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LNUX > SEC Filings for LNUX > Form 10-Q on 16-Mar-2004All Recent SEC Filings

Show all filings for VA SOFTWARE CORP

Form 10-Q for VA SOFTWARE CORP


16-Mar-2004

Quarterly Report

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

Special Note Regarding Forward-Looking Statements

This Form 10-Q contains forward-looking statements that involve risks and uncertainties. Words such as "intend," "expect," "believe," "in our view," and variations of such words and similar expressions, are intended to identify such forward-looking statements, which include, but are not limited to, statements regarding our expectations and beliefs regarding future revenue growth; gross margins; financial performance and results of operations; technological trends in, and emergence of the market for collaborative software development applications; the future functionality, business potential, demand for, efficiencies created by and adoption of SourceForge; demand for online advertising; management's strategy, plans and objectives for future operations; the impact of our restructuring and the amount of cash utilized by operations; our intent to continue to invest significant resources in development; competition, competitors and our ability to compete; liquidity and capital resources; the outcome of any litigation to which we are a party; our accounting policies; and sufficiency of our cash resources, cash generated from operations and investments to meet our operating and working capital requirements. Actual results may differ materially from those expressed or implied in such forward-looking statements due to various factors, including those set forth in the Risk Factors contained in the section of this Form 10-Q entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations." We undertake no obligation to update the forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-Q.

Overview

We were incorporated in California in January 1995 and reincorporated in Delaware in December 1999. From the date of our incorporation through October 2001, we sold Linux-based hardware systems and services under the name VA Linux Systems, Inc. On June 27, 2001, we announced our decision to exit our Linux-based hardware business. Today, we do business under the name VA Software Corporation and we develop, market and support a software application known as SourceForge Enterprise Edition ("SourceForge") and also own and operate the Open Source Development Network, Inc. ("OSDN"), a network of Internet Web sites.

SourceForge is a proprietary, Web-based software application designed for corporate and public-sector information technology ("IT") professionals and software engineering organizations. SourceForge combines software development and collaboration tools with the ability to track, measure, and report on software project activity in real-time. SourceForge improves the software development process by capturing and archiving software development code, documentation and communication in a central location. It enables managers to gain insight and improved visibility into software development activity, thereby providing better resource and requirements management, defect tracking and the ability to resolve critical problems earlier in the development cycle. Organizations with distributed, offshore and/or outsourced software development teams can achieve improved productivity, communication, coordination, collaboration, project clarity and insight through SourceForge's standard set of development tools and secure, centralized code, documentation and communication repository.

OSDN is a network of media and e-commerce Internet Web sites serving the IT professionals and software development communities. As of January 31, 2004, OSDN reaches approximately 12 million unique visitors and serves more than 225 million page views per month. We believe that OSDN is the most dynamic community-driven media network on the Web and a cornerstone of the open source software development community. OSDN attracts IT decision-makers and buyers, from chief technology officers to project managers. Technologists, developers and system administrators turn to OSDN sites to create, debate and make IT news. OSDN is supported by sponsors and advertisers who want to reach the unique demographic of IT professionals and developers that visit our OSDN Web sites monthly. In addition, OSDN runs e-commerce sites to allow its visitors to buy a variety of retail goods of interest to the software development and IT communities. Our OSDN Web sites include:

o SourceForge.net, our flagship Web site and software development center. As of March 1, 2004, SourceForge.net was the development home for more than 76,000 software development projects and had more than 801,000 registered users.

o Slashdot.org, our leading discussion site for technologically-inclined individuals. Slashdot is dedicated to providing the IT and software development communities with cutting-edge technology, science and culture news and interactive commentary.

o ThinkGeek.com, our e-commerce site, which provides online sales of a variety of retail products of interest to the software development and IT communities.

o Linux.com, our comprehensive Web site for Linux and open source news and information. Linux.com caters to business and IT managers looking for migration strategies to Linux.

o freshmeat.net, one of the Internet's most comprehensive indices of downloadable Linux, Unix and cross-platform software.

o NewsForge.com, the online newspaper of record for Linux and open source software.

o ITManagersJournal.com, a Web site delivering strategic and technical information to help top-level IT professionals implement enterprise-level

       open   source   and   proprietary   architecture,    applications,    and
       infrastructure solutions.
o AnimationFactory.com, a source for three-dimensional art, animations and presentations. Animation Factory offers its subscribers a dynamic collection of easy to use animations that work in email, Web pages and presentations.

Critical Accounting Policies

Software Revenues

Software revenue consists principally of fees for licenses of our software products, maintenance, consulting and training. We recognize revenue using the residual method in accordance with Statement of Position ("SOP") 97-2, "Software Revenue Recognition," as amended by SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions." 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 evidence of the vendor specific fair value of one or more undelivered elements does not exist, revenues are deferred and recognized when delivery of those elements occurs or when fair value can be established. Company-specific objective evidence of fair value of maintenance and other services is based on our customary pricing for such maintenance and/or services when sold separately. At the outset of the arrangement with the customer, we defer revenue for the fair value of its

undelivered elements (e.g., maintenance, consulting and training) and recognize revenue for the remainder of the arrangement fee attributable to the elements initially delivered in the arrangement (i.e., software product) when the basic criteria in SOP 97-2 have been met. If such evidence of fair value for each undelivered element of the arrangement does not exist, we defer all revenue from the arrangement until such time that evidence of fair value does exist or until all elements of the arrangement are delivered.

Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, (iv) collectibility is probable and (v) the arrangement does not require services that are essential to the functionality of the software.

Persuasive evidence of an arrangement exists. We determine that persuasive evidence of an arrangement exists with respect to a customer when we have a written contract, which is signed by both us and the customer, or a purchase order from the customer when the customer has previously executed a standard license arrangement with us. We do not offer product return rights.

Delivery has occurred. Our software may be either physically or electronically delivered to the customer. We determine that delivery has occurred upon shipment of the software pursuant to the billing terms of the agreement or when the software is made available to the customer through electronic delivery.

The fee is fixed or determinable. If at the outset of the customer engagement we determine that the fee is not fixed or determinable, we recognize revenue when the fee becomes due and payable. Fees due under a contract are generally deemed not to be fixed or determinable if a significant portion of the fee is beyond our normal payment terms, which are generally no greater than 120 days from the date of invoice.

Collectibility is probable. We determine whether collectibility is probable on a case-by-case basis. When assessing probability of collection, we consider the number of years in business, history of collection, and product acceptance for each customer. We typically sell to customers, for whom there is a history of successful collection. New customers are subject to a credit review process, which evaluates the customer's financial position and ultimately such customer's ability to pay. If we determine from the outset that collectibility is not probable based upon our review process, revenue is recognized as payments are received.

We allocate revenue on software arrangements involving multiple elements to each element based on the relative fair value of each element. Our determination of fair value of each element in multiple-element arrangements is based on vendor-specific objective evidence ("VSOE"). We align our assessment of VSOE for each element to the price charged when the same element is sold separately. We have analyzed all of the elements included in our multiple-element arrangements and determined that we have sufficient VSOE to allocate revenue to the maintenance, support and professional services components of our perpetual license arrangements. We sell our professional services separately, and have established VSOE for professional services on that basis. VSOE for maintenance and support is determined based upon the customer's annual renewal rates for these elements. Accordingly, assuming all other revenue recognition criteria are met, we recognize revenue from perpetual licenses upon delivery using the residual method in accordance with SOP 98-9, and revenue from maintenance and support services is recognized ratably over their respective terms.

Services revenues consist of professional services and maintenance fees. In general, our professional services, which are comprised of software installation and integration, business process consulting and training, are not essential to the functionality of the software. Our software products are fully functional upon delivery and implementation and do not require any significant modification or alteration of products for customer use. Customers purchase these professional services to facilitate the adoption of our technology and dedicate personnel to participate in the services being performed, but they may also decide to use their own resources or appoint other professional service organizations to provide these services. Software products are billed separately from professional services, which are generally billed on a time-and-materials basis. We recognize revenue from professional services as services are performed.

Maintenance agreements are typically priced based on a percentage of the product license fee and have a one-year term, renewable annually. Services provided to customers under maintenance agreements include technical product support and unspecified product upgrades. Deferred revenues from advanced payments for maintenance agreements are recognized ratably over the term of the agreement, which is typically one year.

We expense all manufacturing, packaging and distribution costs associated with software license sales as cost of license revenues.

Online Revenues

Advertising revenues are derived from the sale of advertising space on our various Web sites. We recognize advertising revenues over the period in which the advertisements are displayed, provided that persuasive evidence of an arrangement exists, no significant obligations remain, the fee is fixed or determinable, and collection of the receivable is reasonably assured. Our obligations typically include guarantees of a minimum number of "impressions" (times that an advertisement is viewed by users of our online services). To the extent that minimum guaranteed impressions are not met in the specified time frame, we do not recognize the corresponding revenues until the guaranteed impressions are achieved. We record barter revenue transactions at their estimated fair value based on our historical experience of selling similar advertising for cash in accordance with Emerging Issues Task Force ("EITF") Issue 99-17, "Accounting for Advertising Barter Transactions." We broadcast banner advertising in exchange for similar banner advertising on third-party Web sites. Our barter arrangements are documented with our standard customer insertion order (and accompanying terms and conditions) or, in certain limited instances, via an alternative written contract negotiated between the parties. The standard terms and conditions include, but are not limited to, the Web sites for each company that will display the impressions, the time frame that the impressions will be displayed, the number, type and size of impressions to be delivered.

E-commerce revenues are derived from the online sale of consumer goods and digital animations. We recognize e-commerce revenues from the sale of consumer goods in accordance with SEC Staff Accounting Bulletin ("SAB") No. 104, "Revenue Recognition in Financial Statements." Under SAB 104, product revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sale price is fixed or determinable, and collectibility is reasonably assured In general, we recognize e-commerce revenue upon the shipment of goods We do grant customers a right to return e-commerce products. Such returns are recorded as incurred and have been immaterial for the periods presented. The majority of the revenues derived from digital animation sales are related to membership arrangements. We offer two Animation Factory membership agreement options, Gold and Platinum. Both Gold and Platinum memberships are available for either a three-month or one-year term. During a Gold or Platinum membership term, a member has access to 150,000 animations, 50,000 Mediabuilder Web Designs, 3D Clipart, tiled backgrounds and unlimited downloads. A Platinum member also receives access to extra large animations, presentation elements and PowerPoint presentations. As a result, we recognize the value ratably over the term of the contract, normally 3 or 12 months.

Other Revenues

Our revenue recognition policy related to our former hardware systems business follows SEC SAB 104, "Revenue Recognition in Financial Statements." Under SAB 104, we recognized product revenues from the sale of Linux-based servers, components, and desktop computers when persuasive evidence of an arrangement existed, delivery occurred, the sales price was fixed or determinable and collectibility was reasonably assured. In general, we recognized product revenue upon shipment of the goods. We did not grant our customers any rights to return these products.

We recognize revenues from customer support services, including on-site maintenance and technical support on a pro-rata basis over the term of the related service agreement. We recognized revenues from professional service contracts upon completion of the project, or using the percentage of completion method of the project where project costs could be reasonably estimated. We recorded any payments received prior to revenue recognition as deferred revenue.

Results of Operations

We review our annual and quarterly results, along with key accounting policies, with our audit committee prior to the release of financial results. In addition, we have not entered into any significant transactions with related parties. We do not use off-balance-sheet arrangements with unconsolidated related parties, nor do we use other forms of off-balance-sheet arrangements such as research and development arrangements.

We have completed ten quarters of operations focused on building our application software business, and accordingly have a limited operating history in this business. While we believe that we are making good progress in our application software business, a substantial majority of our revenues continues to be derived from our online business and we face numerous risks and uncertainties that commonly confront new and emerging businesses in emerging markets, some of which we have identified in the "Risk Factors" section below.

The following table sets forth our operating results for the periods indicated as a percentage of total revenues, represented by selected items from the unaudited condensed consolidated statements of operations. This table should be read in conjunction with the consolidated financial statements and the accompanying notes included in this Form 10-Q.

                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                                          Three Months Ended        Six Month Ended
                                                          ------------------        ---------------
                                                       January 31, January 25,   January 31, January 25,
                                                          2004        2003          2004        2003
                                                         -----        -----        -----        -----
Total revenues                                               (unaudited)               (unaudited)
 Software revenues .............................          13.4%        10.5%        13.6%        12.0%
 Online revenues ...............................          86.5%        86.2%        86.1%        84.3%
 Other revenues ................................           0.2%         3.3%         0.3%         3.6%
                                                         -----        -----        -----        -----
   Total revenues ..............................         100.0%       100.0%       100.0%       100.0%
Cost of revenues
 Software cost of revenues .....................           6.1%         7.2%         7.8%         9.1%
 Online cost of revenues .......................          53.9%        52.2%        50.7%        49.3%
 Other cost of revenues ........................           0.0%        -3.1%         0.0%        -3.1%
  Cost of revenues .............................          60.0%        56.2%        58.4%        55.3%
                                                         -----        -----        -----        -----
  Gross margin .................................          40.0%        43.8%        41.6%        44.7%
Operating expenses:
  Sales and marketing ..........................          29.3%        35.4%        34.0%        39.9%
  Research and development .....................          19.4%        29.8%        24.2%        34.4%
  General and administrative ...................          17.6%        29.5%        15.6%        31.7%
  Restructuring costs and other special charges           -0.2%        -1.8%        -0.2%        -1.2%
  Amortization of deferred stock compensation ..           0.0%         0.6%         0.1%         0.7%
  Amortization of goodwill and intangible assets           0.0%         9.8%         0.0%        11.1%
                                                         -----        -----        -----        -----
      Total operating expenses .................          66.1%       103.3%        73.7%       116.6%
                                                         -----        -----        -----        -----
Loss from operations ...........................         -26.1%       -59.5%       -32.1%       -71.9%
Remeasurement of warrant liability .............           7.2%         0.0%         4.4%         0.0%
Interest income, net ...........................           2.7%         4.2%         3.3%         4.8%
Other income (expense), net ....................           0.0%        -0.6%         6.4%         0.0%
                                                         -----        -----        -----        -----
Net loss .......................................         -16.2%       -55.9%       -18.0%       -67.1%
                                                         =====        =====        =====        =====
   Total revenues
During the fourth quarter of fiscal 2003, two separate businesses emerged and as of July 31, 2003, we operate as two reportable business segments: software and online.

Our total revenues increased to $8.9 million and $14.7 million for the three months and six months ended January 31, 2004, respectively, from $6.6 million and $11.6 million for the three and six months ended January 25, 2003, respectively. The $2.3 million and $3.1 million increase in total revenues for the three and six months ended January 31, 2004 was due primarily to an increase in our online and software businesses, offset by a decrease in other revenue derived from our exited hardware business.

For the three and six months ending January 31, 2004, no single customer accounted for more than 10% of our total revenues. For the three and six months ending January 25, 2003 one customer, Intel Corporation, accounted for approximately 15.2% and 17.2% of our total revenues respectively.

Software Revenues

Software revenues are derived from our application software business and include software licenses, professional services, maintenance, support and training. Software revenues represent $1.2 million, or 13.4%, and $0.7 million, or 10.5%, of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. The $0.5 million increase in software revenues was

due to an increase in the licensing component of software revenue. During the quarter ended January 31, 2004, we had one existing customer and one new customer place license orders in excess of $0.2 million, compared to no license orders in excess of $0.2 million for the quarter ended January 25, 2003.

Software revenues represent $2.0 million, or 13.6%, and $1.4 million, or 12.0%, of total revenues for the six months ended January 31, 2004 and January 25, 2003, respectively. The year-over-year $0.6 million increase in software revenue was due to the increased number of new customers that were added during the six months ended January 31, 2004 compared with the six months ended January 25, 2003, coupled with a larger installed base for maintenance revenue and follow-on sales. We began fiscal year 2004 with an installed base of 55 customers and added 20 new customers during the six months ended January 31, 2004 compared to beginning fiscal year 2003 with an installed base of 24 customers and adding 7 new customers during the six months ended January 25, 2003.

Online Revenues

Online revenues include online advertising and e-commerce revenues. Total online revenues of $7.7 million and $5.7 million represented 86.5% and 86.2% of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. Total online revenues of $12.6 million and $9.8 million represented 86.1% and 84.3% of total revenues for the six months ended January 31, 2004 and January 25, 2003, respectively.

Online advertising revenues of $2.2 million and $2.3 million represented 25.1% and 34.8% of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. Online advertising revenues included $0.4 million and $0.5 million of barter revenue for the three months ended January 31, 2004 and January 25, 2003, respectively. Online advertising revenues of $4.5 million and $4.6 million represented 30.6% and 39.7% of total revenues for the six months ended January 31, 2004 and January 25, 2003, respectively. Online advertising revenues included $0.9 million and $1.0 million of barter revenue for the six months ended January 31, 2004 and January 25, 2003, respectively. The average CPM rate (i.e., the average rate at which we receive revenue per 1,000 banner advertisements we display to users of our online services) for the three and six months ended January 31, 2004 decreased by 53.0% and 56.0%, respectively, when compared to the three and six months ended January 25, 2003. The CPM rate decrease was offset by a 456% and 560% increase in the number of impressions delivered for the three and six months ended January 31, 2004, respectively. The increase in the number of impressions was primarily due to general improvement in demand for our online advertising coupled with sales generated by an additional sales representative that we added in the second quarter of fiscal year 2004. We expect the growth of our online advertising revenue to outpace that of the general online advertising market. We believe that our prominent position in serving the growing open source software and Linux markets, along with our favorable online visitor demographics, makes us an attractive advertising vehicle for advertising customers.

E-commerce revenues of $5.4 million and $3.4 million represented 60.7% and 51.5% of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. E-commerce revenues of $8.1 million and $5.2 million represented 55.1% and 44.8% of total revenues for the six months ended January 31, 2004 and January 25, 2003, respectively. The $2.0 million and $2.9 million increases in e-commerce revenues for the three and six months ended January 31, 2004 were primarily due to increased consumer awareness of our site due to expanded advertising, a broader product offering which attracted a larger customer base, web site enhancements and affiliate programs that drove more traffic to our site. As a result of our effort we had a 60.5% and 56.2% year-over-year increase in the number of orders placed for the three and six months ended January 31, 2004, respectively. We expect continued growth in our e-commerce revenue, including the continued seasonal impact from online holiday shoppers in our second fiscal quarter.

Other Revenues

Other revenues are derived from our former hardware, customer support, and professional services businesses. Other revenues represent $15,000, or 0.2%, of total revenues for the three months ended January 31, 2004 and $0.2 million, or 3.3%, for the three months ended January 25, 2003. Other revenues represent $46,000 or 0.3%, of total revenues for the six months ended January 31, 2004 and $0.4 million, or 3.6%, for the six months ended July 25, 2003.

Cost of Revenues

Cost of software revenues include direct material and production costs for CDs and manuals, professional services cost and support department costs. Cost of software revenues were $0.5 million for each of the three months ended January 31, 2004 and January 25, 2003. Cost of software revenues were 6.1% and 7.2% of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. Cost of software revenues were $1.1 million for each of the six months ended January 31, 2004 and January 25, 2003. Cost of software revenues were 7.8% and 9.1% of total revenues for the six months ended January 31, 2004 and January 25, 2003, respectively. The three and six month percentage of total revenue decreases were completely related to the increase in total revenue; the cost of software revenues did not increase in the three or six months ended January 31, 2004 compared to the comparable periods ended January 25, 2003. We anticipate that cost of software revenues will remain relatively constant through the end of our fiscal year 2005.

Software gross margin increased $0.4 million to $0.6 million for the three months ended January 31, 2004 from $0.2 million for the three months ended January 25, 2003. The software gross margin was 7.3% and 3.3% of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. The $0.4 million increase in gross margin was due to a $0.5 million increase in software revenue coupled with no significant year-over-year increase in the services and support department cost structure. The software gross margin increased $0.6 million to $0.9 million for the six months ended January 31, 2004 from $0.3 million for the six months ended January 25, 2003. The software gross margin was 5.8% and 2.9% of total revenues for the six months ended January 31, 2004 and January 25, 2003, respectively. The $0.6 million increase in gross margin was due to the $0.6 million increase in software revenue coupled with no significant year-over-year increase in the services and support department cost structure. We anticipate that software gross margins in absolute dollars will increase in direct relationship to revenue increases.

Cost of online revenues includes cost of e-commerce materials, shipping and fulfillment costs, and employee costs associated with the editorial, operations and merchandising functions. Cost of online revenues increased $1.4 million to $4.8 million for the three months ended January 31, 2004 from $3.4 million for the three months ended January 25, 2003. Cost of online revenues were 53.9% and 52.2% of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. The $1.4 million increase in online cost of revenues was primarily due to a $1.1 million increase in e-commerce material costs and $0.6 million increase in shipping and fulfillment costs associated with e-commerce partially offset by a $0.3 million reduction in our online advertising business cost of revenues. Cost of online revenues increased $1.7 million to $7.4 million for the six months ended January 31, 2004 from $5.7 million for the six months ended January 25, 2003. Cost of online revenues were 50.7% and 49.3% of total revenues for the six months ended January 31, 2004 and January 25, 2003 respectively. The $1.7 million increase in online cost of revenues was primary due to the increase in material costs of $1.4 million and $0.8 million in shipping and fulfillment costs associated with e-commerce partially offset by a $0.5 million reduction in our online advertising cost of revenues. The increase in e-commerce materials, shipping and fulfillment costs for both the three- and six-month periods was directly related to increases in revenue.

Online gross margin increased $0.7 million to $2.9 million for the three months ended January 31, 2004 from $2.2 million for the three months ended January 25, 2003. Online gross margin was 32.6% and 34.0% of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. Online gross margin increased $1.1 million to $5.2 million for the six months ended January 31, 2004 from $4.1 million for the six months ended January 25, 2003. Online gross margin was 35.4% and 35.0% of total revenues for the six months ended January 31, 2004 and January 25, 2003, respectively. The three- and six-month increases in online gross margin are related to increases in total online revenue partially offset by an increase in cost of online revenues. We expect to see continued quarterly variations in online gross margins as a percent of online revenues due to the mix of our higher margin advertising revenue with lower margin, seasonal e-commerce revenue.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in sales, marketing and sales support functions, as well as costs associated with trade shows, advertising and promotional activities.

Sales and marketing expenses increased $0.3 million to $2.6 million for the three months ended January 31, 2004 from $2.3 million for the three months January 25, 2003. The $0.3 million increase in expense was due to a $0.1 million increase in commission expense associated with the increased revenue, a $0.1 million increase in outside contractor expense and a $0.1 million increase in other miscellaneous expense categories. Sales and marketing expenses increased $0.4 million to $5.0 million for the six months ended January 31, 2004 from $4.6 million for the six months ended January 25, 2003. The $0.4 million increase was due to the $0.3 million expense increase explanation above coupled with a $0.1 million increase in marketing activities associated with our online business.

Sales and marketing expenses were 29.3% and 35.4% of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. Sales and marketing expenses were 34.0% and 39.9% of total revenues for the six months ended January 31, 2004 and January 25, 2003, respectively. These decreases as a percentage of total revenues were primarily related to our increase in revenue. Going forward, we expect sales and marketing expenses to increase in absolute dollars but decrease as a percentage of total revenues through our fiscal year 2005.

Research and Development Expenses

Research and development expenses consist primarily of salaries and related expenses for software engineers. Total research and development expenses related to our software business were $1.2 million and $1.5 million for the three months ended January 31, 2004 and January 25, 2003, respectively. Total research and development expenses related to our software business were $2.5 million and $3.2 million for the six month ended January 31, 2004 and January 25, 2003, respectively. Software research and development expenses are primarily related to the development of new products and enhancements to our current products. Total research and development expenses for our online business were $0.5 million and $0.4 million for the three months ended January 31, 2004 and January 25, 2003, respectively. Total online research and development expenses were $1.0 million and $0.8 million for the six months ended January 31, 2004 and January 25, 2003, respectively. Online research and development is directed toward the improvement of existing products and services.

Research and development expenses decreased by $0.2 million to $1.7 million for the three months ended January 31, 2004 from $1.9 million for the three months ended January 25, 2003. The $0.2 million decrease was primarily due to a $0.1 million decrease in salary expense and a $0.1 million decrease in outside contractor expense. Research and development expenses decreased by $0.5 million to $3.5 million for the six months ended January 31, 2004 from $4.0 million for the six months ended January 25, 2003. The $0.5 million decrease was due to a $0.3 million decrease in employee labor expenses, a $0.1 million decrease in outside contractor expense and a $0.1 million decrease in allocated overhead expenses such as rent and utilities. Average headcount decreased by 6 to 38 during the three and six months ended January 31, 2004 from an average headcount of 44 during the three and six months ended January 25, 2003.

Research and development expenses were 19.4% and 29.8% of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. Research and development expenses were 24.2% and 34.4% of total revenues for the six months ended January 31, 2004 and January 25, 2003, respectively. These decreases as a percentage of total revenues were primarily related to our increase in revenue and the year-over-year reduction in headcount. Going forward we expect research and development expenses to remain stable in absolute dollars and decrease as a percentage of total revenues through our fiscal year 2005.

General and Administrative Expenses

General and administrative expenses consist of salaries and related expenses for finance and administrative personnel and professional fees for accounting and legal services.

General and administrative expenses decreased $0.3 million to $1.6 million for the three months ended January 31, 2004 from $1.9 million for the three months ended January 25, 2003. The $0.3 million dollar decrease was due to a $0.2 million decrease resulting from a change in the structure of our bonus plan and $0.1 million in lower labor costs resulting from a decrease in headcount from 21 to 18. General and administrative expenses decreased $1.4 million to $2.3 million for the six months ended January 31, 2004 from $3.7 million for the six months ended January 25, 2003. The $1.4 million dollar decrease was due to lower labor and bonus costs as noted above; the remaining $1.1 million dollar decrease was due to a $0.9 million reversal of accrued legal expenses reserved for securities litigation expenses that were ultimately paid by one of our insurers, and a $0.3 million reversal of legal expenses related to a lawsuit that was favorably resolved during our first fiscal quarter, partially offset by a $0.1 million increase in recruiting fees.

General and administrative expenses were 17.6% and 29.5% of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. General and administrative expenses were 15.6% and 31.7% of total revenues for the six months ended January 31, 2004 and January 25, 2003, respectively. These decreases as a percentage of total revenues were primarily related to our increase in revenue and due to the expense reduction reasons noted above. Going forward we expect general and administrative expenses to increase slightly in absolute dollars but decrease as a percentage of total revenues through our fiscal year 2005.

Restructuring Costs and Other Special Charges

In fiscal 2001 and 2002, we adopted plans to exit the systems and hardware-related software engineering and professional services businesses, as well as exit a sublease agreement and reduce our general and administrative overhead costs. We exited these activities to pursue our software and online businesses and reduce our operating losses to improve cash flow. We recorded restructuring charges of $180.2 million related to exiting these activities, $160.4 million of which was included in restructuring charges and other special charges in operating expenses and $19.8 million of which was included in cost of sales. Included in the restructuring were charges related to excess facilities from non-cancelable leases (with payments continuing until fiscal 2010, unless sublet completely). The accrual from non-cancelable lease payments includes management's estimates of sublease income. These estimates are subject to change based on actual events. We evaluate and update, if applicable, these estimates quarterly. As of January 31, 2004, we had an accrual of approximately $12.9 million outstanding related to these non-cancelable leases, all of which was originally included in operating expenses

We recorded an $18,000 and $35,000 net credit in restructuring expenses in the consolidated statement of operations for the three months and six months ended January 31, 2004. The net credits were a result of sublease income earned from a non-related party.

In February 2004, we adopted a plan to relocate our Fremont, California headquarters to a smaller building in the same complex. As a result, we expect to expense the remaining lease obligation, net of assumed sublease income of our currently occupied space, and to write off the leasehold improvements and furniture and fixtures in the current space. We had previously expensed the remaining lease obligation, net of assumed sublease income of the space that we are planning to move into; with the move, we will adjust the restructuring reserve for the new smaller building. We expect to complete our relocation during the quarter ended April 30, 2004, and anticipate that the move, coupled with recent changes to our assumptions relating to expected future sublease income from our restructured idle office space will result in our booking a net restructuring expense of between $4.5 million and $5.0 million during the quarter ended April 30, 2004.

Below is a summary of the restructuring charges in operating expenses (in thousands):

                                                                                              Total
                                                                                            Charged To
                                                                                            Operations                Restructuring
                                                      Total       Total         Total       Six Months       Total    Liabilities
                                                    Charged To  Charged To    Charged To       ended          Cash         at
                                                    Operations  Operations    Operations    January 31,     Receipts/  January 31,
                                                   Fiscal 2001 Fiscal 2002   Fiscal 2003       2004         Payments      2004
                                                   ----------- -----------   -----------    ----------      --------  --------------
Cash Provisions:
  Other special charges relating to
    restructuring activities ....................   $  2,159     $   (888)     $     78      $     --       $ (1,349)    $     --
  Facilities charges ............................      6,584        9,401           191           (35)        (3,286)    $ 12,855
  Employee severance and other related charges ..      3,498        1,997            37            --         (5,532)          --
                                                    --------     --------      --------      --------       --------     --------
      Total cash provisions .....................     12,241       10,510           306           (35)      $(10,167)    $ 12,855
                                                    --------     --------      --------      --------       ========     ========
Non-cash:
  Write-off of goodwill and intangibles .........     59,723       30,632            --            --
   Write-off of other special charges relating to
    restructuring activities ....................      4,434        5,442          (553)           --
  Write-off of accelerated options from
    terminated employees ........................      1,352           --            --            --
   Acceleration of deferred stock compensation ..     35,728          352           (16)           --
                                                    --------     --------      --------
      Total non-cash provisions .................    101,237       36,426          (569)           --
                                                    --------     --------      --------
      Total provisions ..........................   $113,478     $ 46,936      $   (263)     $    (35)
                                                    ========     ========      ========      ========

Below is a summary of the changes to the restructuring liability (in thousands):

                                                              Balance at     Charged to                    Balance at
                                                              Beginning      Costs and                        End
Changes in the total accrued restructuring  liability         of Period      Expenses      Deductions      of Period
-----------------------------------------------------         ---------      --------      ----------      ---------
   For the year ended July 28, 2001                             $    --        $12,241       $(2,728)       $ 9,513
   For the year ended July 27, 2002                             $ 9,513        $10,510       $(2,029)       $17,994
   For the year ended July 31, 2003                             $17,994        $   306       $(3,411)       $14,889
   For the six months ended January 25, 2003                    $17,994        $  (135)      $(1,518)       $16,341
   For the six months ended January 31, 2004                    $14,889        $   (35)      $(1,999)       $12,855
                                                                 Short          Long         Total
Components of the total accrued restructuring liability          Term           Term        Liability
-------------------------------------------------------         ------         ------       ---------
   For the year ended July 28, 2001                             $3,135         $ 6,378       $ 9,513
   For the year ended July 27, 2002                             $3,397         $14,597       $17,994
   For the year ended July 31, 2003                             $4,117         $10,772       $14,889
   For the six months ended January 25, 2003                    $3,931         $12,410       $16,341
   For the six months ended January 31, 2004                    $3,383         $ 9,472       $12,855
Amortization of Deferred Stock Compensation

In connection with the grant of stock options to employees during fiscal 1999 and prior to our initial public offering in fiscal 2000, we expensed deferred stock compensation of $0 and $20,000 during the three and six months ended January 31, 2004, respectively, compared to $41,000 and $79,000 during the three and six months ended January 25, 2003, respectively. We do not expect any further expenses associated with deferred stock compensation through fiscal year 2004.

Amortization of Intangible Assets

In July 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible Assets." Under SFAS No. 142, goodwill and intangible assets with indefinite lives are not amortized but are subject to at least an annual assessment for impairment applying a fair-value based test. Upon adoption of SFAS No. 142 on July 29, 2001, we no longer amortize goodwill. In connection with the acquisition of OSDN, we amortized $3,000 and $0.6 million of intangibles for the three months ended January 31, 2004 and January 25, 2003, respectively. We amortized $6,000 and $1.3 million of intangibles for the six months ended January 31, 2004 and January 25, 2003, respectively. The estimated total amortization expense of acquired intangible assets is $12,700 and $9,500 for the fiscal years ending July 31, 2004 and July 31, 2005, respectively.

We periodically evaluate the carrying amount of our long-lived assets and apply the provisions of SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 requires that long-lived assets and certain identifiable intangibles to be held and used or disposed of by an entity be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. No changes occurred during the three months ended January 31, 2004 that would indicate a possible impairment in the carrying value of intangible assets at January 31, 2004.

Remeasurement of Warrant Liability, Interest and Other Income, Net

On November 6, 2003, we entered into a securities purchase agreement in which we completed a private placement of 3,529,412 shares of our common stock with The Riverview Group LLC ("Riverview") at an issue price of $4.25 per share for aggregate proceeds of approximately $15 million (the "Private Placement"). In connection with the Private Placement, the Company retained Wharton Capital Partners Ltd. ("Wharton") to act as a financial consultant and placement agent. Also in connection with the Private Placement, Riverview and Wharton received three-year warrants to purchase a total of 705,883 and 25,000 shares of our common stock, respectively, at an exercise price of $6.00 and $6.14 per share, respectively (collectively, the "Warrants"). We entered into a registration rights agreement with Riverview on November 6, 2003 (the "Registration Rights Agreement") in which we agreed to provide certain registration rights under the Securities Act of 1933, as amended and the rules and regulations promulgated thereunder, and applicable state securities laws with respect to the common stock and the warrants issued to Riverview.

The shares of our common stock sold in the Private Placement and the shares of our common stock underlying the Warrants do not have the same rights as the other shares which are included in the Equity section of the Consolidated Balance sheet. Therefore, the shares of our common stock sold in the Private Placement and the shares of our common stock underlying the Warrants are classified as liabilities on the Consolidated Balance sheet. Liabilities must be reported at fair value as of the balance sheet date. We valued the Warrants as of November 6, 2003 using the Black-Scholes valuation model and then, on January 31, 2004, revalued them using the same Black-Scholes valuation model. Based on our remeasurement, our net warrant liability for the Warrants decreased by $0.8 million to $1.7 million as of January 31, 2004, from $2.5 million as of November 6, 2003. This $0.8 million decrease in warrant liability was partially offset by a $0.2 million non-cash expense associated with not having the shares of common stock associated with the Private Placement registered as of January 31, 2004. Due to a penalty clause in the Registration Rights Agreement, if we are unable to effect registration of the shares of our common stock sold in the Private Placement and the shares of our common stock

underlying the Warrants, we will be required to expense a total of $3.0 million over the next 56 months. We present the net $0.6 million on our income statement as remeasurement of warrant liability income (for additional information please see footnote number 10 in the notes to the consolidated financial statements). Once the shares of our common stock sold in the Private Placement and the shares underlying the Warrants have been registered, they will have the same rights as our other outstanding, registered common stock and we will no longer be required to record income or expense associated with remeasurement of the Warrants or for the potential penalty associated with not registering the shares of our common stock sold in the Private Placement and the shares underlying the Warrants. After the shares of our common stock sold in the Private Placement and the shares underlying the Warrants have been registered, they will then be moved from the liability section of our consolidated balance sheet to the equity section of our consolidated balance sheet.

Interest income, net, includes income from our cash investments net of interest expense. Net interest income decreased $0.1 million to $0.2 million for the three months ended January 31, 2004 from $0.3 million for the three months ended January 25, 2003. Net interest income decreased $0.1 million to $0.5 million for the six months ended January 31, 2004 from $0.6 million for the six months ended January 25, 2003. These decreases were primarily related to the year-over-year interest rate decline.

Interest income, net, was 2.7% and 4.2% of total revenues for the three months ended January 31, 2004 and January 25, 2003, respectively. Interest income, net, was 3.3% and 5.4% of total revenues for the six months ended January 31, 2004 and January 25, 2003, respectively. These decreases as a percentage of total revenues were primarily related to our increase in revenue and due to lower interest rates. Going forward we expect interest income to decrease as a percentage of total revenues.

Other income, net, includes items such as legal settlement proceeds net of other expenses. Other income net, was $0 for the three months ended January 31, 2004 and a $37,000 expense for the three months ended January 25, 2003. Other income net, increased $1.0 million to $0.9 million for the six months ended January 31, 2004 from a $65,000 expense for the six months ended January 25, 2003. The $1.0 million increase in interest and other income was due to a $1.0 million legal settlement and a $0.3 million business recovery payment related to the World Trade Center disaster, partially offset by a decrease $0.3 million of other expenses related to our exited hardware business.

Income Taxes

As of January 31, 2004, we had federal and state net operating loss carry-forwards for tax reporting purposes available to offset future taxable income. A valuation allowance has been recorded for the total deferred tax assets as a result of uncertainties regarding realization of the assets based on the lack of consistent profitability to date and the uncertainty of future profitability. The federal and state net operating loss carry-forwards expire at various dates through fiscal year 2021 and fiscal year 2012, respectively, to the extent that they are not utilized. We have not recognized any benefit from these net operating loss carry-forwards because of uncertainty surrounding their realization. The amount of net operating losses that we can utilize is limited under tax regulations because we have experienced a cumulative stock ownership change of more than 50% over the last three years.

Liquidity and Capital Resources

As of January 31, 2004, our available capital resources totaled $49.4 million, comprised of marketable securities of $37.9 million and cash and cash equivalents of $11.5 million. As of July 31, 2003, our available capital resources totaled $38.8 million, comprised of $32.5 million in marketable securities and $6.3 million in cash and cash equivalents. Our average net monthly cash flow shortfall during the three months ended January 31, 2004 was approximately $0.8 million. The cash flow shortfall is primarily due to operating lease commitments that were entered into while we were operating our hardware business and employee costs associated with our software business. We believe that at our current cash flow shortfall rates, we have enough cash to operate through fiscal year 2005. We will continue to invest significant resources in an effort to grow our software business.

Net cash used in operating activities was $6.2 million in the six months ended January 31, 2004 and $8.3 million in the six months ended January 25, 2003. Net cash used in operating activities during the six months ended January 31, 2004 primarily reflected a net loss of $2.7 million, a decrease in accrued liabilities of $3.1 million, including a $2.0 million reduction in accrued restructuring accruals as we make lease payments on restructured space and a $0.9 million reduction in legal expenses due to the agreement by our insurers to pay the legal expenses associated with the initial public offering securities litigation; an increase in accounts receivable of $1.0 million, related to the higher level of sales in the three months ending January 31, 2004 compared to the three months ending July 31, 2003; net remeasurement of warrant liability of $0.6 million, associated with the private placement; and an increase in prepaid assets and inventories of $0.6 million, due to the payment of insurance premiums and seasonal inventory needs

for our e-commerce business, respectively; partially offset by depreciation expense $0.9 million and an increase in deferred revenue of $0.9 million. Net cash used in operating activities during the six months ended January 25, 2003 of $8.3 million primarily reflected a net loss of $7.8 million, a decrease in accrued liabilities of $2.8 million, a decrease in accounts payable of $0.7 million, an increase in accounts receivable of $0.4 million, a restructuring expense of $0.2 million and an increase in prepaid assets and inventories of $0.2 million partially offset by depreciation and amortization of intangible asset expense $3.1 million, an increase in deferred revenue of $0.6 million and an increase in other long-term liabilities of $0.1 million.

A significant portion of our cash inflows have historically been generated by our sales. These inflows may fluctuate significantly from period to period. A decrease in customer demand or decrease in the market acceptance of our products would jeopardize our future ability to generate positive cash flows from operations.

For the six months ended January 31, 2004, we used $5.9 million in cash for investing activities, compared to the use of $15.5 million for the six months ended January 25, 2003. During the six months ended January 31, 2004 we purchased $0.5 million in fixed assets and $10.1 million in marketable securities and sold $4.8 million in marketable securities. Cash used for investing activities was significantly higher for the six months ended January 25, 2003 when we purchased $23.7 million in marketable securities and sold $8.1 million in marketable securities, due to implementing our strategic decision to increase our short- and long-term investments and decrease our cash equivalent investments in an effort to maximize our rate of return.

For the six months ended January 31, 2004, we generated $17.3 million in cash from financing activities, compared to $0.2 million for the six months ended January 25, 2003. Net proceeds from the private placement generated $14.5 million during the six months ended January 31, 2004 and cash generated from the issuance of common stock to our employees increased to $2.8 million during the six months ended January 31, 2004 compared to the $0.2 million for the six months ended January 25, 2003. We do not anticipate entering into additional private placement transactions in the foreseeable future and the level of cash, if any, that will be generated in the future from the issuance of common stock to our employees from the exercising of options is dependant upon several factors, including the market price of our common stock and the number of employees participating in our stock option plans.

For the six months ended January 31, 2004 and January 25, 2003, exchange rate changes had an immaterial effect on cash and cash equivalents. We expect that exchange rate changes will have an immaterial effect on cash and cash equivalents in the near future due to our focus on US-based business.

As of January 31, 2004 and July 31, 2003, we had outstanding letters of credit issued under a line of credit of approximately $0.9 million related to the corporate facility lease. The amount related to this letter of credit is recorded in the "Restricted cash" section of the condensed consolidated balance sheet. We anticipate that this balance will decline by $0.5 million in the fourth quarter of each fiscal year through 2005 under our existing lease agreement.

Future payments due under debt and lease obligations as of January 31, 2004 are as follows (in thousands):

                                            Gross                    Net
                                          Operating     Sublease  Operating
                                            Leases      Income      Leases
                                           -------      ------     -------
2004 ..................................    $ 2,647      $  341     $ 2,306
2005 ..................................      5,002         663       4,339
2006 ..................................      3,741         151       3,590
2007 ..................................      3,511          --       3,511
2008 ..................................      3,616          --       3,616
Thereafter ............................      6,905          --       6,905
                                           -------      ------     -------
          Total minimum lease payments     $25,422      $1,155     $24,267
                                           =======      ======     =======
Our liquidity and capital requirements depend on numerous factors, including market acceptance of our products, the resources we devote to developing, marketing, selling and supporting our products, the timing and expense associated with expanding our distribution channels, potential acquisitions and other factors. We expect to devote capital resources to continue our research and development efforts, to invest in our sales, support, marketing and product development organizations, to enhance and introduce marketing programs, and for other general corporate activities. We believe that our existing cash balances will be sufficient to fund

our operations through fiscal 2005 under our current business strategy, however, if we fail to adequately monitor and minimize our use of existing cash, we may need additional capital to fund continued operations beyond fiscal year 2005. We expect to continue to experience negative cash flow from operations for at least the foreseeable future. Unless we monitor and minimize the level of use of our existing cash, cash equivalents and marketable securities, we may require additional capital to fund continued operations beyond our fiscal year 2005. See "Risks Related to our Financial Results" in the Risk Factors section of this Form 10-Q.

Financial Risk Management

As a primarily US-based company, we face limited exposure to adverse movements in foreign currency exchange rates and we do not engage in hedging activity. We do not anticipate significant currency gains or losses in the near term. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial results.

We maintain investment portfolio holdings of various issuers, types and maturities. These securities are classified as available-for-sale, and consequently are recorded on the condensed consolidated balance sheet at fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income (loss). These securities are not leveraged and are held for purposes other than trading.

Critical Accounting Policies

There have been no material changes to our critical accounting policies and estimates from those disclosed in our report on Form 10-K for our fiscal year ended July 31, 2003.

Recent Accounting Pronouncements

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 addresses certain financial instruments that, under previous guidance, could be accounted for as equity, but now must be classified as liabilities in statements of financial position. These financial instruments include: 1) mandatory redeemable financial instruments, 2) obligations to repurchase the issuer's equity shares by transferring assets, and 3) obligations to issue a variable number of shares. SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The implementation of SFAS No. 150 is not expected to have a material effect on our consolidated financial statements.

In December 2003, the SEC issued SAB 104, Revenue Recognition, ("SAB 104") which supercedes SAB 101, Revenue Recognition in Financial Statements. SAB 104's primary purpose is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, which was superceded as a result of the issuance of EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. We do not believe the adoption of SAB 104 will have a material impact on the financial statements.

                                  Risk Factors

INVESTORS SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW BEFORE MAKING AN

INVESTMENT DECISION. IN ADDITION, THESE RISKS ARE NOT THE ONLY ONES FACING OUR

COMPANY. ADDITIONAL RISKS OF WHICH WE ARE NOT PRESENTLY AWARE OR THAT WE

CURRENTLY BELIEVE ARE IMMATERIAL MAY ALSO IMPAIR OUR BUSINESS OPERATIONS. OUR

BUSINESS COULD BE HARMED BY ANY OF THESE RISKS. THE TRADING PRICE OF OUR COMMON

STOCK COULD DECLINE DUE TO ANY OF THESE RISKS, AND INVESTORS MAY LOSE ALL OR

PART OF THEIR INVESTMENT.

                     Risks Related To Our Software Business
Because the market for our SourceForge application software is new and rapidly evolving, we do not know whether existing and potential customers will license SourceForge in sufficient quantities for us to achieve profitability.

Our future growth and financial performance will depend on market acceptance of SourceForge and our ability to license our software in sufficient quantities and under acceptable terms. The number of customers using SourceForge is still relatively small. We expect that we will continue to need intensive marketing and sales efforts to educate prospective clients about the uses and benefits of SourceForge. Various factors could inhibit the growth of the market for and market acceptance of SourceForge. In particular, potential customers may be unwilling to make the significant capital investment needed to license SourceForge. Many of our customers have licensed only limited quantities of SourceForge, and these or new customers may decide not to broadly implement our software by licensing additional copies from us. We cannot be certain that a viable market for SourceForge will emerge or, if it does emerge, that it will be sustainable. If a sustainable viable market for SourceForge fails to emerge, this would have a significant, adverse effect upon our software business and operating results.

We are devoting the majority of our research and development spending on our SourceForge application, so if this software does not achieve market acceptance we are likely to experience continued operating losses.

Although in the second quarter of our fiscal year 2004, which ended on January 31, 2004, approximately 13% of our revenue was derived from our software business, we devoted 70.6%, or $1.2 million, of our research and development spending to research and development associated with our SourceForge software application. Given that SourceForge remains a relatively new enterprise software application, we expect to continue to allocate the majority of our research and development resources to SourceForge for the foreseeable future. There can be no assurance, however, that we will be sufficiently successful in marketing, licensing, upgrading and supporting SourceForge to offset our substantial software research and development expenditures. A failure to grow SourceForge revenue sufficiently to offset SourceForge's significant research and development costs will materially and adversely affect our business and operating results.

If we fail to attract and retain larger corporate and enterprise-level customers, our revenues will not grow and may decline.

We have focused our sales and marketing efforts upon larger corporate and enterprise-level customers. This strategy may fail to generate sufficient revenue to offset the substantial demands that this strategy will place on our business, in particular the longer sales cycles, higher levels of service and support and volume pricing and terms that larger corporate and enterprise accounts often demand. In addition, these larger customers generally have significant financial and personnel resources. As a result, rather than license SourceForge, our target customers may develop collaborative software development applications internally, including ad hoc development of applications based on open source code. A failure to successfully obtain revenues from larger corporate or enterprise-level customers will materially and adversely affect our operating results.

If we fail to anticipate or respond adequately to technology developments, industry standards, or practices and customer requirements, or if we experience any significant delays in product development, introduction, or integration, SourceForge may become obsolete or unmarketable, our ability to compete may be impaired, and our software revenues may not grow or may decline.

Rapid technological advances, changes in customer requirements, and frequent new product introductions and enhancements characterize the software industry generally. We must respond rapidly to developments related to hardware platforms, operating systems, and software development tools. These developments will require us to make substantial product development investments. We believe the success of our software business will become increasingly dependent on our ability to:

o support multiple platforms, including Linux, commercial UNIX and Microsoft Windows;

o use the latest technologies to continue to support Web-based collaborative software development; and

o continually support the rapidly changing standards, tools and technologies used in software development.

Our application software has a long and unpredictable sales cycle, which makes it difficult to forecast our future results and may cause our operating results to vary significantly.

The period between initial contact with a prospective customer and the licensing of our software varies and has often exceeded three and occasionally exceeded twelve months. Additionally, our sales cycle is complex because customers consider a number of factors before committing to license SourceForge. Factors that our customers and potential customers have informed us that they considered when evaluating SourceForge included product benefits, cost and time of implementation, and the ability to operate with existing and future computer systems and applications. We have found that customer evaluation, purchasing and budgeting processes vary

significantly from company to company. As a result, we spend significant time and resources informing prospective customers about our software products, which may not result in completed transactions and associated revenue. Even if SourceForge has been chosen by a customer, completion of the transaction is subject to a number of contingencies, which make our quarterly revenues difficult to forecast. These contingencies include but are not limited to the following:

o Our ability to sell SourceForge licenses may be impacted by changes in the strategic importance of software projects due to our customers' budgetary constraints or changes in customer personnel;

o A customer's internal approval and expenditure authorization process can be difficult and time consuming. Delays in approvals, even after we are selected as a vendor, could impact the timing and amount of revenues recognized in a quarterly period; and

o The number, timing and significance of enhancements to our software products and future introductions of new software by our competitors and us may affect customer-purchasing decisions.

If we do not continue to receive repeat business from existing customers, our revenue will not grow and may decline.

We generate a significant amount of our software license revenues from existing customers. Most of our current customers initially purchased a limited number of licenses as they implemented and adopted SourceForge. Even if customers successfully use SourceForge, such customers may not purchase additional licenses to expand the use of our product. Purchases of additional licenses by these customers will depend on their success in deploying SourceForge, their satisfaction with our product and support services and their use of competitive alternatives. A customer's decision to widely deploy SourceForge and purchase additional licenses may also be affected by factors that are outside of our control or which are not related to our product or services. In addition, as we deploy new versions of SourceForge, or introduce new products, our current customers may not require the functionality of our new versions or products and may decide not to license these products.

If we fail to maintain our strategic relationship with IBM, the market acceptance of our products and our financial performance may suffer.

To date, the majority of our SourceForge revenue has come from our direct sales efforts. To offer products and services to a larger customer base, we entered into a commercial relationship with IBM. If we are unable to maintain our existing strategic relationship with IBM, our ability to increase our sales may be harmed. We would also lose anticipated customer introductions and co-marketing benefits. In addition, IBM could terminate its relationship with us, pursue other relationships, or attempt to develop or acquire products or services that compete with our products and services. Even if we succeed in maintaining or expanding our relationship with IBM, the relationship may not result in additional customers or revenues. We have begun exploring other possible relationships and marketing alliances to obtain customer leads, referrals and distribution opportunities. Even if we succeed in securing such additional strategic relationships, the relationships may not result in additional customers or revenues.

Increased utilization and costs of our technical support services may adversely affect our financial results.

Over the short term, we may be unable to respond to fluctuations in customer demand for support services. We may also be unable to modify the format of our support services to compete with changes in support services provided by competitors. Further, customer demand for these services could cause increases in the costs of providing such services and adversely affect our operating results.

Contractual issues may arise during the negotiation process that may delay the anticipated closure of a transaction and our ability to recognize revenue as anticipated. The occurrence of such issues might cause our software revenue and operating results to fall below our publicly-stated expectations, the expectations of securities analysts or the expectations of investors. Failure to meet public expectations is likely to materially and adversely affect the trading price of our common stock.

Because we focus on selling enterprise solutions, the process of contractual negotiation is critical and may be lengthy. Additionally, several factors may require us to defer recognition of license revenue for a significant period of time after entering into a license agreement, including instances where we are required to deliver either unspecified additional products or specified upgrades for which we do not have vendor-specific objective evidence of fair value. While we have a standard software license agreement that provides for revenue recognition provided that delivery has taken place, collectibility from the customer is reasonably assured and assuming no significant future obligations or customer acceptance rights exist, customer negotiations and revisions to these terms could impact our ability to recognize revenues at the time of delivery.

Many enterprise customers negotiate software licenses near the end of each quarter. In part, this is because enterprise customers are able, or believe that they are able, to negotiate lower prices and more favorable terms at that time. Our reliance on a large portion of software revenue occurring at the end of the quarter and the increase in the dollar value of transactions that occur at the end of a quarter can result in increased uncertainty relating to quarterly revenues. Due to end-of-period variances, forecasts may not be achieved, either because expected sales do not occur or because they occur at lower prices or on terms that are less favorable to us. In addition, slowdowns in our quarterly license contracting activities may impact our service offerings and may result in lower revenues from our customer training, professional services and customer support organizations. Our ability to maintain or increase service revenues is highly dependent on our ability to increase the number of license agreements we enter into with customers.

                      Risks Related To Our Online Business
If our online business fails to continue to deliver original and compelling content and services, we will be unable to attract and retain users, which will adversely affect our financial results.

The successful development and production of content and services is subject to numerous uncertainties, including our ability to:

o anticipate and successfully respond to rapidly changing consumer tastes and preferences;

o fund new program development; and

o attract and retain qualified editors, writers and technical personnel.

We cannot assure you that our online content and services will be attractive to a sufficient number of users to generate revenues consistent with our estimates or sufficient to sustain operations. In addition, we cannot assure you that any new content or services will be developed in a timely or cost-effective manner. If we are unable to develop content and services that allow us to attract, retain and expand a loyal user base that is attractive to advertisers, we will be unable to generate sufficient revenue to grow our online business.

Decreases or delays in advertising spending due to general economic conditions could harm our ability to generate advertising revenue, which would adversely affect our financial results.

Expenditures by advertisers tend to be cyclical, reflecting overall economic conditions as well as budgeting and buying patterns. The overall market for advertising, including Internet advertising, has been generally characterized in recent quarters by minimal growth of marketing and advertising budgets and delays in spending of budgeted resources. Because we derive a large part of our revenues from advertising fees, the decrease in or delay of advertising spending could reduce our revenues or negatively impact our ability to grow our revenues. Even if economic conditions continue to improve, marketing budgets and advertising spending may not increase from current levels.

We cannot predict our e-commerce customers' preferences with certainty and such preferences may change rapidly. If we fail to accurately assess and predict our e-commerce customers' preferences, it will adversely impact our financial results.

Our e-commerce offerings on our ThinkGeek.com Web site are designed to appeal to IT professionals, software developers and others in technical fields. Misjudging either the market for our products or our customers' purchasing habits will cause our sales to decline, our inventories to increase and/or require us to sell our products at lower prices, all of which would have a negative effect on our business.

We are exposed to significant inventory risks as a result of seasonality, new product launches, rapid changes in product cycles and changes in consumer tastes with respect to our products offered at our ThinkGeek e-commerce Web site. Failure to properly assess our inventory needs will adversely affect our financial results.

In order to be successful, we must accurately predict our consumer tastes and avoid overstocking or under-stocking products. Demand for products can change significantly between the time inventory is ordered and the date of sale. In addition, when we begin selling a new product, it is particularly difficult to forecast product demand accurately. The acquisition of certain types of inventory, or inventory from certain sources, may require significant lead-time and prepayment, and such inventory may not be returnable. We carry a broad selection and significant inventory levels of certain products and we may be unable to sell products in sufficient quantities or during the relevant selling seasons.

If we do not maintain sufficient e-commerce inventory levels, or if we are unable to deliver our e-commerce products to our customers in sufficient quantities, our online business operating results will be adversely affected.

We must be able to deliver our merchandise in sufficient quantities to meet the demands of our customers and deliver this merchandise to customers in a timely manner. We must be able to maintain sufficient inventory levels, particularly during the peak holiday selling seasons. If we fail to achieve these goals, we may be unable to meet customer demand, and our financial results will be adversely affected.

Our ThinkGeek e-commerce Web site is dependent upon a single third party fulfillment and warehouse provider. The satisfaction of our e-commerce customers is highly dependent upon fulfillment of orders in a professional and timely manner, so any decrease in the quality of service offered by our fulfillment and warehouse provider will adversely affect our reputation and the growth of our e-commerce business.

Our ThinkGeek e-commerce Web site's ability to receive inbound inventory and ship completed orders efficiently to our customers is substantially dependent on efillit Inc., a third-party contract fulfillment and warehouse provider located in Baltimore, Maryland. efillit has generally kept pace with ThinkGeek's growth to date, however, we cannot be certain that efillit will be able to satisfactorily accommodate ThinkGeek's future growth. If efillit fails to meet our future distribution and fulfillment needs, our relationship with and reputation among our e-commerce customers will suffer and this will adversely effect our e-commerce growth. Additionally, if efillit cannot meet our distribution and fulfillment needs, or our contract with efillit terminates, we may fail to secure a suitable replacement or second-source distribution and fulfillment provider on comparable terms, which would adversely affect our e-commerce financial results.

                     Risks Related To Our Financial Results
If we fail to adequately monitor and minimize our use of existing cash, we may need additional capital to fund continued operations beyond fiscal year 2005.

Since becoming a public company, we have experienced negative cash flow from operations and expect to experience negative cash flow from operations for fiscal year 2004. Our average net monthly cash flow shortfall during the quarter ended January 31, 2004 was approximately $0.8 million. Although this average net monthly cash flow shortfall approximation should not be relied upon as an indicator of our average net monthly cash flow shortfall in the future, it further illustrates that unless we monitor and minimize the level of use of our existing cash, cash equivalents and marketable securities, we may require additional capital to fund continued operations beyond our fiscal year 2005. While we believe we will not require additional capital to fund continued operations through fiscal year 2005, we may require additional funding within this time frame, and this additional funding, if needed, may not be available on terms acceptable to us, or at all. A continued slowdown in technology or advertising spending as compared to the general economy, as well as other factors that may arise, could affect our future capital requirements and the adequacy of our available funds. As a result, we may be required to raise additional funds through private or public financing facilities, strategic relationships or other arrangements. Any additional equity financing would likely be dilutive to our stockholders. Debt financing, if available, may involve restrictive covenants on our operations and financial condition. Our inability to raise capital when needed could seriously harm our business.

Because we have a limited operating history selling SourceForge, we may not accurately forecast our sales and revenues, which will cause quarterly fluctuations in our total revenues and financial results.

We have a limited operating history as a provider of SourceForge, our proprietary software application. As a result, our historical financial information is of limited value in projecting future operating results. On June 27, 2001, we announced our plan to exit our hardware business. In the first quarter of our fiscal year 2002, we made the strategic decision to exit, and exited, the hardware-related software engineering and professional services fields to focus on SourceForge. These changes required us to adjust our business processes and make a number of significant personnel changes, including changes and additions to our engineering and management teams. Therefore, in evaluating our business you must consider the risks and difficulties frequently encountered by early stage companies in new and rapidly evolving markets. In addition, most of our operating costs are fixed and based on our revenue expectations. Therefore, if we have a shortfall in revenues, we may be unable to reduce our expenses quickly enough to avoid lower quarterly operating results.

Certain factors specific to our businesses over which we have limited or no control may nonetheless adversely impact our quarterly total revenues and financial results.

The primary factors over which we have limited or no control that may adversely impact our quarterly total revenues and financial results include the following:

o specific economic conditions relating to IT spending;

o the discretionary nature of our software customers' purchase and budget cycles;

o the size and timing of software customer orders;

o long software sales cycles;

o our ability to retain skilled software engineers and sales personnel;

o the timing of announcements and releases of new or enhanced versions of our products and product upgrades;

o the possibility that software development delays will result from our outsourcing of certain SourceForge research and development efforts to Cybernet Software Systems, Inc., an independent contractor located primarily in India;

o economic conditions relating to online advertising and sponsorship, and e-commerce;

o our ability to demonstrate and maintain attractive online user demographics;

o our ability to retain a skilled online advertising and sponsorship sales force;

o the addition or loss of specific online advertisers or sponsors, and the size and timing of advertising or sponsorship purchases by individual customers; and

o our ability to keep our Web sites operational at a reasonable cost.

If our revenues and operating results fall below our expectations, the expectations of securities analysts or the expectations of investors, the trading price of our common stock will likely be materially and adversely affected. You should not rely on the results of our business in any past periods as an indication of our future financial performance.

Future guidelines and interpretations regarding software revenue recognition could cause delays in our ability to recognize revenue, which will adversely impact our quarterly financial results.

From time to time, the American Institute of Certified Public Accountants (AICPA), the Public Company Accounting Oversight Board (PCAOB) and the SEC will issue guidelines and interpretations regarding the recognition of revenue from software and other activities. These new guidelines and interpretations could result in a delay in the company's ability to recognize revenue. If the company has to delay the recognition of a significant amount of revenue in the future, this will have a material impact on the company's reported financial results.

We have a history of losses and expect to continue to incur net losses for the foreseeable future. Failure to become and remain profitable may materially and adversely affect the market price of our common stock and our ability to raise capital and continue operations.

We incurred a loss of $1.4 million for our fiscal second quarter ended January 31, 2004, and we had an accumulated deficit of $742.4 million as of January 31, 2004. We expect to continue to incur net losses for at least the foreseeable future. If we do achieve profitability, we may not be able to sustain it. Failure to become and remain profitable may materially and adversely affect the market price of our common stock and our ability to raise capital and continue operations beyond our fiscal year 2005.

Despite reductions in the size of our workforce, our business may fail to grow rapidly enough to offset our ongoing operating expenses.

During fiscal years 2001, 2002 and 2003, we substantially reduced the size of our workforce. As of January 31, 2004, we had 121 employees. Despite these reductions in our workforce, our business may fail to grow rapidly enough to offset our ongoing operating expenses. As a result, our quarterly operating results could fluctuate, and such fluctuation could adversely affect the market price of our common stock.

The lack of inclusion of a consent of Arthur Andersen LLP to this Registration Statement limits your ability to assert a claim against Arthur Andersen LLP.

Our financial statements for the fiscal year ended July 28, 2001 are included in our Annual Report on Form 10-K. On April 17, 2002, we dismissed Arthur Andersen LLP ("Arthur Andersen") as our independent auditor. Given the changes at Arthur Andersen, we are unable to obtain Arthur Andersen's written consent to the incorporation of its audit report into the Registration Statement with respect to our financial statements as of July 28, 2001.

As a result, Arthur Andersen will not have any liability under Section 11(a) of the Securities Act for any untrue statements of a material fact contained in the financial statements audited by Arthur Andersen or any omissions of a material fact required to be stated therein. Accordingly, investors would be unable to assert a claim against Arthur Andersen under Section 11(a) of the Securities Act for any purchases of securities under Registration Statements made on or after the date of this Form S-3.

                          Risks Related To Competition
If we do not effectively compete with new and existing competitors, our revenues will not grow and may decline, which will adversely impact our financial results.

We believe that the newly emerging collaborative software development market is fragmented, subject to rapid change and highly sensitive to new product introductions and marketing efforts by industry participants. Competition in related markets is intense. If our products gain market acceptance, we expect the competition to rapidly intensify as new competitors enter the marketplace. Our potential competitors include companies entrenched in closely related markets who may choose to enter and focus on collaborative software development. Although we do not believe that we presently have an entrenched competitor, we expect competition to intensify in the future if the market for collaborative software development applications continues to expand. Our potential competitors include providers of software and related services as well as providers of hosted application services. Many of our potential competitors have significantly more resources, more experience, longer operating histories and greater financial, technical, sales and marketing resources than we do. We cannot guarantee that we will be able to compete successfully against current and future competitors or that competitive pressure will not result in price reductions, reduced operating margins and loss of market share, any one of which could seriously harm our business. Because individual product sales often lead to a broader customer relationship, our products must be able to successfully compete with and complement numerous competitors' current and potential offerings. Moreover, we may be forced to compete with our strategic partners, and potential strategic partners, and this may adversely impact our relationship with an individual partner or a number of partners. Consolidation is underway among companies in the software industry as firms seek to offer more extensive suites of software products and broader arrays of software solutions. Changes resulting from this consolidation may negatively impact our competitive position and operating results.

Online competition is intense. Our failure to compete successfully could adversely affect our revenue and financial results.

The market for Internet content and services is intensely competitive and rapidly evolving. It is not difficult to enter this market and current and new competitors can launch new Internet sites at relatively low cost. We derive revenue from online advertising and sponsorships, for which we compete with various media including newspapers, radio, magazines and various Internet sites. We also derive revenue from e-commerce, for which we compete with other e-commerce companies as well as traditional, "brick and mortar" retailers. We may fail to compete successfully with current or future competitors. Moreover, increased competition could result in price reductions, reduced margins or loss of market share, any of which could have a material adverse effect on our future revenue and financial results. If we do not compete successfully for new users and advertisers, our financial results may be materially and adversely affected.

                     Risks Related To Intellectual Property
We are vulnerable to claims that our products infringe third-party intellectual property rights. Any resulting claims against us could be costly to defend or subject us to significant damages.

We expect that our software products will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. In addition, we may receive patent infringement claims as companies increasingly seek to patent their software. Our developers may fail to perform patent searches and may therefore unwittingly infringe on third-party patent rights. We cannot prevent current or future patent holders or other owners of intellectual property from suing us and others seeking monetary damages or an injunction against shipment of our software offerings. A patent holder may deny us a license or force us to pay royalties. In either event, our operating results could be seriously harmed. In addition, employees hired from competitors might utilize proprietary and trade secret information from their former employers without our knowledge, even though our employment agreements and policies clearly prohibit such practices. Any litigation regarding our intellectual property, with or without merit, could be costly and time consuming to defend, divert the attention of our management and key personnel from our business operations and cause product shipment delays. Claims of intellectual property infringement may require us to enter into royalty and licensing agreements that may not be available on terms acceptable to us, or at all. In addition, parties making claims against us may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the United States and abroad and could result in an award of substantial damages against us. Defense of any lawsuit or failure to obtain any required license could delay shipment of our products and increase our costs. If a successful claim is made against us and we fail to develop or license a substitute technology, our business, results of operations, financial condition or cash flows could be immediately and materially adversely affected.

If we fail to adequately protect our intellectual property rights, competitors may use our technology and trademarks, which could weaken our competitive position, reduce our revenues, and increase our costs.

We rely on a combination of copyright, trademark and trade-secret laws, employee and third-party nondisclosure agreements, and other arrangements to protect our proprietary rights. Despite these precautions, it may be possible for unauthorized third parties to copy our products or obtain and use information that we regard as proprietary to create products that compete against ours. Some license provisions protecting against unauthorized use, copying, transfer, and disclosure of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries.

In addition, the laws of some countries do not protect proprietary rights to the same extent as do the laws of the United States. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase.

Our collection of trademarks is important to our business. The protective steps we take or have taken may be inadequate to deter misappropriation of our trademark rights. We have filed applications for registration of some of our trademarks in the United States and internationally. Effective trademark protection may not be available in every country in which we offer or intend to offer our products and services. Failure to protect our trademark rights adequately could damage our brand identity and impair our ability to compete effectively. Furthermore, defending or enforcing our trademark rights could result in the expenditure of significant financial and managerial resources.

The scope of United States patent protection in the software industry is not well defined and will evolve as the United States Patent and Trademark Office grants additional patents. Because patent applications in the United States are not publicly disclosed until the patent is issued, applications may have been filed that would relate to our products.

Our software business success depends significantly upon our proprietary technology. Despite our efforts to protect our proprietary technology, it may be possible for unauthorized third parties to copy certain portions of our products or to reverse engineer or otherwise obtain and use our proprietary information. We do not have any software patents, and existing copyright laws afford only limited protection. In addition, we cannot be certain that others will not develop substantially equivalent or superseding proprietary technology, or that equivalent products will not be marketed in competition with our products, thereby substantially reducing the value of our proprietary rights. We cannot assure you that we will develop proprietary products or technologies that are patentable, that any patent, if issued, would provide us with any competitive advantages or would not be challenged by third parties, or that the patents of others will not adversely affect our ability to do business. Litigation may be necessary to protect our proprietary technology. This litigation may be time-consuming and expensive.

                       Other Risks Related To Our Business
We may be subject to claims as a result of information published on, posted on or accessible from our Internet sites, which could be costly to defend and subject us to significant damage claims.

We may be subject to claims of defamation, negligence, copyright or trademark infringement (including contributory infringement) or other claims relating to the information contained on our Internet sites, whether written by third parties or us. These types of claims have been brought against online services in the past and can be costly to defend regardless of the merit of the lawsuit. Although federal legislation protects online services from some claims when third parties write the material, this protection is limited. Furthermore, the law in this area remains in flux and varies from state to state. We receive notification from time to time of potential claims, but have not been named as a party to litigation involving such claims. While no formal complaints have been filed against us to date, our business could be seriously harmed if one were asserted.

We may be subject to product liability claims if people or property are harmed by the products we sell on our e-commerce web sites, which could be costly to defend and subject us to significant damage claims.

Some of the products we offer for sale on our e-commerce Web sites, such as consumer electronics, toys, computers and peripherals, toiletries, beverages and clothing, may expose us to product liability claims relating to personal injury, death or property damage caused by such products, and may require us to take actions such as product recalls. Although we maintain liability insurance, we cannot be certain that our coverage will be adequate for liabilities actually incurred or that insurance will continue to be available to us on economically reasonable terms, or at all. In addition, some of our vendor agreements with our suppliers do not indemnify us from product liability.

If we are unable to implement appropriate systems, procedures and controls, we may not be able to successfully offer our services and grow our software business.

Our ability to successfully offer our services and grow our software business requires an effective planning and management process. We updated our operations and financial systems, procedures and controls following our strategic decision to focus on our application software and online businesses. Our systems will continue to require additional modifications and improvements to respond to current and future changes in our business. If we cannot grow our software and online businesses, and manage that growth effectively, or if we fail to timely implement appropriate internal systems, procedures, controls and necessary modifications and improvements to these systems, our businesses will suffer.

Our stock price has been volatile historically and may continue to be volatile.

The trading price of our common stock has been and may continue to be subject to wide fluctuations. During the second quarter of fiscal year 2004, the closing sale prices of our common stock on the Nasdaq ranged from $2.98 to $5.26 per share and the closing sale price on January 30, 2004 was $3.99 per share. Our stock price may fluctuate in response to a number of events and factors, such as quarterly variations in operating results, announcements of technological innovations or new products and media properties by us or our competitors, changes in financial estimates and recommendations by securities analysts, the operating and stock price performance of other companies that investors may deem comparable to us, and news reports relating to trends in our markets or general economic conditions.

In addition, the stock market in general, and the market prices for Internet-related companies in particular, have experienced volatility that often has been unrelated to the operating performance of such companies. These broad market and industry fluctuations may adversely affect the price of our stock, regardless of our operating performance. Additionally, volatility or a lack of positive performance in our stock price may adversely affect our ability to retain key employees, all of whom have been granted stock options.

Sales of our common stock by significant stockholders may cause the price of our common stock to decrease.

Several of our stockholders own significant portions of our common stock. If these stockholders were to sell significant amounts of their holdings of our common stock, then the market price of our common stock could be negatively impacted. The effect of such sales, or of significant portions of our stock being offered or made available for sale, could result in strong downward pressure on our stock. Investors should be aware that they could experience significant short-term volatility in our stock if such stockholders decide to sell a substantial amount of their holdings of our common stock at once or within a short period of time.

Our networks may be vulnerable to unauthorized persons accessing our systems, which could disrupt our operations and result in the theft of our proprietary information.

A party who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions or malfunctions in our Internet operations. We may be required to expend significant capital and resources to protect against the threat of security breaches or to alleviate problems caused by breaches in security.

Increasing regulation of the Internet or imposition of sales and other taxes on products sold or distributed over the internet could harm our business.

The electronic commerce market on the Internet is relatively new and rapidly evolving. While this is an evolving area of the law in the United States and overseas, currently there are relatively few laws or regulations that directly apply to commerce on the Internet. Changes in laws or regulations governing the Internet and electronic commerce, including, without limitation, those governing an individual's privacy rights, pricing, content, encryption, security, acceptable payment methods and quality of products or services could have a material adverse effect on our business, operating results and financial condition. Taxation of Internet commerce, or other charges imposed by government agencies or by private organizations, may also be imposed. Any of these regulations could have an adverse effect on our future sales and revenue growth.

Business disruptions could affect our future operating results.

Our operating results and financial condition could be materially and adversely affected in the event of a major earthquake, fire or other catastrophic event. Our corporate headquarters, the majority of our research and development activities and certain other critical business operations are located in California, near major earthquake faults. A catastrophic event that results in the destruction of any of our critical business or information technology systems could severely affect our ability to conduct normal business operations and as a result our future operating results could be adversely affected.

System disruptions could adversely affect our future operating results.

Our ability to attract and maintain relationships with users, advertisers, merchants and strategic partners will depend on the satisfactory performance, reliability and availability of our Internet channels and network infrastructure. Our Internet advertising revenues relate directly to the number of advertisements delivered to our users. System interruptions or delays that result in the unavailability of Internet channels or slower response times for users would reduce the number of advertisements and sales leads delivered to such users and reduce the attractiveness of our Internet channels to users, strategic partners and advertisers or reduce the number of impressions delivered and thereby reduce revenue. In the past twelve months, some of our sites have experienced a small number of brief service interruptions. We will continue to suffer future interruptions from time to time whether due to natural disasters, telecommunications failures, other system failures, rolling blackouts, viruses, hacking or other events. System interruptions or slower response times could have a material adverse effect on our revenues and financial condition.

Risks Related to the sale of shares of our common stock in the Private Placement

The common stock sold in the Private Placement will increase the supply of our common stock on the public market, which may cause our stock price to decline.

The sale into the public market of the common stock to be sold in the Private Placement could adversely affect the market price of our common stock. Most of our shares of common stock outstanding are eligible for immediate and unrestricted sale in the public market at any time. Once the registration statement in connection with the Private Placement is declared effective, the 5,107,354 shares of common stock covered by that prospectus will be eligible for immediate and unrestricted resale into the public market. The presence of these additional shares of common stock in the public market may depress our stock price.

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