UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED MARCH 31,JUNE 30, 2004

For The Transition Period From                    To                    

Commission file number 0-22292

Captiva Software Corporation

(Exact name of Registrant as specified in its charter)

10145 Pacific Heights Boulevard

San Diego, CA 92121

(858) 320-1000

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

Former name, former address and former fiscal year, if changed since last report:

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

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

As of April 30,July 31, 2004, there were 11,387,55411,918,362 shares of the registrant’s common stock, par value $0.01, outstanding.

CAPTIVA SOFTWARE CORPORATION

FORM 10-Q

FOR THE QUARTER ENDED MARCH 31,JUNE 30, 2004

INDEX

PART I—FINANCIAL INFORMATION

Item 1—Financial Statements

CAPTIVA SOFTWARE CORPORATION

Item 1—Financial Statements

CAPTIVA SOFTWARE CORPORATION

CONSOLIDATED CONDENSED BALANCE SHEETS*

(UNAUDITED)

(IN THOUSANDS)

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

CAPTIVA SOFTWARE CORPORATION

CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS*

(UNAUDITED)

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

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

CAPTIVA SOFTWARE CORPORATION

CONSOLIDATED CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY AND TOTAL COMPREHENSIVE INCOME*

(UNAUDITED)

(IN THOUSANDS)

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

CAPTIVA SOFTWARE CORPORATION

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS*

(UNAUDITED)

(IN THOUSANDS)

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

CAPTIVA SOFTWARE CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(UNAUDITED)

1.    Basis of Preparation and Accounting Policies

Unaudited Interim Financial Information

In this document, “we,” “our,” “us” and the “Company” refer to Captiva Software Corporation, formerly known as ActionPoint, Inc., and its subsidiaries, unless the context otherwise requires. The accompanying unaudited interim consolidated condensed financial statements of the Company have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission. The December 31, 2003 balance sheet data was derived from audited financial statements contained in the Company’s 2003 Annual Report on Form 10-K but does not include all disclosures required by accounting principles generally accepted in the United States of America.

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

In the opinion of management, the unaudited consolidated condensed financial statements for the three-monththree and six-month periods ended March 31,June 30, 2004 and 2003 include all adjustments, consisting only of normal recurring adjustments necessary to present fairly the financial information set forth herein.herein, consisting only of normal recurring adjustments except for the write-off of withdrawn stock offering costs as discussed below and the purchase accounting entries for the Company’s acquisition of ADP Context, Inc. as discussed in Note 2. These consolidated condensed financial statements and notes hereto should be read in conjunction with the audited financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003. The results of operations for the interim periods presented in this quarterly report on Form 10-Q are not necessarily indicative of the results to be expected for any other interim period or the entire fiscal year and should not be relied upon as such.

Revenue Recognition

Revenue is generated primarily from three sources: (i) software, which is primarily software license revenue, software subscription license revenue, which includes subscriptions to information databases, and royalty revenue, (ii) services, which includes software license maintenance fees, training and professional services revenue and (iii) hardware and other products, which were primarily sales of digital scanners in the three and six months ended March 31,June 30, 2004 and 2003. Software license revenue is recognized upon shipment provided that persuasive evidence of an arrangement exists, fees are fixed or determinable, collection is probable and no significant undelivered obligations remain. Software subscription license revenue is recognized over the term of the license, generally twelve months. Royalty revenue is recognized when partners ship or pre-purchase rights to ship products incorporating the Company’s software, provided collection of such revenue is determined to be probable and the Company has no further obligations. Services revenue is recognized ratably over the period of the maintenance contract or as the services are provided. Payments for maintenance fees are generally made in advance and are non-refundable. Revenue for hardware and other products is recognized when the following criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the selling price is fixed or determinable and (iv) collectibility is reasonably assured.

For arrangements with multiple elements (e.g., delivered and undelivered products, maintenance and other services), the Company allocates revenue to each element of the arrangement based on the fair value of the undelivered elements, which is specific to the Company, using the residual value method. The fair values for

CAPTIVA SOFTWARE CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

ongoing maintenance and support obligations are based upon separate sales of renewals to customers or upon substantive renewal rates quoted in the agreements. The fair values for services, such as training or consulting, are based upon prices of these services when sold separately to other customers. Deferred revenue is primarily comprised of undelivered maintenance services and in some cases hardware and other products delivered but not yet accepted. When software licenses are sold with professional services and such services are deemed essential to the functionality of the software, combined software and service revenue is recognized as the services are performed. When software licenses are sold with professional services and such services are not considered essential to the functionality of the software, software revenue is recognized when the above criteria are met and service revenue is recognized as the services are performed.

Intangible Assets

Goodwill represents the excess of purchase price and related costs over the value assigned to the net tangible and identifiable intangible assets of businesses acquired. Goodwill is not amortized but is tested at least annually for impairment. Other intangible assets are amortized on a straight-line basis over their estimated useful lives, ranging from less than one year to five years.

The determination of the fair value of certain acquired assets and liabilities is subjective in nature and often involves the use of significant estimates and assumptions. Determining the fair values and useful lives of intangible assets especially requires the exercise of judgment. While there are a number of different generally accepted valuation methods to estimate the value of intangible assets acquired, the Company primarily used the discounted cash flow method. This method requires significant management judgment to forecast the future operating results used in the analysis. In addition, other significant estimates are required, such as residual growth rates and discount factors. The estimates that the Company has used are consistent with the plans and estimates that the Company uses to manage its business, based on available historical information and industry averages. The judgments made in determining the estimated useful lives assigned to each class of assets acquired can also significantly affect the Company’s net operating results. Amortization of purchased intangibles is expected to be $2.6 million, $1.9 million, $0.7 million, $0.3 million and $0.2 million for the years ending December 31, 2004, 2005, 2006, 2007 and 2008 and thereafter, respectively.

In addition, the value of the Company’s intangible assets, including goodwill, is subject to future impairments if the Company experiences declines in operating results or negative industry or economic trends or if the Company’s future performance is below the Company’s projections and estimates.

Valuation of Goodwill

The Company assesses the impairment of goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Impairment is reviewed at least annually.

Important factors that could trigger an impairment, include the following:

CAPTIVA SOFTWARE CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

When there is an indication that the carrying value of goodwill may not be recoverable based upon the existence of one or more of the above indicators, an impairment loss would be recognized if the carrying amount exceeds its fair value. The Company performed its annual impairment review induring the quarter ended June 30, 20032004 and determined there was no impairment.

Offering Costs

On April 12, 2004, the Company filed a registration statement (the Registration Statement) with the Securities and Exchange Commission (SEC) to register shares of the Company’s common stock in preparation for an underwritten public offering. In May 2004, the Company decided not to proceed with the underwritten public offering, withdrew this Registration Statement and wrote off $0.2 million of costs incurred in the registration process and initially deferred in connection with the anticipated offering.

Stock-Based Compensation

The Company has elected to utilize the intrinsic value method to account for its employee stock option plans. When the exercise price of the Company’s employee stock options equals the fair value price of the underlying stock on the date of grant, no compensation expense is recognized in the Company’s financial statements. Compensation expense for options granted to non-employees is determined in accordance with Statement of Financial Accounting Standards (SFAS) No. 123 and Emerging Issues Task Force (EITF) No. 96-18 as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured. Deferred charges for options granted to non-employees are periodically remeasured as the underlying options vest.

Had compensation cost for the Company’s stock-based compensation to employees been determined based on the fair value method, the amount of stock-based employee compensation cost and the Company’s pro forma results would have been as indicated below (in thousands, except per share data):

CAPTIVA SOFTWARE CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

Reclassifications

Certain prior period items have been reclassified to conform with the current period’s presentation. These reclassifications had no impact on total assets, net revenues, operating income or net income as previously reported.

2.    Acquisition of ADP Context, Inc.

On February 1, 2004, the Company completed the acquisition of ADP Context, Inc., an Illinois corporation (Context). The Company acquired Context to expand the Company’s product offerings and application expertise

CAPTIVA SOFTWARE CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

to the provider side of the healthcare market. The Context products complement the Company’s existing ClaimPack product line and enhance the Company’s product offerings to its claim processing customers. The Context product line also allows the Company to extend its reach into the provider side of the healthcare market. The acquisition was effected in accordance with a stock purchase agreement dated as of February 1, 2004 by and among the Company, ADP Integrated Medical Solutions, a Delaware corporation (ADP), and ADP Claims Solutions Group, Inc. (CSG), pursuant to which the Company purchased all of the issued and outstanding capital stock of Context from ADP and paid to ADP approximately $5.2$5.3 million in immediately available cash.cash (including a final cash payment of approximately $0.2 million which was paid to ADP in the second quarter of 2004). The sole source of the cash consideration the Company paid in the acquisition was the Company’s cash and cash equivalents. There were no material relationships between the Company or any of the Company’s affiliates, directors or officers, on the one hand, and ADP or CSG, on the other hand, at the time of the acquisition.

On the date of the acquisition, theThe purchase price was allocated as follows (in thousands):

In connection with the acquisition, the Company wrote off the purchased in-process research and development of $0.1 million, which was charged to operations in the three months ended March 31, 2004. A final purchase price adjustment of approximately $0.2 million, which was recorded as goodwill, will be paid to ADP in the second quarter of 2004. The results of operations of Context are included in the threesix months ended March 31,June 30, 2004 starting from February 1, 2004, the date of acquisition. The following table summarizes unaudited pro forma financial information assumingIf the acquisition had occurred on January 1, 2003, and includes the amortization of purchased intangible assets from the beginning of each of the periods presented and excludes a write-off of in-process research and development of $0.1 million in the three months ended March 31, 2004pro forma financial information would have been as follows (in thousands, except per share information):

This pro forma financial information is for informational purposes only and does not reflect any operating efficiencies or inefficiencies which may result from the acquisition and, therefore, is not necessarily indicative of results that would have been achieved had the businesses been combined during the periods presented.

CAPTIVA SOFTWARE CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

3.    MergerComposition of ActionPoint and Captiva SoftwareCertain Balance Sheet Captions (in thousands)

On July 31, 2002, the Company completed the merger with privately-held Captiva Software Corporation, a California corporation (Old Captiva), of San Diego, California. Old Captiva was a provider of forms input management software and related services. Under the terms of the merger agreement, the Company exchanged all of Old Captiva’s outstanding common stock for 4.4 million shares of the Company’s common stock and replacement options to purchase 2.2 million shares of common stock, of which options to purchase 772,000 shares of common stock were vested, and issued warrants to purchase approximately 8,000 shares of common stock. The options to purchase 2.2 million shares of common stock have exercise prices ranging from $0.52 to $2.43 per share and a weighted-average exercise price of $1.94 per share. The warrants to purchase common stock had an exercise price of $2.43 per share. In November 2003, these warrants were converted in a net exercise, in accordance with the warrant agreements, into approximately 6,000 shares of the Company’s common stock.

The merger was accounted for as a purchase. The fair value of the Company’s common stock issued in the merger of $1.11 per share was determined based on the average closing price three days prior to the completion date of the merger. The fair value of the vested replacement options was estimated based on a Black-Scholes model utilizing the following assumptions: fair value of common stock of $1.11 per share, expected term of two years, expected volatility of 90%, expected dividend yield of 0%, and a risk-free interest rate of 2.3%.

On the date of the Merger the purchase price was allocated as follows (in thousands):

During the year ended December 31, 2002, as the result of a review of the combined operations, the Company adopted a plan which included a reduction of its workforce and office space made redundant by the merger. This plan was largely completed during 2003. As a result of the adoption of this plan, the Company recorded charges of $2.1 million during the year ended December 31, 2002. These charges primarily related to the consolidation of the Company’s continuing operations resulting in the impairment of an asset, excess lease costs and employee severance costs related to a reduction in workforce.In the three months ended March 31, 2004, the Company paid $0.1 million in satisfaction of its remaining excess lease obligation resulting from the merger.

CAPTIVA SOFTWARE CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

4.    Composition of Certain Balance Sheet Captions (in thousands)

CAPTIVA SOFTWARE CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

5.4.    Computation of Net Income Per Share

Basic net income per share is computed by dividing the net income available to common stockholders by the weighted average number of common shares outstanding for that period. Diluted net income per share is computed giving effect to all dilutive potential common shares that were outstanding during the period. Dilutive potential common shares consist of incremental common shares issuable upon exercise of stock options and warrants.

Dilutive securities include options subject to vesting and warrants on an as-if-converted-to-common stock basis. Dilutive securities of 2.01.6 million shares and 0.51.8 million shares are included in the diluted earnings per share calculation for the three and six months ended March 31,June 30, 2004, respectively. Dilutive securities of 1.3 million shares and 0.9 million shares are included in the diluted earnings per share calculation for the three and six months ended June 30, 2003, respectively. Potentially dilutive securities totaling 0.20.7 million shares and 3.90.5 million shares for the three and six months ended March 31,June 30, 2004, respectively, and 1.0 million shares and 2.0 million shares for the three and six months ended June 30, 2003, respectively, were excluded from basic and diluted earnings per share because of their anti-dilutive effect.

6.5.    Comprehensive Income

Comprehensive income consists of the following components (in thousands):

CAPTIVA SOFTWARE CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS—(Continued)

(UNAUDITED)

7.6.    Line of Credit

The Company has a bank line of credit that will expire in August 2004. On March 31,June 30, 2004, there was no outstanding principal balance under the line of credit. Borrowings under the line of credit are limited to the lesser of $3.0 million or 80% of eligible accounts receivable. Any outstanding balances under the line of credit would bear interest at the bank’s prime rate plus 0.5%. The line of credit is securedcollateralized by all assets of the Company. The Company is restricted from paying dividends under the terms of the line of credit. The line of credit includes various financial covenants related to the Company’s operating results. As of March 31,June 30, 2004 the Company was in compliance with all loan covenants.

8.7.    Income Taxes

The provision for income taxes for interim periods is based on estimated effective income tax rates for the year. The Company’s estimated effective tax rate for 2004 is 39%, which was applied to the results for the three and six months ended March 31,June 30, 2004. The Company’s estimated effective income tax rate for 2004 differs from the U.S. federal statutory rate of 34% primarily due to state income taxes. The Company’s estimated effective tax rate for the three and six months ended March 31,June 30, 2003 was 40%.

9.8.    Business Segments and Geographic Reporting

The Company has a single reportable segment consisting of the development, marketing and servicing of input management software. Management uses one measurement of profitability and does not disaggregate its business for internal reporting. Operations outside the United States primarily consist of sales offices of the Company’s subsidiaries in the United Kingdom, Germany and Australia, which are responsible for sales to international customers. The international subsidiaries do not carry any significant tangible long-lived assets, and the total assets of the Company’s international subsidiaries were not significant for any period presented.

The following table presents revenue derived from domestic and international sales, based on location of customer for the three and six months ended March 31,June 30, 2004 and 2003, respectively (in thousands, except percentage data):

10.9.    Guarantees

From time to time, theThe Company provides indemnifications of varying scope to customers against claims of intellectual property infringement made by third parties arising from the use of the Company’s products. To date, the Company has not encountered material costs as a result of such obligations and has not accrued any liabilities related to such indemnifications in its financial statements.

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

Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms, or other words of similar meaning. These statements are only predictions based on information currently available to us. Actual events or results may differ materially. Risks that may cause actual results to differ materially from the forward-looking statements are described in the section entitled “Risk Factors” in this Quarterly Report on Form 10-Q and identified from time to time in our filings with the Securities and Exchange Commission, press releases and other communications.

Although we believe that the estimates and expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We assume no obligation to update any of the forward-looking statements contained in this Quarterly Report on Form 10-Q.

Overview

We are a leading provider of input management solutions designed to manage business-critical information from paper, faxed and electronic forms, documents and transactions into the enterprise. Our solutions automate the processing of billions of forms, documents and transactions annually, converting their content into information that is usable in database, document, content and other information management systems. We believe that our products and services enable organizations to reduce operating costs, obtain higher information accuracy rates and speed processing times. Our objective is to extend our position as a leading provider of input management solutions. Key elements of our growth strategy include leveraging our existing customer base, broadening our sales channels and expanding our markets, expanding our international presence, broadening our product offerings and pursuing strategic acquisitions.

Our products offer organizations a cost-effective, accurate and automated alternative to both manual data entry and electronic data interchange (EDI). These traditional approaches are typically labor intensive, time consuming and costly methods of managing the input of information into the enterprise. Organizations can utilize our products to capture information digitally, extract the meaningful content or data, and apply business rules that ensure the data’s accuracy.

In the three and six months ended March 31,June 30, 2004, our revenues increased to $15.9$16.8 million and $32.7 million, respectively, from $12.6$13.9 million and $26.5 million in the three and six months ended March 31, 2003.June 30, 2003, respectively. In addition, in the three and six months ended March 31,June 30, 2004, our net income increased to $0.5$0.9 million and $1.3 million, respectively, from $0.1$0.3 million and $0.4 million in the three and six months ended March 31, 2003.June 30, 2003, respectively.

On July 31, 2002, ActionPoint, Inc. merged with Captiva Software Corporation, a California corporation. As a result of this transaction, (the Merger), Old Captiva became a wholly-owned subsidiary of ActionPoint, and ActionPoint changed its name to Captiva Software Corporation and remained a Delaware corporation.

On February 1, 2004, we completed the acquisition of all of the issued and outstanding capital stock of Context for approximately $5.2 million of cash derived from our existing cash and cash equivalents. We will paymade a final purchase price adjustmentcash payment of approximately $0.2 million in the second quarter of 2004. Under generally accepted accounting principles, the results of operations of Context are included in our results of operations for the threesix months ended March 31,June 30, 2004 starting from February 1, 2004. We acquired Context to expand our product offerings and application expertise to the provider side of the healthcare market. The Context products complement our existing ClaimPack product line and enhance our product offerings to our claim processing customers. The Context product line also allows us to extend our reach into the provider side of the healthcare market. We are not planning to make significant changes to Context’s cost structure, and we expect both our consolidated revenues and expenses to increase in the future as a result of this acquisition.

Critical Accounting Policies and Estimates

A critical accounting policy is one that is both important to the portrayal of a company’s financial condition or results of operations and requires significant judgment or complex estimation processes. We believe that the following accounting policies fit this definition:

Revenue Recognition

Our revenue is generated primarily from three sources: (i) software, primarily software license revenue, software subscription license revenue, which includes subscriptions to information databases, and royalty revenue, (ii) services, including software license maintenance fees, training fees and professional services revenue and (iii) hardware and other products, primarily sales of digital scanners in the three and six months ended March 31,June 30, 2004 and 2003. Software license revenue is recognized upon shipment provided that persuasive evidence of an arrangement exists, fees are fixed or determinable, collection is probable and no significant undelivered obligations remain. Software subscription license revenue is recognized over the term of the license, generally twelve months. Royalty revenue is recognized when our resellers ship or pre-purchase rights to ship products incorporating our software, provided collection of the revenue is determined to be probable and we have no further obligations. Services revenue is recognized ratably over the period of the maintenance contract or as the services are provided. Payments for maintenance fees are generally made in advance and are non-refundable. Revenue for hardware and other products is recognized when the following criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the selling price is fixed or determinable and (iv) collectibility is reasonably assured.

For arrangements with multiple elements (e.g., delivered and undelivered products, maintenance and other services), we allocate revenue to each element of the arrangement based on the fair value of the undelivered elements, which is specific to us, using the residual value method. The fair values for ongoing maintenance and support obligations are based upon separate sales of renewals to customers or upon substantive renewal rates quoted in the agreements. The fair values for services, such as training or consulting, are based upon prices of these services when sold separately to other customers. Deferred revenue is primarily comprised of undelivered maintenance services and in some cases hardware and other products delivered but not yet accepted. When software licenses are sold with professional services and those services are deemed essential to the functionality of the software, combined software and service revenue is recognized as the services are performed. When software licenses are sold with professional services and those services are not considered essential to the functionality of the software, software revenue is recognized when the above criteria are met and service revenue is recognized as the services are performed.

Intangible Assets

Goodwill represents the excess of purchase price and related costs over the value assigned to the net tangible and identifiable intangible assets of businesses acquired. Goodwill is not amortized, but is tested at least annually for impairment. Other intangible assets are amortized on a straight-line basis over their estimated useful lives, ranging from less than one year to five years.

The determination of the fair value of certain acquired assets and liabilities is subjective in nature and often involves the use of significant estimates and assumptions. Determining the fair values and useful lives of intangible assets especially requires the exercise of judgment. While there are a number of different generally accepted valuation methods to estimate the value of intangible assets acquired, we primarily used the discounted cash flow method. This method requires significant management judgment in forecasting the future operating results used in the analysis. This method also requires other significant estimates, such as residual growth rates and discount factors. The estimates we have used are consistent with the plans and estimates that we use to manage our business, based on available historical information and industry averages. The judgments made in determining the estimated useful lives assigned to each class of assets acquired can significantly affect our net

operating results. Amortization of purchased intangibles is expected to be $2.6 million, $1.9 million, $0.7 million, $0.3 million and $0.2 million for the years ending December 31, 2004, 2005, 2006, 2007 and 2008 and thereafter, respectively.

In addition, the value of our intangible assets, including goodwill, is subject to future impairment if we experience declines in operating results or negative industry or economic trends or if our future performance is below our projections and estimates.

Valuation of Goodwill

We assess the impairment of goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Impairment is reviewed at least annually.

Factors we consider important that could trigger an impairment include the following:

If there were an indication that the carrying value of goodwill might not be recoverable based upon the existence of one or more of the above indicators, we would recognize an impairment loss if the carrying value exceeds its fair value. We performed our annual impairment review induring the quarter ended June 30, 20032004 and determined there was no impairment.

Income Tax Valuation Allowance

On a quarterly basis, management evaluates the realizability of our net deferred tax assets and assesses the need for a valuation allowance. Realization of our net deferred tax assets is dependent on our ability to generate sufficient future taxable income. The amount of the net deferred tax assets actually realized could vary if there are differences in the timing or amount of future reversals of existing deferred tax liabilities or changes in the actual amounts of future taxable income. If we do not generate our forecasted taxable income, we may be required to establish a valuation allowance against all or part of our net deferred tax assets based upon applicable accounting criteria. To the extent we establish a valuation allowance, an expense will be recorded within the provision for income taxes line in our Statement of Operations. As of March 31,June 30, 2004, management has determined that it is more likely than not that our net deferred tax assets will be realized based on forecasted taxable income.

Results of Operations

Three Months Ended March 31,June 30, 2004 and 2003

Revenues

Total revenues increased 26%21% in the three months ended March 31,June 30, 2004 to $15.9$16.8 million from $12.6$13.9 million in the three months ended March 31,June 30, 2003.

Our software revenues increased 20%24% in the three months ended March 31,June 30, 2004 to $6.7$8.4 million from $5.6$6.8 million in the three months ended March 31,June 30, 2003. As a percentage of total revenues, software revenues

accounted for 42%50% in the three months ended March 31,June 30, 2004 and 44%49% in the three months ended March 31,June 30, 2003. The increase in software revenues in absolute terms was primarily attributable to both the acquisition of Context.Context and an increase in sales

of non-Context products. The decreaseincrease in software revenues as a percentage of total revenues was primarily attributable to the increase in software revenues in absolute terms and the decrease in hardware and other revenues in absolute terms and as a percentage of total revenues in the three months ended March 31,June 30, 2004 as a result of an increase in sales of digital scanners.compared to the three months ended June 30, 2003.

Our service revenues increased 21%33% in the three months ended March 31,June 30, 2004 to $6.9 million from $5.7$5.2 million in the three months ended March 31,June 30, 2003. As a percentage of total revenues, services accounted for 44%41% in the three months ended March 31,June 30, 2004 and 45%37% in the three months ended March 31,June 30, 2003. The increase in service revenues in absolute terms reflects both a growing installed base of customers, most of which purchase ongoing software maintenance support, and approximately $0.2 milliona growth in maintenance reinstatement fees revenueprofessional services revenues in the first quarter of 2004.three months ended June 30, 2004 compared to the three months ended June 30, 2003. The decreaseincrease in service revenues as a percentage of total revenues was primarily attributable to the increase in hardware and other revenues as a percentage of totalservice revenues in absolute terms and the three months ended March 31, 2004 as a result of an increase in sales of digital scanners.

Our hardware and other revenues increased 71% in the three months ended March 31, 2004 to $2.3 million from $1.3 million in the three months ended March 31, 2003. As a percentage of total revenues, hardware and other revenues accounted for 14% in the three months ended March 31, 2004 and 11% in the three months ended March 31, 2003. The increasesdecrease in hardware and other revenues in absolute terms and as a percentage of total revenues reflect an increasein the three months ended June 30, 2004.

Our hardware and other revenues decreased 22% in the three months ended June 30, 2004 to $1.5 million from $1.9 million in the three months ended June 30, 2003. As a percentage of total revenues, hardware and other revenues accounted for 9% in the three months ended June 30, 2004 and 14% in the three months ended June 30, 2003. The decrease in hardware and other revenues in absolute terms and as a percentage of total revenues reflects a decrease in sales of digital scanners.

Gross Profit

Gross profit increased 23%31% in the three months ended March 31,June 30, 2004 to $9.9$11.2 million from $8.0$8.6 million in the three months ended March 31,June 30, 2003. Gross profit as a percentage of total revenues decreasedincreased to 63%67% in the three months ended March 31,June 30, 2004 from 64%62% in the three months ended March 31,June 30, 2003. The decreaseincrease in gross profit as a percentage of total revenues was due to a combination of the decrease in hardware and other revenues, which have lower gross margins than software and service revenues, and a shiftleveraging of our existing professional services and maintenance support services infrastructure which kept services cost of revenues for the three months ended June 30, 2004 consistent with the three months ended June 30, 2003, while services revenues increased 33% in revenue mixthe three months ended June 30, 2004 compared to the three months ended June 30, 2003.

Research and Development

Research and development expenses increased 19% in the three months ended June 30, 2004 to $2.5 million from $2.1 million in the three months ended June 30, 2003. As a percentage of total revenues, research and development expenses were 15% in both the three months ended June 30, 2004 and 2003. The increase in research and development expenses in absolute terms was primarily attributable to the acquisition of Context which resulted in increases in headcount and related labor costs. The consistency in research and development expenses as a percentage of total revenues was due to the increase in absolute terms being offset by the increase in total revenues in the three months ended June 30, 2004 compared to the three months ended June 30, 2003. We expect research and development expenses to continue to increase in absolute terms in 2004 as we continue to expand our research and development staff to support the development of new products and enhancements to current products.

Sales and Marketing

Sales and marketing expenses increased 20% in the three months ended June 30, 2004 to $5.4 million from $4.5 million in the three months ended June 30, 2003. As a percentage of total revenues, sales and marketing expenses were 32% in the three months ended June 30, 2004 and 33% in the three months ended June 30, 2003. The increase in sales and marketing expenses in absolute terms was due to an expansion of our sales force and higher commissions and related sales costs resulting from the growth in revenues, partially offset by $0.2 million

of expenses incurred in the second quarter of 2003 related to a large trade show that took place in the first quarter of 2004 instead of in the second quarter of 2004. The expansion of our sales force includes the Context sales force acquired in the first quarter of 2004. The decrease in sales and marketing expenses as a percentage of total revenues was due to the increase in absolute terms being more than offset by the increase in total revenues in the three months ended June 30, 2004 compared to the three months ended June 30, 2003. We expect sales expenses to continue to increase in absolute terms in 2004 as we continue to add to our sales force and experience continued revenue growth.

General and Administrative

General and administrative expenses increased 19% in the three months ended June 30, 2004 to $1.7 million from $1.4 million in June 30, 2003. As a percentage of total revenues, general and administrative expenses were 10% in both the three months ended June 30, 2004 and 2003. The increase in general and administrative expenses in absolute terms was primarily due to the acquisition of Context which resulted in increases in headcount and related labor costs in the three months ended June 30, 2004 compared to the three months ended June 30, 2003. The consistency in general and administrative expenses as a percentage of total revenues was due to the increase in absolute terms being offset by the increase in total revenues in the three months ended June 30, 2004 compared to the three months ended June 30, 2003.

Write-off of Withdrawn Stock Offering Costs

On April 12, 2004, we filed a Registration Statement with the Securities and Exchange Commission (SEC) to register shares of our common stock in preparation for an underwritten public offering. In May 2004, the Company decided not to proceed with the underwritten public offering, withdrew this Registration Statement and wrote off $0.2 million of costs incurred in the registration process and initially deferred in connection with the anticipated offering.

Provision for Income Taxes

In the three months ended June 30, 2004, we recorded a tax provision of $0.6 million, which represented an effective tax rate of 39%. In the three months ended June 30, 2003, we recorded a tax provision of $0.2 million, which represented an effective tax rate of 40%.

Six Months Ended June 30, 2004 and 2003

Revenues

Total revenues increased 23% in the six months ended June 30, 2004 to $32.7 million from $26.5 million in the six months ended June 30, 2003.

Our software revenues increased 22% in the six months ended June 30, 2004 to $15.1 million from $12.4 million in the six months ended June 30, 2003. As a percentage of total revenues, software revenues accounted for 46% in the six months ended June 30, 2004 and 47% in the six months ended June 30, 2003. The increase in software revenues in absolute terms was attributable to the acquisition of Context and an increase in sales of non-Context products. The decrease in software revenues as a percentage of total revenues was primarily attributable to the increase in service revenues as a percentage of total revenues in the six months ended June 30, 2004.

Our service revenues increased 27% in the six months ended June 30, 2004 to $13.8 million from $10.9 million in the six months ended June 30, 2003. As a percentage of total revenues, services accounted for 42% in the six months ended June 30, 2004 and 41% in the six months ended June 30, 2003. The increase in service revenues in absolute terms and as a percentage of total revenues reflects both a growing installed base of customers, most of which purchase ongoing software maintenance support, and a growth in professional services revenues in the six months ended June 30, 2004 compared to the six months ended June 30, 2003.

Our hardware and other revenues increased 16% in the six months ended June 30, 2004 to $3.8 million from $3.2 million in the six months ended June 30, 2003. As a percentage of total revenues, hardware and other revenues accounted for 11% in the six months ended June 30, 2004 and 12% in the six months ended June 30, 2003. The increase in hardware and other revenues in absolute terms reflects an increase in sales of digital scanners. The decrease in hardware and other revenues as a percentage of total revenues is due to the higher software and services revenues in the six months ended June 30, 2004 compared to the six months ended June 30, 2003.

Gross Profit

Gross profit increased 27% in the six months ended June 30, 2004 to $21.2 million from $16.6 million in the six months ended June 30, 2003. Gross profit as a percentage of total revenues increased to 65% in the six months ended June 30, 2004 from 63% in the three months ended June 30, 2003. The increase in gross profit as a percentage of total revenues was due to a leveraging of our existing professional services and maintenance support services infrastructure which kept services cost of revenues for the six months ended June 30, 2004 consistent with the six months ended June 30, 2003, while services revenues increased 27% in the six months ended June 30, 2004 compared to the six months ended June 30, 2003. This increase was partially offset by both an increase in hardware and other revenues, which have lower gross margins than software and service revenues, and an increase in intangibles amortization of approximately $0.1$0.2 million in the threesix months ended March 31,June 30, 2004 compared to the threesix months ended March 31,June 30, 2003 related to the Context acquisition.acquisition

Research and Development

Research and development expenses increased 27%23% in the threesix months ended March 31,June 30, 2004 to $2.7$5.2 million from $2.1$4.2 million in the threesix months ended March 31,June 30, 2003. As a percentage of total revenues, research and development expenses were 17%16% in both the threesix months ended March 31,June 30, 2004 and 2003. The increase in research and development expenses in absolute terms was primarily attributable to the acquisition of Context which resulted in increases in headcount and related labor costs needed to meet product development requirements and was also attributable to an increase of approximately $0.2 million related to localizing products for international markets. The consistency in research and development expenses as a percentage of total revenues was due to the increase in absolute terms being offset by the increase in total revenues in the threesix months ended March 31,June 30, 2004 compared to the threesix months ended March 31,June 30, 2003. We expect research and development expenses to continue to increase in absolute terms in 2004 dueas we continue to an expansion ofexpand our research and development staff.staff to support the development of new products and enhancements to current products.

Sales and Marketing

Sales and marketing expenses increased 19%20% in the threesix months ended March 31,June 30, 2004 to $5.2$10.6 million from $4.4$8.9 million in March 31,the six months ended June 30, 2003. As a percentage of total revenues, sales and marketing expenses were 33% in the threesix months ended March 31,June 30, 2004 and 35%34% in the threesix months ended March 31,June 30, 2003. The increase in sales and marketing expenses in absolute terms was due to an expansion of our sales force and revenue growth resulting in higher commissions and to $0.2 millionrelated sales costs resulting from the growth in revenues. The expansion of expenses relating to a large trade showour sales force includes the Context sales force acquired in the first quarter of 2004, which took place in the second quarter of the prior year.2004. The decrease in sales and marketing expenses

as a percentage of total revenues was due to the increase in absolute terms being more than offset by the increase in total revenues in the threesix months ended March 31,June 30, 2004 compared to the threesix months ended March 31,June 30, 2003. We expect sales expenses to continue to increase in absolute terms in 2004 dueas we continue to an expansion ofexpand our sales force and experience continued revenue growth.

General and Administrative

General and administrative expenses decreased 14%increased 2% in the threesix months ended March 31,June 30, 2004 to $1.3$3.0 million from $1.5$2.9 million in March 31,the six months ended June 30, 2003. As a percentage of total revenues, general and

administrative expenses decreased to 8%9% in the threesix months ended March 31,June 30, 2004 from 12%11% in the threesix months ended March 31,June 30, 2003. The increase in general and administrative expenses in absolute terms was primarily due to the acquisition of Context which resulted in increases in headcount and related labor costs in the six months ended June 30, 2004 compared to the six months ended June 30, 2003, partially offset by a decrease in professional fees of $0.1 million in the six months ended June 30, 2004 compared to the six months ended June 30, 2003. The decrease in general and administrative expenses in absolute terms and as a percentage of total revenues was primarily due to a decreasethe increase in professional feesabsolute terms being more than offset by the increase in total revenues in the threesix months ended March 31,June 30, 2004 compared to the threesix months ended March 31,June 30, 2003.

Merger Costs

Merger costs relate to the merger of ActionPoint, Inc. and Old Captiva. In the threesix months ended March 31,June 30, 2003, we recorded sublease receipts in excess of estimated receipts of $44,000 related to an excess lease obligation recorded upon the merger.

Write-off of Withdrawn Stock Offering Costs

On April 12, 2004, we filed a Registration Statement with the SEC to register shares of our common stock in preparation for an underwritten public offering. In May 2004, the Company decided not to proceed with the underwritten public offering, withdrew this Registration Statement and wrote off $0.2 million of costs incurred in the registration process and initially deferred in connection with the anticipated offering.

Provision for Income Taxes

In the threesix months ended March 31,June 30, 2004, we recorded a tax provision of $0.3$0.9 million, which represented an effective tax rate of 39%. In the threesix months ended March 31,June 30, 2003, we recorded a tax provision of $0.1$0.3 million, which represented an effective tax rate of 40%.

Liquidity and Capital Resources

At March 31,June 30, 2004, we had cash and cash equivalents of $16.2$19.2 million, compared to $16.0 million at December 31, 2003. On February 1,In the six months ended June 30, 2004 we completed the acquisition of all of the issued and outstanding capital of Context for approximately $5.2$5.5 million in cash derived from our existing cash and cash equivalents. We will pay a final purchase price adjustmentThe $5.5 million included $0.1 million of approximately $0.2 million indirect costs of the second quarter of 2004.Context acquisition.

Net cash provided by operating activities was $3.1$5.1 million in the threesix months ended March 31,June 30, 2004 and $0.9$1.4 million in the threesix months ended March 31,June 30, 2003. The net cash provided by operating activities in the threesix months ended March 31,June 30, 2004 was primarily attributable to net income of $0.5$1.3 million, depreciation and amortization of $0.7$1.5 million, and a decrease in accounts receivableother current assets and other assets of $2.4$1.2 million, offset by net decreases in liabilities and deferred revenue of $1.6$1.7 million. In addition, the tax benefit of $1.1$2.2 million we received fromrelated to stock option exercisesdeductions had a positive effect on our net cash provided by operating activities and could continue to have a positive effect if stock options continue to be exercised. The net cash provided by operating activities in the three months ended March 31, 2003 was primarily attributable to net income of $0.1 million, depreciation and amortization of $0.7 million and a decrease in accounts receivable of $2.2 million, offset by decreases in liabilities and deferred revenue of $1.7 million.

Net cash used in investing activities was $5.5$5.9 million in the threesix months ended March 31,June 30, 2004 and $0.2 million in the threesix months ended March 31,June 30, 2003. NetThe increase in net cash used in investing activities in the threesix months ended March 31,June 30, 2004 included $5.2compared to the six months ended June 30, 2003 was primarily attributable to the $5.5 million of cash used in the acquisition of Context, direct costs of the acquisition of $0.1 million and additions to property and equipment of $0.2 million. The $0.2 million of additions to property and equipment in the three months ended March 31, 2004 is consistent with our expected rate of capital expenditures in the short-term. Net cash used in investing activities in the three months ended March 31, 2003 was exclusively for additions to property and equipment.Context.

Net cash provided by financing activities was $2.5$3.9 million in the threesix months ended March 31,June 30, 2004 compared to net cash used inprovided by financing activities of $0.1$0.5 million in the threesix months ended March 31,June 30, 2003. Net

The increase in net cash provided by financing activities in the threesix months ended March 31,June 30, 2004 consisted of $2.5compared to the six months ended June 30, 2003 was primarily attributable to the $3.1 million ofincrease in proceeds from the exercise of common stock options. Net cash used in financing activities inoptions and the three months ended March 31, 2003 consistedsale of a $0.1 million discretionary principal repayment againstcommon stock under our line of credit.employee stock purchase plan period over period. In the

future, we expect to generate further net cash from financing activities from the sale of common stock under our employee stock purchase plan and the exercise of stock options.

We have a bank line of credit that will expire in August 2004. On March 31,June 30, 2004, there was no outstanding principal balance under the line of credit. Borrowings under the line of credit are limited to the lesser of $3.0 million or 80% of eligible accounts receivable. Any outstanding balances under the line of credit would bear interest at the bank’s prime rate plus 0.5%. The line of credit is secured by all assets of the Company. The line of credit restricts us from paying dividends on our common stock. The line of credit also includes various financial covenants related to our operating results. As of March 31,June 30, 2004, we were in compliance with all loan covenants. We expect to renew the line of credit prior to its expiration, however, there is no assurance that we will be able to do so on comparable terms or at all.

Our principal sources of liquidity are cash and cash equivalents, as well as expected cash flows from operations and the line of credit. We may also continue to receive and use proceeds from the sale of common stock under our employee stock purchase plan and the exercise of stock options. We believe that our cash, cash equivalents and cash flows from operations will be sufficient to meet our liquidity and capital requirements for at least the next 12 months. We may, however, seek additional equity or debt financing to fund further expansion. There can be no assurance that additional financing will be available on terms favorable to us or at all.

Risk Factors

You should carefully consider the following risk factors and all other information contained in this Quarterly Report on Form 10-Q. Investing in our common stock involves a high degree of risk. In addition to those we describe below, risks and uncertainties that are not presently known to us or that we currently believe are immaterial may also impair our business operations. See “Forward-Looking Statements” above. If any of the following risks occur, our business could be harmed, the price of our common stock could decline and you may lose all or part of your investment.

Because of the unpredictability and variability of revenues from our products, we may not accurately forecast revenues or match expenses to revenues, which could harm our quarterly operating results and cause volatility or declines in our stock price.

Our quarterly revenues, expenses and operating results have varied significantly in the past, and our quarterly revenues, expenses and operating results may fluctuate significantly from period to period in the future due to a variety of factors, including:

We believe that comparisons of quarterly operating results will not necessarily be meaningful and should not be relied upon as the sole measure of our future performance. In addition, we may from time to time provide estimates of our future performance. For example, we typically estimate that the first quarter of each year is our weakest quarter and the fourth quarter of each year is our strongest quarter. Estimates are inherently uncertain, and actual results are likely to deviate, perhaps substantially, from our estimates as a result of the many risks and uncertainties in our business, including, but not limited to, those set forth in these risk factors. We do not undertake noany duty to update estimates if given. Our operating results in one or more future quarters may fail to meet the expectations of securities analysts or investors. If this occurs, the trading price of our stock is likely to decline significantly.

If we fail to reduce expenses rapidly in the event our revenues unexpectedly decline, our results may be harmed.

We currently operate with virtually no software order backlog because our software products are shipped shortly after orders are received. This fact makes software revenues in any quarter substantially dependent on orders booked and shipped throughout that quarter. In addition, a large portion of our orders tend to be booked late in each quarter and we obtain a significant portion of our revenues from indirect sales channels over which we have little control. The combination of these factors makes our revenues difficult to predict from period to period. Expense levels are based to a significant extent on expectations of future revenues and are relatively fixed in the short term. In particular, we increased hiring and product development expenses in the fourth quarter of 2003 in anticipation of an improving economic environment. We expect to continue these higher levels of expenses and, ifIf revenue levels are below expectations, our operating results are likely tocould be harmed.

Our future success depends on the services of our key management, sales and marketing, professional services, technical support and research and development personnel, whose knowledge of our business and technical expertise would be difficult to replace.

Our products and technologies are complex, and we are substantially dependent upon the continued service of existing key management, sales and marketing, professional services, technical support and research and

development personnel. All of these key employees are employees “at will” and can resign at any time. The loss of the services of one or more of these key employees could slow product development processes or sales and marketing efforts or otherwise harm our business.

A significant aspect of our ability to attract and retain highly qualified employees is the equity compensation that we offer, typically in the form of stock options. Bills are currently pending before Congress, and the Financial Accounting Standards Board has issued an Exposure Draft, that would require companies to include in their statements of operations compensation expense relating to the issuance of employee stock options. As a result, we may decide to issue fewer stock options and may be impaired in our efforts to attract and retain necessary personnel.

If we fail to recruit and retain a significant number of qualified technical personnel, we may not be able to develop, introduce or enhance products on a timely basis.

We require the services of a substantial number of qualified professional services, technical support and research and development personnel. The market for these highly skilled employees is characterized by intense competition, which is heightened by their high level of mobility. These factors make it particularly difficult to attract and retain the qualified technical personnel we require. We have experienced, and expect tomay continue to experience, difficulty in hiring and retaining highly skilled employees with appropriate technical qualifications.

If we are unable to recruit and retain a sufficient number of technical personnel with the skills required for existing and future products, we may not be able to complete development of, or upgrade or enhance, our products in a timely manner. Even if we are able to expand our staff of qualified technical personnel, they may require greater than expected compensation packages that would increase operating expenses.

We have a long sales cycle, and our solutionsproducts and services require a sophisticated sales effort.

Given the high average selling price of, and the cost and time required to implement our solutions,products and services, a customer’s decision to license our products typically involves a significant commitment of resources and is influenced by the customer’s budget cycles and internal approval procedures for IT purchases. In addition, selling our solutionsproducts and services requires us to educate potential customers on our solutions’the uses and benefits.benefits of our products and services. As a result, our solutionsproducts and services have a long sales cycle, which can take three to six months or more. Consequently, we have difficulty predicting the quarter in which sales to expected customers may occur. The salesales of our solutions isproducts and services are also subject to delays from the lengthy budgeting, approval and competitive evaluation processes of our customers, which typically accompany significant capital expenditures.

Our solutionsproducts and services require a sophisticated sales effort targeted at senior management of our prospective customers. New employees in our sales department require extensive training and typically take at least six months to achieve full productivity. There is no assurance that new sales representatives will ultimately become productive. If we were to lose qualified and productive sales personnel, our revenues could be adversely impacted.

We may not be able to compete successfully against current and potential competitors.

The input management software industry is currently fragmented and extremely competitive, with no one company having a significant market share. We expect that competition in this industry will intensify in the future. The market for forms processing and document capture solutions is very competitive and subject to rapid change. In addition, because there are relatively low barriers to entry into the software market, we may encounter additional competition from both established and emerging companies. Our current competitors could be acquired by larger companies and could become more formidable competitors. Many potential competitors have longer operating histories and significantly greater financial, technical, marketing and other resources than we

do, in addition to significantly greater name recognition and a larger installed base of customers. As a result,

these potential competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to the development, promotion and sale of competitive products than we can. There is also a substantial risk that announcements of competing products by current or potential competitors could result in the delay or postponement of customer orders in anticipation of the introduction of the competitors’ new products.

In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address customer needs. These cooperative relationships may limit our ability to sell our products through particular reseller partners. Accordingly, new competitors or competitive cooperative relationships may emerge and rapidly gain significant market share. Contributing to these challenges, our industry is subject to consolidation, which could subject us to competition with larger companies offering integrated solutions and a greater breadth of products. Potential competitors may bundle their products or incorporate additional components into existing products in a manner that discourages users from purchasing our products.

Increased competition as a result of any combination of the above factors is likely to result in price reductions, fewer customer orders, reduced margins and loss of market share, any of which could harm our revenues, business and operating results.

If the market for input management software does not grow, our revenues are unlikely to grow.

The market for input management software has had limited if any, growth in recent years. In addition, the concept of input management software is not widely understood in the marketplace. We have spent, and intend to continue to spend, considerable resources educating potential customers about our software products and the input management market in general. These expenditures may fail to achieve any broadening of the market or additional degree of market acceptance for our products. The rate at which organizations have adopted our products has varied significantly in the past, and we expect to continue to experience variations in the future. If the market for input management products grows more slowly than we anticipate or not at all, our revenues are unlikely to grow and our operating results will suffer.

We currently depend on repeat business for a substantial portion of our revenues and need to increase our customer base to grow in the future.

Currently, a significant portion of our revenues is generated from existing customers. Many of our customers initially make a limited purchase of our products and services on a departmental basis or for limited form or document types. These customers may not choose to purchase additional licenses to expand their use of our products. If this occurs, or if existing customers fail to renew services or maintenance contracts, then our revenues from new customers may not be sufficient to offset this and enable us to sustain our current revenue levels.

Conversely, a significant factor in our ability to grow our revenues in the future will be our ability to expand our customer base. We believe our ability to grow depends in part on our ability to expand into the “mid-market” segment of the input management market. Some of our competitors are more established in this segment of the market, and price is a more significant factor in the mid-market segment than the ability of our products to handle large volumes of documents. We have recently released products that address this market segment, and it is uncertain whether and to what extent these products will be successful and to what extent price-driven competition will erode our margins. If we are unsuccessful in expanding into the mid-market segment, or otherwise fail to increase our customer base, our business and operating results will be harmed.

If we are unable to respond in an effective and timely manner to technological change and new products in our industry, our revenues and operating results will suffer.

We currently expect to release a number of new products and enhancements to existing products in 2004 and anticipate that a substantial portion of our product revenue growth will come from these new releases. If we

experience material delays in introducing new products or product enhancements, our customers may forego the use of our products and use those of our competitors. The market for input management is characterized by rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, changes in customer demands and evolving industry standards. The introduction of products embodying new technologies and the emergence of new industry standards can render existing products obsolete and unmarketable. Our future success will depend upon our ability to continue to enhance our current products while developing and introducing new products on a timely basis that keep pace with technological developments and satisfy increasingly sophisticated customer requirements. As a result of the complexities inherent in our software, new products and product enhancements can require long development and testing periods. Significant delays in the general availability of these new releases or significant problems in the installation or implementation of these new releases could harm our operating results and financial condition. We have experienced delays in the past in the release of new products and product enhancements. We may fail to develop and market on a timely and cost-effective basis new products or product enhancements that respond to technological change, evolving industry standards or customer requirements. We may also experience difficulties that could delay or prevent the successful development, introduction or marketing of our products or reduce the likelihood that our new products and product enhancements will achieve market acceptance. Any such failures or difficulties would harm our business and operating results.

We may not be successful in expanding into new markets.

One element of our strategy involves applying our technology in new applications for additional markets. To be successful in expanding our sales in new markets, we will need to develop additional expertise in these markets. We may be required to hire new employees with expertise in new target markets in order to compete effectively in those markets. If we are not successful in growing our sales in additional markets, we may not achieve desired sales growth.

We have incurred losses in the past and we may incur losses in the future.

We have only recently become profitable, with net income of $0.5$1.3 million for the threesix months ended March 31,June 30, 2004 and $2.6 million for the year ended December 31, 2003. We incurred a net loss of $0.5 million in 2002 and $1.9 million in 2001. Given the competitive and evolving nature of the industry in which we operate, we may not be able to sustain or increase profitability on a quarterly or annual basis, which would likely cause our stock price to decline.

We could be subject to potential product liability claims and third-party litigation related to our products and services, and as a result our operating results might suffer.

Our products are used in connection with critical business functions and may result in significant liability claims if they do not work properly. Limitation of liability provisions included in our license agreements may not sufficiently protect us from product liability claims because of limitations in existing or future laws or unfavorable judicial decisions. The sale and support of our products may give rise to claims in the future that may be substantial in light of the use of those products in business-critical applications. Liability claims could require expenditure of significant time and money in litigation or payment of significant damages.

Software defects could also damage our reputation, causing a loss of customers and resulting in significant costs.

Our software products are complex and may contain errors or defects, particularly when first introduced or when new versions or enhancements are released. In the past, we have discovered software errors in certain

products after they were released to the market. In addition, our products are combined with complex products developed by other vendors. As a result, should problems occur, it may be difficult to identify the source or

sources of the problems. Defects and errors, or end-user perception of defects and errors, found in current versions, new versions or enhancements of these products after commencement of commercial shipments may result in:

The occurrence of any one or more of these factors could harm our operating results and financial condition.

If we cannot manage and expand international operations or respond to changing regulatory conditions in international markets, our revenues may not increase and our business and results of operations could be harmed.

We currently have international operations, including offices in the United Kingdom, Germany and Australia. For the quarterssix months ended March 31,June 30, 2004 and 2003, international sales represented approximately 19%21% and 20%23% of our revenues, respectively. We anticipate that international sales will increase as a percentage of our revenues and that, for the foreseeable future, a significant portion of our revenues will be derived from sources outside the United States. We intend to continue to expand sales and support operations internationally. We could enter additional international markets, which would require significant management time and financial resources and which, in turn, could adversely affect our operating margins and earnings. To expand international sales, we may establish additional international operations, expand international sales channel management and support organizations, hire additional personnel, customize our products for local markets, recruit additional international resellers and attempt to increase the productivity of existing international resellers. If we are unable to do any of the foregoing in a timely and cost-effective manner, our international sales growth, if any, will be limited, and our business, operating results and financial condition may be harmed. Even if we are able to expand international operations successfully, we may not be able to maintain or increase international market demand for our products. Our international operations are generally subject to a number of risks, including: