Forward Looking Statements

The statements contained in the following discussion that are not purely historical are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including without limitation statements about the expectations, beliefs, intentions or strategies regarding the future of our business. Words such as "expects," "intends," "plans," "projects," "believes," "estimates," and similar expressions are used to identify these forward-looking statements. These include, among others, statements regarding our future expectations, performance, plans and prospects as well as assumptions about future events. All forward-looking statements included in this annual report are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. The forward-looking statements contained herein involve risks and uncertainties discussed in Item 1A. "Risk Factors" of this annual report. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of such factors, including those set forth in this annual report.

The following discussion should be read in conjunction with our Consolidated Financial Statements and the Notes to those statements included elsewhere in the Annual Report on Form 10-K.

We provide vertical search services to trade publishers. Our technology and services help publishers to build a loyal online community and increase their internet advertising revenues. With the use of our vertical search services, our customers can create search engines customized to meet the specialized information needs of their audience by combining publisher proprietary content with an authoritative subset of the Web. On March 31, 2007, we agreed to sell the assets of our Enterprise Search business for $23.0 million in cash to FAST. This transaction closed on August 9, 2007 with FAST assuming certain obligations of the business and retaining certain employees serving its Enterprise Search customers. Accordingly, revenues and expenses and cash flows related to the Enterprise Search business for the periods prior to this transaction closing have been reflected as discontinued operations in the accompanying Consolidated Statements of Operations and of Cash Flows. See further discussion in Note 2, "Discontinued Operations" in the Notes to Consolidated Financial Statements.

Our principal source of revenue is provided through sales of our vertical search services to the websites of publishers of trade business and specialist publications. Our vertical search technology is a hosted application sold as a service to the publishers. We generate our revenues from contracts based on search volume or by receiving a percentage of publishers' advertising revenues earned by the search sites. Many of our contracts with publishers contain monthly minimum fees that we are entitled to receive until website advertising revenue generated by the publishers' search sites exceeds these monthly minimum amounts. We can also generate revenues from hosting publisher web sites and from providing technical staff training. We offer professional services to customize publisher web sites and optimize search engines, as well as web site monetization consulting.

We use an AT&T facility to host our vertical search offering. This facility, located in Dallas, Texas, is operated under a master hosting arrangement that expires in July 2009. However, the master hosting arrangement contains an option for an extension of an additional 18 months at a moderate increase above the current contractual rate that is not reflected in the contractual obligations of this section or in Note 12 "Commitments and Contingencies." We also maintained a hosting facility in San Diego, CA, which was vacated on January 31, 2008 in an effort to appropriately scale our hosting infrastructure. We believe that our current hosting center environment has sufficient equipment capacity and redundancy to host vertical search websites for 200 trade publications each with an average community of 40,000 users at competitive search performance levels, which is enough capacity to meet our current needs.

Trends

As of January 31, 2009, Convera had 82 vertical search service websites with 28 separate publishers under contract. A total of 51 Convera supported websites were in production and a total of 31 vertical search websites were in development awaiting launch. As of January 31, 2008, Convera had 76 vertical search sites under contract, a total of 39 Convera supported websites were in production and a total of 37 vertical search sites were in development awaiting launch. At January 31, 2007, Convera had 3 vertical search sites under contract and in production; the first Convera vertical search service website was launched into production in November 2006.

Our strategy for fiscal 2010 continues to target the top 50 B2B publishers in the United States and United Kingdom, which have an estimated 2,000 plus relevant trade magazine titles that have the economic attributes necessary to support search-based websites. For both newly signed and current customers, our expectation is that the publishers will develop and launch vertical search-based websites in a much shorter period of time than was typical in fiscal 2009 due to the release of version 2 of our Publisher Control Panel. The tools included in this version of the Publisher Control Panel shortens the time required to launch a site from nine months to less than a month, which should translate into our receiving advertising based revenues sooner than in prior periods.

During fiscal 2009, we began offering a capacity-based pricing model for our search service to our customer base as an alternative to the advertising revenue share model we have offered since the inception of our vertical search service. The capacity-based pricing model allows the customer to pay a fixed monthly amount for search volume and/or websites indexed and stored and allows the publisher to retain revenue generated by their search site. The capacity-based pricing model has proven to be a popular alternative with our higher search volume customers and we expect the percentage of our customers on this model to grow during fiscal 2010. Under the advertising revenue share model, we earn a percentage of customer search-related advertising revenue (typically between 20% and 50% of net advertising revenues). Many of these advertising revenue share contracts also contain a monthly minimum fee to supplement the revenue share. We will receive the minimum fee for each vertical market served until our share of the website's advertising revenues surpasses the minimum fee.

The majority of the revenues earned for fiscal years 2009 and 2008 represented contract minimum amounts for hosted services. We expect continued growth in hosted service fee revenues, as our new and renewal contracts with publishers will typically contain a minimum service fee for our vertical search services.

In fiscal 2008, we launched the Convera Ad Service ("CAS") as an integral part of our vertical search services. CAS enables publishers to better manage the monetization of their professional communities' search experiences and increase the effectiveness of search-based revenues on their websites. CAS can also connect the publisher websites directly with the providers of advertising inventory, increasing the opportunities for the websites to grow their advertising revenues.

In September 2008, we signed a contract with Microsoft's advertising network which will provide us with a revenue share on all search sites that publishers deploy Microsoft Ads. This service was implemented in January 2009 and is fully integrated with CAS. We expect advertising to begin appearing on publisher sites in fiscal 2010. We are now working on other advertising partnerships to maximize the monetization potential of each and every page view on our search system.

While the addition of the new capacity-based revenue model coupled with the launch of CAS and the addition of the Microsoft Ad network to our service during fiscal 2009 offers new opportunities for our customers and Convera to increase revenue growth, the economic slowdown and recession that has been experienced over most sectors of the global economy will more than likely result in slower advertising share growth during fiscal 2010. The publishing industry overall is experiencing a downturn as a result of the recession and their investment in online technology has slowed considerably. Industry analysts and several of our customers are expecting lower ad revenues and slower online ad growth on a site by site basis. While we will attempt to counteract this trend with new publisher contracts and an overall increase in search site launches, we could experience lower revenues in the coming quarters from our revenue sharing contracts with publishers.

In the fourth quarter of fiscal 2009, in response to the slower contracting pace, lower ad revenues and slower online ad growth we took action to reduce our operating costs. In November 2008, we streamlined our sales process and took steps to reduce the cost structure of our sales, marketing and customer service functions. This action has resulted in reducing our sales, marketing and customer service headcount by nine and led to the shut down of our U.K. sales office in January 2009. As a result of this action, the Company recorded severance expense of approximately $403,000 in the fourth quarter of fiscal year 2009. We believe that this action will allow us to continue to serve our customers effectively while substantially reducing our operating costs.

In February 2009, we further reduced our operating costs by reorganizing our engineering and hosting operations group, reducing headcount in our Carlsbad, CA facility by 23 and reducing our expense base by approximately $2.8 million on an annual basis. We incurred approximately $259,000 in severance expense related to the reduction in our engineering and operations staff which will be recorded in our first quarter of fiscal 2010. Convera has 32 employees after the completion of this action.

The combined reduction in expenses and a potential increase in revenues could result in a significant decrease in the loss from continuing operations in fiscal 2010. We will continue to evaluate our revenue growth as well as the related operating expenses and endeavor to maintain these expenses in line with anticipated fiscal 2010 revenue attainment. We will continue to pursue opportunities to expand distribution and increase revenue opportunities for our service through resellers and Ad networks. We are also actively exploring merger and acquisition opportunities with companies whose customer base, products or services are similar to or compatible with ours to accelerate our pathway to profitability.

During the quarter ended January 31, 2009 we evaluated the carrying value of the long-lived assets related to our web hosting facility for impairment in accordance with SFAS No. 144. Current projections indicate that the future cash flows utilized for impairment analysis were insufficient to recover the carrying value of the long-lived assets related to web hosting, indicating that such assets were impaired. Consequently, we recorded a $3.1 million charge to reflect the impairment of the software licenses at January 31, 2009.

With the closing of the U.K. sales office in January 2009 as well as the impending wind up of the sublease of our Montreal office space in fiscal 2010, the Company will be evaluating various alternatives for formally closing down the foreign subsidiaries out of which these offices operate. Among our options are formal or informal liquidation or leaving these entities dormant until such time that they may be needed to operate again. The Company is in the process of examining the potential issues and tax implications of each scenario. If the Company makes the decision to liquidate these foreign subsidiaries the related accumulated other comprehensive loss would be included in determining net income in the period of liquidation. If only one of the subsidiaries is liquidated only the portion of accumulated other comprehensive loss attributable to the closed subsidiary would be included in the net income calculation in the period of liquidation.

Recently Issued Accounting Standards

In December 2007, the FASB issued a revision to SFAS No. 141, "Business Combinations" ("SFAS 141R"). The objective of this Statement is to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial reports about a business combination and its effects. This Statement will apply prospectively to any business combinations we may enter into for which the acquisition date is on or after the beginning of our first annual reporting period beginning after December 15, 2008.

Recently Adopted Accounting Standards

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157 ("SFAS 157"), Fair Value Measurements. SFAS 157 provides guidance for measuring the fair value of assets and liabilities. It requires additional disclosures related to the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. It does not require any new fair value measurements. SFAS 157 became effective for us beginning February 1, 2008 and did not have a material impact on our consolidated results of operations and financial condition.

In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - including an Amendment of SFAS No. 115" ("SFAS 159"), which permits an entity to measure many financial assets and financial liabilities at fair value that are not currently required to be measured at fair value. Entities that elect the fair value option will report unrealized gains and losses in earnings at each subsequent reporting date. The fair value option may be elected on an instrument-by-instrument basis, with few exceptions. SFAS 159 amends previous guidance to extend the use of the fair value option to available-for-sale and held-to-maturity securities. SFAS 159 also establishes presentation and disclosure requirements to help financial statement users understand the effect of the election. SFAS 159 became effective for us beginning February 1, 2008 and the adoption did not have a material impact on our consolidated results of operations and financial condition.

Critical Accounting Policies

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. For a comprehensive discussion of our significant accounting policies, see Note 1 in the accompanying consolidated financial statements included in this Form 10-K. We do not have any material ownership interest in any entities that are not wholly owned and consolidated subsidiaries. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base those estimates on historical experience and other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets, liabilities and equity that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following accounting policies reflect the more significant judgments and estimates used in the preparation of this discussion of our financial condition and results of operations.

Revenue Recognition

Revenue from our vertical search service offering can consist of hosted services, professional services and advertising revenue shares. Our vertical search services revenues are recognized in accordance with SEC Staff Accounting Bulletin No. 104 (SAB 104) "Revenue Recognition". We evaluate vertical search services arrangements that have multiple deliverables, in accordance with Emerging Issues Task Force ("EITF") Abstract Issue No. 00-21 "Revenue Arrangements with Multiple Deliverables." Judgment is required in interpreting a revenue contract to determine the appropriate accounting for the transaction. Multiple deliverable arrangements that contain elements that do not qualify as separate units of accounting are recognized ratably over the term of the hosting arrangement. Our vertical search service contracts typically include advertising share revenue agreements, and may include monthly contract minimum service fees. Monthly contract minimums and other hosting fees or set-up fees are recognized ratably over the term of the hosting agreement. Advertising share revenues are recognized when earned under the provisions of the hosting agreement. Revenue from training and professional services is recognized when the services are performed. In addition, in all cases, to recognize revenue we need to assess whether the price is fixed and determinable, whether persuasive evidence of an arrangement exists, whether the service has been delivered and whether collection of the receivable is reasonably assured.

Provision for Doubtful Accounts

A considerable amount of judgment is required in assessing the ultimate realization of individual accounts receivable balances and determining whether a provision for doubtful accounts is warranted. Our determination is based on an analysis of our historical collection experience and our portfolio of customers taking into consideration the general economic environment as well as the industry in which we operate. To the extent we do not recognize deterioration in our customers' financial condition in the period it occurs, or to the extent we do not accurately estimate our customers' ability to pay, the amount of bad debt expense recognized in a given reporting period will be impacted. At January 31, 2009, we determined that a provision for estimated losses resulting from the inability of our customers to make the required payments of $165,000 was required. No provision for doubtful accounts was required at January 31, 2008.

Impairment of Long-Lived Assets

We evaluate all of our long-lived assets for impairment in accordance with the provisions of SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 requires that we review our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. This review requires significant judgments both in assessing events and circumstances as well as estimating future cash flows. Should events indicate that any of our assets are impaired, the amount of such impairment will be measured as the difference between the carrying value and the fair value of the impaired asset and the impairment will be recorded in earnings during the period of such impairment. The determination of fair value is inherently an estimate and requires significant judgment. See Note 3, "Impairment of Long-Lived Assets" in the accompanying consolidated financial statements included in this Form 10-K for information about the impairment charges we have taken.

Software Development Costs

Our software development costs are accounted for in accordance with AICPA Statement of Position 98-1 (SOP98-1) "Accounting for the Cost of Computer Software Developed or Obtained for Internal Use". We expense costs incurred in the preliminary project stage and, thereafter, we capitalize permitted costs incurred in the development or acquisition of internal use software. Certain costs such as research and development, maintenance and training are expensed as incurred. Amortization of the capitalized costs is performed on a straight-line basis over the estimated use life of the asset. No software development costs have been capitalized in fiscal year 2009.

Accounting for Income Taxes

We follow Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). Under the asset and liability method of SFAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax laws and tax rates in each jurisdiction where we operate, and applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities due to a change in tax rates is recognized in income in the period that includes the enactment date. We calculate estimated income taxes in each of the jurisdictions in which we operate. This process involves estimating actual current tax expense along with assessing temporary differences resulting from differing treatment of items for both book and tax purposes.

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. Realization of the deferred tax assets is principally dependent upon the achievement of projected future taxable income. If the estimates and related assumptions change in the future we may be required to adjust our valuation allowance against our deferred tax assets, resulting in a benefit or a charge to income in the period such determination is made. As of January 31, 2009, we have recorded a full valuation allowance against the net deferred tax asset.

We adopted the provisions of the Financial Accounting Standards Board ("FASB") Interpretation No. 48, "Accounting for Uncertainty in Income Taxes" ("FIN 48"), on February 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS No. 109. FIN 48 also prescribes a recognition threshold and measurement standard for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. We previously recognized income tax positions based on management's estimate of whether it was reasonably possible that a liability had been incurred for unrecognized tax benefits by applying SFAS No. 5, Accounting for Contingencies. The provisions of FIN 48 became effective for the Company on February 1, 2007.

Significant judgment is required in evaluation our uncertain tax positions and determining the valuation allowance applied to deferred tax assets. We have concluded that there are no uncertain tax positions requiring recognition in our consolidated financial statements.

Stock-Based Compensation

On February 1, 2006, we adopted the provisions of and accounted for stock-based compensation in accordance with Statement of Financial Accounting Standards No.
123 (Revised 2004), Share-Based Payment ("SFAS 123(R)"), that addresses the accounting for stock-based compensation. SFAS 123(R) requires that stock based compensation be accounted for using a fair value based method. We use the Black-Scholes-Merton ("Black-Scholes") option pricing model to determine the fair value of stock-based awards under SFAS 123(R). We are required to make significant judgments and estimates in the application of SFAS 123(R), in particular with regards to forfeiture rates, volatility and expected life assumptions. If any of the assumptions used in the Black-Scholes model change, stock based compensation expense could differ materially in the future from that recorded in the current period.

For the fiscal year ended January 31, 2009, total revenues from continuing operations were $1.3 million, as compared to revenues of $1.1 million in fiscal year 2008. The loss from continuing operation for fiscal 2009 was $22.6 million or $ (0.42) per common share, compared to a loss from continuing operations of $27.0 million or $(0.51) per common share in fiscal year 2008. The net loss for fiscal 2009 was $22.6 million or $(0.42) as compared to a net loss of $9.1 million or $(0.17) per common share in fiscal year 2008. The net loss for fiscal 2008 includes a $17.9 million gain from the sale of discontinued operations or $0.34 per share.

For the fiscal year ended January 31, 2007, total revenues from continuing operations were $0.3 million. The loss from continuing operations for fiscal 2007 was $45.3 million, or $(0.87) per common share. Income from discontinued operations was $0.5 million, or $0.01 per common share in fiscal 2007. The net loss for fiscal 2007 was $44.8 million or $(0.86) per common share.

The following charts summarize the components of revenues and the categories of expenses, including the amounts expressed as a percentage of total revenues, for each of the three fiscal years in the period ended January 31, 2009 (dollars in thousands):

                                      Components of Revenue and Expenses                             Increase (Decrease)
                                        Fiscal years ended January 31,                           From 2009        From 2008
                           2009                      2008                      2007               to 2008          to 2007

                       $             %           $             %           $             %           %                %
Continuing
Operations:

Revenue            $   1,341         100 %   $   1,118         100 %   $     269         100 %           20 %            316 %

Expenses:
Cost of revenues       7,003         522 %       9,660         864 %       8,138        3025 %          -28 %             19 %
Sales and
marketing              3,340         249 %       3,880         347 %       4,386        1630 %          -14 %            -12 %
Research and
product
development            4,668         348 %       4,652         416 %      11,010        4093 %            0 %            -58 %
General and
administrative         7,040         525 %      11,179        1000 %      14,833        5514 %          -37 %            -25 %
Amortization of
capitalized
software
development
costs                      -           0 %           -           0 %       3,045        1132 %            0 %           -100 %
Impairment of
long-lived
assets                 3,133         234 %         603          54 %       6,407        2382 %          420 %            -91 %
Total operating
expenses              25,184        1878 %      29,974        2681 %      47,819       17776 %          -16 %            -37 %

Operating loss       (23,843 )                 (28,856 )                 (47,550 )

Other income,
net                    1,257                     1,815                     2,267                        -31 %            -20 %

. . .