revoked or modified, if our software is unlawfully exported or if the United States adopts new legislation restricting export of software and encryption technology, we may experience delay or reduction in shipment of our products internationally. Current or future export regulations could limit our ability to distribute our products outside of the United States. While we take precautions against unlawful exportation of our software, we cannot effectively control the unauthorized distribution of software across the Internet.

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Unauthorized break-ins or other assaults on our computer systems could harm our business.
     Our servers are vulnerable to physical or electronic break-ins and similar disruptions, which could lead to loss of data or public release of proprietary information. In addition, unauthorized persons may improperly access our data. These and other types of attacks could harm us. Actions of this sort may be very expensive to remedy and could adversely affect results of operations.
Changes to accounting standards and financial reporting requirements or taxes, may affect our financial results.
     We are required to follow accounting standards and financial reporting set by governing bodies in the U.S. and other countries where we do business. From time to time, these governing bodies implement new and revised laws and regulations. These new and revised accounting standards, financial reporting and tax laws may require changes to accounting principles used in preparing our financial statements. These changes may have a material impact on our business and financial results. For example, a change in accounting rules can have a significant effect on our reported results and may even affect our reporting of transactions completed before the change became effective. As a result, changes to existing rules or reconsideration of current practices caused by such changes may adversely affect our reported financial results or the way we conduct our business.
Increasing government regulation of the Internet could limit the market for our products and services, or impose greater tax burdens on us or liability for transmission of protected data.
     As electronic commerce and the Internet continue to evolve, federal, state and foreign governments may adopt laws and regulations covering issues such as user privacy, taxation of goods and services provided over the Internet, pricing, content and quality of products and services. If enacted, these laws and regulations could limit the market for electronic commerce, and therefore the market for our products and services. Although many of these regulations may not apply directly to our business, we expect that laws regulating the solicitation, collection or processing of personal or consumer information could indirectly affect our business.
     Laws or regulations concerning telecommunications might also negatively impact us. Several telecommunications companies have petitioned the Federal Communications Commission to regulate Internet service providers and online service providers in a manner similar to long distance telephone carriers and to impose access fees on these companies. This type of legislation could increase the cost of conducting business over the Internet, which could limit the growth of electronic commerce generally and have a negative impact on our business and operating results.
ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Items 2(a) and 2(b) are inapplicable.

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(c) Issuer Purchases of Equity Securities.
     The following table presents information with respect to purchases of our common stock made during the three months ended June 30, 2006 by us or any “affiliated purchaser” of ours as defined in Rule 10b-18(a)(3) under the Exchange Act.
                                 
                    (c) Total Number of   (d) Maximum Number (or
    (a) Total           Shares Purchased as   Approximate Dollar Value) of
    Number of   (b) Average   Part of Publicly   Shares that May Yet Be
    Shares   Price Paid per   Announced Plans or   Purchased Under the Plans or
Period   Purchased   Share   Programs (1)   Programs
April 1, 2006 – April 30, 2006
    269,583     $ 2.69       269,583     $ 21,157,058  
 
                               
May 1, 2006 – May 31, 2006
    499,741     $ 2.61       499,741     $ 19,832,096  
 
                               
June 1, 2006 – June 30, 2006
    437,107     $ 2.48       437,107     $ 18,730,948  
 
                               
 
                               
Total
    1,206,431     $ 2.58       1,206,431     $ 18,730,948  
 
                               
 
(1)   On November 9, 2005, Selectica announced that its Board of Directors had authorized a new $25 million stock repurchase program. The new repurchase plan resulted in shares of our stock being repurchased in the open market from time to time based on market conditions. This new program replaced the prior repurchase plan previously announced on May 6, 2003.
(2) Shares have only been repurchased through publicly announced programs.
ITEM 3: DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
ITEM 5: OTHER INFORMATION
Not applicable.
ITEM 6: EXHIBITS
     
Exhibit 31.1
  Certification of President, Chief Executive Officer and Chief Financial Officer (Interim) pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
Exhibit 32.1
  Certification of President, Chief Executive Officer and Chief Financial Officer (Interim) pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES
     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: August 9, 2006
         
  SELECTICA, INC.
Registrant
 
 
 
     
  /s/ STEPHEN BENNION    
  Stephen Bennion   
  President, Chief Executive Officer and Chief Financial Officer (Interim)   

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Exhibit Index
         
Exhibit   Description
  31.1    
Certification of President, Chief Executive Officer and Chief Financial Officer (Interim) pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
       
 
  32.1    
Certification of President, Chief Executive Officer and Chief Financial Officer (Interim) pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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