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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

x Quarterly report pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934

For the quarterly period ended March 31, 2003

OR

             ¨ Transition report pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934

Commission File Number: 0-27696

GENSYM CORPORATION

(Exact name of registrant as specified in its charter)

52 Second Avenue

Burlington, MA 01803

(Address of principal executive offices)

Telephone Number (781) 265-7100

(Registrant’s telephone number, including area code)

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 checkmark whether the registrant is an accelerated filer (as defined in Rule 12-b-2 of the Exchange Act)  

Yes ¨ No x

As of May 14, 2003 there were 6,877,783 shares of the Registrant’s Common Stock outstanding.

PART I. FINANCIAL INFORMATION

ITEM 1.    Consolidated Financial Statements

GENSYM CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share and per share amounts)

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

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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

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

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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

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

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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    Operations

We are a provider of operations management and expert systems software products and services. Our products emulate the reasoning of human experts using process knowledge and often real-time data and then, on the basis of such reasoning, make recommendations or take direct operational actions. Most applications of our products are in the areas of abnormal condition management manufacturing environments, supply chain and logistics management, and network management. Benefits derived from the use of our products include waste reduction, avoidance of off-specification product, avoidance of system down time in mission-critical networks, and proactive alarms that signify potential process problems and avoid plant shut downs. Our products have been used in the manufacturing, transportation, communications, aerospace and government sectors for many years.

2.    Basis of Presentation

The unaudited consolidated financial statements included herein have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial reporting. Certain information and footnote disclosures, normally included in financial statements prepared for the full year in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to such SEC rules and regulations; nevertheless, the management of the Company believes that the disclosures herein are adequate to make the information presented not misleading. In the opinion of management, the consolidated financial statements reflect all adjustments (of a normal and recurring nature) which are necessary to present fairly the consolidated financial position of the Company as of March 31, 2003 and the results of its operations for the three-month periods ended March 31, 2003 and 2002. These consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on  Form 10-K for the year ended December 31, 2002, filed with the SEC on March 31, 2003. The results of operations for interim periods are not necessarily indicative of the results of operations for the full year or any other interim period.

We achieved operating and overall profitability as well as positive cash flows for the year ended December 31, 2002. Previously, we had incurred operating losses for both December 31, 2001 and 2000. We have incurred an operating loss in the three months ended March 31, 2003 as a result of declining revenues, primarily in the chemical, oil and gas markets, which are a significant component of our business and have been adversely affected by the situation in the Middle East. We achieved profitability in 2002 based on expense control, cost reductions completed in 2001 and maintaining revenues from existing sales of licenses. The benefits of our expense control and cost reduction actions have continued in 2003, however, license sales have declined which has contributed to our net loss in the first quarter of 2003. We will continue to pursue new license sales to generate additional product revenue in 2003 and believe that our current cash and cash equivalent balances and cash flows from operations will be sufficient to meet our operating, investing and financing cash flow requirements through at least December 31, 2003. Our ability to continue to maintain profitability beyond 2003 is dependent on continued market acceptance of our existing range of products and services and renewal of maintenance contracts for customer support at or above current levels.

3.    Comprehensive Income (Loss )

The components of comprehensive income (loss) for the three-month period ended March 31, 2003 and 2002 are as follows (in thousands):

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4.    Computation of Earnings (Loss) Per Share

Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing income (loss) by the weighted average common shares outstanding plus additional common shares that would have been outstanding if potentially dilutive common shares had been issued. For purposes of this calculation, stock options are considered to be stock equivalents in periods in which they have a dilutive effect. Options that are anti-dilutive are excluded from this calculation.

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The following is a reconciliation of basic and weighted average shares used in the computation of earnings (loss) per share (in thousands):

For the three-month periods ended March 31, 2003 and 2002, options to purchase 681,025 and 519,273 shares of common stock, respectively, were outstanding, but were not included in the computation of diluted EPS because the options’ exercise prices were greater than the average market price of the common shares and thus would be anti-dilutive. For the three-month period ended March 31, 2003, potential common stock equivalents of 242,410 were not included in the per share calculation for diluted EPS, because the effect of their inclusion would be anti-dilutive.

5.    Stock Based Compensation

We follow the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of FASB Statement No. 123.” We continue to recognize compensation costs using the intrinsic value based method described in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.”

Net income (loss) and net income (loss) per share as reported in these consolidated financial statements and on a pro forma basis, as if the fair value based method described in SFAS No. 123 had been adopted, are as follows:

6.    Intangible assets

On March 12, 2003, we acquired certain intellectual property from Key Control, Inc. This intellectual property comprises intelligent objects for embedding in process management applications. In connection with the acquisition, we agreed to pay $250,000 under deferred payment terms. All payments will be made by September 30, 2003.

7.    Segment Reporting

Revenue is presented geographically based on the country to where the product is shipped or where the services are provided. The following table presents revenues by geographic area:

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Domestic and international long-lived assets are as follows at March 31, 2003 and December 31, 2002 (in thousands):

8. Guarantor Arrangements

In November 2002, the FASB issued FASB Interpretation (FIN) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN No. 45 clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, while the disclosure requirements are applicable in 2002. We have adopted the disclosure requirements of FIN No. 45 and do not expect that the adoption of FIN No. 45 will have a material impact on our financial position or results of operations.

The following is a summary of our agreements that we have determined is within the scope of FIN No. 45:

As permitted under Delaware law, we have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a Director and Officer insurance policy that limits its exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. All of these indemnification agreements were grandfathered under the provisions of FIN No. 45 as they were in effect prior to December 31, 2002. Accordingly, we believe our liabilities recorded for these agreements as of March 31, 2003 is immaterial.

We enter into standard indemnification agreements in our ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we believe our liabilities recorded for these agreements as of March 31, 2003 is immaterial.

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Forward-Looking Statements

This quarterly report contains forward-looking statements and information relating to us and our subsidiaries, which are based on management’s beliefs, as well as assumptions made by our management and information currently available to us. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. When used herein, words such as “anticipate”, “believe”, “estimate”, ‘expect”, “intend” and similar expressions, as they relate to us or our management identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties, and assumptions, including but not limited to those factors set forth below under the caption “Factors Affecting Future Operating Results”. Should one or more of these risks or uncertainties materialize, or should underlying assumption prove incorrect, actual results may vary materially from those described in this report as anticipated, believed, estimated, expected or intended. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their respective dates. We undertake no obligation to update or revise any forward-looking statements.

Business Overview

We were incorporated in Delaware in 1986 to develop and sell software products for expert operations management. Our flagship product has been, and continues to be, G2, which can emulate the reasoning of human experts as it assesses, diagnoses and responds to unusual operating situations or as it seeks to optimize operations. We have also developed a number of market-specific products using G2 as a platform. Since our inception, we have sold over 15,000 licenses to customers in a variety of industries.

Over the years we have developed and improved G2 and its related products on a regular basis, in terms of performance, functionality and their ability to integrate with a wide variety of industry-standard products and protocols. We released our latest version of G2, version 7.0, in March 2003, which constituted a significant advance in our product. Version 7.0 included many significant enhancements intended to bring G2 into line with current industry standards.

In addition to our continuous efforts to upgrade and enhance all of our products, which provide customers with important reasons to renew their maintenance contracts, we are pursuing a more collaborative approach with our customers to develop and maintain applications on an ongoing basis. We anticipate that this collaboration will give us increased opportunities for incremental professional services beyond just implementation assistance, which may result in to higher margins and more revenue per customer.

We conduct our business in North and South America, Europe, the Middle East, Africa and the Asian Pacific. In the first quarter of 2003, approximately 30% of our revenues were generated from license sales, 13% from consulting and training and 57% from payments for customer support services. For the year 2002, these percentages were 37%, 14% and 49% respectively. Prices for our products are generally denominated in U.S. dollars, although we do some business in local currencies. Chemical, oil and gas companies are a major market for us. Due to the current geo-political situation in the Middle East, we have experienced and may continue to experience a near-term reduction in the amount of business that we are able to conduct with these companies. We are affected both by the slowdown in spending by these companies and by the logistical difficulties of negotiating business and implementing solutions.

Detailed industry knowledge and expertise are critical elements to the success of our product implementations. Therefore, we frequently work closely with partners who are able to provide such expertise and are familiar with those markets and applications. Our partners may be value-added resellers, original equipment manufacturers, or systems integrators. These partner relationships are key to us and historically have accounted for approximately one-quarter of our product revenues.

On March 12, 2003 we acquired certain intellectual property from Key Control, Inc. This intellectual property comprises intelligent objects for embedding in process management applications. The use of intelligent objects may significantly shorten development time and avoid implementation risk for certain applications.

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Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, income taxes, and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

For a more detailed explanation of the judgments made in these areas, refer to our Annual Report on Form 10-K for the year ended December 31, 2002. Our critical accounting policies, as detailed in our 10-K for the year ended December 31, 2002, have not changed during the three-month period ended March 31, 2003.

Results of Operations

The following table sets forth, as a percentage of total revenues, consolidated statement of operations data for the periods indicated:

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Three Months Ended March 31, 2003 and 2002

Revenues

Our revenues are derived from two sources: product and services. Product revenues include revenues from sales of licenses for use of our software products. Services revenues consist of fees for support and maintenance, which is generally provided on an annual contract basis, consulting services, and training courses related to our products.

Total revenues were $3,458,000 for the three-month period ended March 31, 2003, a decrease of $860,000, or 20%, from the same period in 2002. Total revenues decreased as a result of a decrease in sales of licenses, application consulting services and product maintenance contracts. United States revenues accounted for 45% of total revenues for the three months ended March 31, 2003 and 47% for the same period in 2002, while international revenues accounted for 55% and 53% of total revenues for the same period. In 2003 we began a campaign to re-sign customers who allowed their maintenance contracts to lapse has proved to be successful and have recaptured approximately $129,000 in maintenance bookings.

Product. Product revenues were $1,044,000 for the three-month period ended March 31, 2003, a decrease of $394,000, or 27%, from the same period of 2002. This decrease was attributable to difficult economic conditions in most US market sectors and lower revenues in Europe and the Middle East. The chemical, oil and gas markets, from which we typically derive approximately one- quarter of our revenues, were particularly affected by the uncertainty before and during the war in Iraq.

Services. Services revenues were $2,414,000 for the three-month period ended March 31, 2003, a decrease of $466,000, or 16% from the same period of 2002. Consulting revenues were $413,000 for the three-months ended March 31, 2003, a decrease of $151,000 or 27% from March 31, 2002. This decrease was primarily due to the continued difficult economic climate, which has directly impacted consulting sales. Customer support, or maintenance, revenues decreased by $231,000, or 12% from $2,182,000 in 2002 to $1,951,000 in 2003 as a result of the decline in license sales, and some non-renewal of maintenance contracts as some customers sought to reduce operating expenses.

Cost of Revenues

Cost of revenues primarily consists of consulting labor, technical support costs, general office expenses, and the costs of material and labor involved in producing and distributing our software. These costs for the three-month period ended March 31, 2003 were $934,000, largely unchanged from costs of $945,000 for the same period in 2002. Our gross margin for the quarter ended March 31, 2003 was 73%, compared to 78% for the corresponding quarter ended March 31, 2002. This decrease resulted from the decline in revenue while our costs remained relatively fixed .

Product. Product cost of revenues for the three-month period ended March 31, 2003 was $227,000, an increase of $55,000, or 32%, from the same period in 2002. A commission program for customer support personnel was introduced at a cost of $57,000 and there was an increase of $46,000 in royalties paid to vendors of certain technologies embedded in our products. This was partially offset by reductions of $20,000 in personnel costs and a reduction in other operating costs of $27,000.

Services. Services cost of revenues for the three-month periods ended March 31, 2003 was $707,000, a decrease of $66,000, or 9%, from the same period in 2002. The reduction resulted mainly from making less use of outside consultants, due to having excess in-house professional services capacity available.

Operating Expenses

Sales and Marketing. Sales and marketing expenses consist primarily of costs associated with personnel involved in the sales and marketing process, sales commissions, sales facilities, travel and lodging, trade shows and seminars, advertising, and promotional materials. Sales and marketing expenses were $1,529,000 for the three-month period ended March 31, 2003, an increase of $288,000, or 23%, from the same period in 2002. The increase was primarily attributable to increases in personnel-related expenses as a result of hiring senior sales management, increasing the direct sales resources in order to better serve our existing markets and build our indirect channels, and the operating costs associated with doing this. We also increased our promotional costs by $60,000 in 2003 over the corresponding quarter in 2002.

Research and Development. Research and development expenses consist primarily of costs of personnel, equipment, and facilities. These expenses were $862,000 for the three-month period ended March 31, 2003, an increase of $158,000, or 22%, from the same period in 2002. This increase was primarily attributable to an increase in our research and development expenses related to development of a new product line.

General and Administrative. General and administrative expenses consist primarily of personnel costs for finance, administration, operations, and general management, as well as legal and accounting expenses. These expenses were $715,000 for

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the three-month period ended March 31, 2003, a decrease of $130,000, or 15%, from the same period in 2002. This decrease was mainly attributable to reductions personnel costs of $70,000, a reduction in facilities costs in certain of our US and international offices of $36,000, and a general effort to contain our administrative costs.

Other income (expense), net

Other income, net consists primarily of interest income and expense, realized gains or losses on foreign exchange transactions, and translation adjustments charged to income. Other income, net for the three-month period ended March 31, 2003 was $23,000, compared to an expense of $18,000 for the same period in 2002. Other income, net for the period resulted primarily from a reversal of an employee benefit accrual. For the three-month period ended March 31, 2002, the other expense, net resulted primarily from foreign currency transaction losses of $155,000 and interest expense of $52,000.

Income Taxes

Our provision for income taxes primarily pertains mainly to income taxes in foreign jurisdictions where our wholly-owned subsidiaries have taxable income but do not have operating loss carry forwards.

Liquidity And Capital Resources

Our March 31, 2003 cash and cash equivalents were $3,634,000, a decrease of $250,000 from December 31, 2002. Cash provided by operations for the quarter ended March 31, 2003 was $331,000. Specifically, we had net loss of $636,000, net of non-cash expenses (depreciation and amortization, foreign currency translation adjustment, issuance of treasury shares and loss on disposal of equipment), $861,000 in cash received from accounts receivable and a $390,000 decrease in accounts payable. This was partially offset by a decrease in deferred revenue of $221,000, a decrease in accrued expenses of $153,000 and an increase in prepaid expenses of $127,000.

Cash used in investing activities for the quarter ended March 31, 2003 was $616,000, which primarily consisted of $250,000 used to purchase intangible asset, and $91,000 for the purchase of property and equipment.

Cash used in financing activities for the quarter ended March 31, 2003 was $20,000, which consisted of $20,000 in principle payments on capital leases.

On March 28, 2001, we entered into an accounts receivable financing agreement with Silicon Valley Bank. The financing agreement provides us with the ability to borrow up to 80% of our qualified and eligible gross domestic accounts receivable up to a maximum of $2.5 million. Borrowings under this agreement will be at an interest rate of 2% per month of the average gross daily purchase account balance, plus an administration fee of 1% of gross purchased account receivables. On August 16, 2001, we renegotiated the terms of the financing agreement, and signed an accounts receivable purchase agreement that does not include restrictive financial covenants. The total available borrowings, interest rate and administrative fee under the renegotiated facility remain unchanged. At March 31, 2003 we had no borrowings outstanding under this facility. Amounts under this facility are collateralized by substantially all of our corporate assets. The facility may be terminated by either party at any time. As of March 31, 2003, the amount of eligible borrowings under this facility was approximately $700,000.

We currently finance our operations, along with capital expenditures, primarily through cash flows from operations and our current cash. Our lease commitments consist of operating leases primarily for our facilities and computer equipment. We also have capital leases for our communications equipment and certain computers.

We achieved operating and overall profitability as well as positive cash flows for the year ended December 31, 2002. Previously, we had incurred operating losses for both December 31, 2001 and 2000. We have incurred an operating loss in the three months ended March 31, 2003 as a result of declining revenues, primarily in the chemical, oil and gas markets, which are a significant component of our business and have been adversely affected by the situation in the Middle East. We achieved profitability in 2002 based on expense control, cost reductions completed in 2001 and maintaining revenues from existing sales of licenses. The benefits of our expense control and cost reduction actions have continued in 2003, however, license sales have declined which has contributed to our net loss in the first quarter of 2003. We will continue to pursue new license sales to generate additional product revenue in 2003 and believe that our current cash and cash equivalent balances and cash flows from operations will be sufficient to meet our operating, investing and financing cash flow requirements through at least December 31, 2003. Our ability to continue to maintain profitability beyond 2003 is dependent on continued market acceptance of our existing range of products and services and renewal of maintenance contracts for customer support at or above current levels.

Commitments and Contingencies

(a) Leases

The Company leases its facilities and certain equipment under operating and capital leases. The future minimum annual payments under these leases at March 31, 2003 are as follows:

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(b) Other Contractual Obligation

Amount owed for purchase of intangible assets                                                                                                           $ 250

(Payable in full by September 30, 2003)

Stock Repurchase Program

In the third quarter of 1998, the Company began a program to repurchase up to 650,000 shares of its Common Stock on the open market. As of March 31, 2003, 501,300 shares had been repurchased at a cost of approximately $1,869,000. No shares were purchased in 2003 or 2002. In 2003 and 2002, respectively, we reissued 13,948 and 35,957 shares of Common Stock to non-employee directors and a consultant. As of March 31, 2003, 451,395 shares remained in treasury at a cost of $1,683,000.

Related party transaction

On January 9, 2002 we entered into a three-year Original Equipment Manufacturer agreement with Integration Objects Inc., an offshore Tunisian corporation founded by a one of our employees who continues to work for us. The agreement calls for the payment of royalties, based on a fixed and determinable percentage of the product sale price, in connection with our use of their product. These payments are to be made within 30-days after payment from the end user is received. During the first quarter of 2003, we paid Integration Objects $31,000.

Factors That May Affect Future Results

The following important factors, among others, could cause our actual operating results to differ materially from those indicated or suggested by forward-looking statements made in this Form 10-Q or presented elsewhere by our management from time to time.

We have a history of operating losses, and we may not return to profitability.

We have incurred operating losses for four of the five years in the period ended December 31, 2002. In August 2001, we announced a strategic restructuring of our company that included a 40% reduction in workforce, a realignment of our software and services product lines and a renewed focus on our existing customers. With the restructuring, we achieved profitability for each of the quarters in 2002. However, due to continued declines in our product and service revenues, which we were not able to offset by additional reductions in expenses, we incurred a loss in the first quarter of 2003. Our ability to return to profitability will depend on our ability to control our expenses, achieve possible cost reductions and derive additional revenue from new and existing customers. However, there can be no assurance that we will be able to return to profitability in the future.

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Competition in the market for expert operations management systems is intensifying and may reduce our revenues.

Substantially all of our revenues are derived from the licensing and support of software platforms and products for expert operations management. Although organizations such as Objective Systems Integrators, Inc., Micromuse, RiverSoft and Systems Management Arts (SMARTS) have begun to deploy, or have announced plans to deploy, such systems, our systems are different from the basic monitoring and control systems that are traditionally employed by these organizations. There can be no assurance that these organizations will be able to introduce expert operations management systems successfully, nor that such systems will gain widespread acceptance. In addition, the timing of the implementation of expert operations management systems by organizations may be affected by economic factors, government regulations, and other factors. Delays in the introduction of expert operations management systems or the failure of these systems to gain widespread market acceptance would materially and adversely affect our business, results of operations, or financial condition. In addition, we believe that end-users in our markets are increasingly seeking application-specific products and components as well as complete solutions, rather than general software tools to develop application-specific functionality and solutions. Meeting this demand has required us to modify our sales approach. We are also increasingly reliant on value-added resellers and systems integrators to satisfy market requirements. The modified sales approach may also lengthen our average sales cycle. Our failure to respond appropriately to shifts in market demand could have a material adverse effect on our business, results of operations, or financial condition.

We rely heavily on indirect distribution channels and strategic partner relationships for the sales of our products. If these relationships are disrupted, our revenues may be adversely affected.

We sell our products in part through value-added resellers, systems integrators and original equipment manufacturers, which are not under our control. Sales of our products through these channels represented 56% and 23% of our product revenues in the three-month periods ending March 31, 2003 and 2002 respectively. We rely heavily on our indirect sales partners for sales of our expert operations management products to new customers. The loss of major original equipment manufacturers or resellers of our products, a significant decline in their sales, or difficulty on the part of such third-party developers or resellers in developing successful G2-based applications could have a material adverse effect on our business, results of operations, or financial condition. There can be no assurance that we will be able to attract or retain additional qualified third-party resellers, or that third-party resellers will be able to effectively sell and implement our products. In addition, we rely on third-party resellers to provide post-sales service and support to our customers, and any deficiencies in such service and support could adversely affect our business, results of operations, or financial condition.

We depend heavily on our sales and marketing force.

Our future success in the expert operations management marketplace will depend, in part, upon the productivity of our sales and marketing personnel and our ability to continue to attract, integrate, train, motivate and retain new sales and marketing personnel. There can be no assurance that our investment in sales and marketing will ultimately prove to be successful. In addition, there can be no assurance that our sales and marketing personnel will be able to compete successfully against the significantly more extensive and better-funded sales and marketing operations of many of our current and potential competitors. Our inability to manage our sales and marketing personnel effectively could have a material adverse effect on our business, operating results and financial condition.

Our quarterly operating results may vary, leading to fluctuations in trading prices for our common stock and possible liquidity problems.

We have experienced, and may experience in the future, significant quarter-to-quarter fluctuations in our operating results. There can be no assurance that revenue growth or profitable operations can be attained on a quarterly or annual basis in the future. Our sales cycle typically ranges from six to 12 months, and the cost of acquiring our software, building and deploying applications, and training users represents a significant expenditure for customers. Our relatively long sales cycle and high license fees, together with fixed short-term expenses, can cause significant variations in operating results from quarter to quarter, based on a relatively small variation in the timing of major orders. Factors such as the timing of new product introductions and upgrades and the timing of significant orders could contribute to this quarterly variability. In addition, we ship software products within a

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short period after receipt of an order and typically do not have a material backlog of unfilled orders of software products. Therefore, revenues from software licenses in any quarter are substantially dependent on orders booked in that quarter. Historically, a majority of each quarter’s revenues from software licenses has come from license contracts that have been executed in the final weeks of that quarter. The revenues for a quarter may include some large orders. If the timing of any of these orders is delayed, it could result in a substantial reduction in revenues for that quarter. Our expense levels are based in part on expectations of future revenue levels. A shortfall in expected revenues could therefore result in a disproportionate decrease in our net income and cash flows, which may impact our ability to continue as an independent concern.

Our common stock has been delisted from the Nasdaq National Market. As a result of the delisting, our stockholders may face an illiquid market for the shares of our stock that they own.

Our common stock was delisted from the Nasdaq National Market on August 20, 2001 because we failed to meet the listing standards required by Nasdaq. The delisting may negatively impact the liquidity of our common stock, not only in the number of shares that can be bought or sold, but also through delays in the timing of transactions and the reductions in potential security analyst and media coverage. This may reduce the demand for our common stock and its trading price. The delisting may also impair our ability to raise additional working capital.

Sales of our products are highly dependent on our customers’ capital expenditure budgets. If an economic downturn causes our customers to reduce their capital expenditures, our revenues may be further adversely affected.

Because capital expenditures are often viewed as discretionary by organizations, sales of our products for capital budget projects are subject to general economic conditions. Future recessionary conditions in the industries that use our products may adversely affect our business, results of operations, or financial condition.

We rely heavily on revenues from our G2 and G2-based products. If demand for the G2 product declines, our revenues may be adversely affected.

Substantially all of our license revenues are derived from G2, a customizable object-oriented development and deployment platform for building expert operations management systems, and from software application products based on G2 and other core technologies. Accordingly, our business and financial results are substantially dependent upon the continued customer acceptance and deployment of G2 and our other products. The timing of major G2 releases may affect the timing of purchases of our products. We have introduced several G2-based products for building applications and are developing others. We believe that market acceptance of these products will be important to our future growth. There can be no assurance that such products will achieve market acceptance or that new products will be successfully developed.

In addition, we rely on many of our distribution partners to develop G2-based products for specialized markets. Accordingly, our business and financial results are also linked to the continued successful product development by our partners and market acceptance of such G2-based products. Any decline in the demand for G2 and our other products, whether as a result of competitive products, price competition, the lack of success of our partners, technological change, the shift in customer demand toward complete solutions, or other factors, could have a material adverse effect on our business, results of operations, or financial condition.

Our business may be adversely affected if we fail to develop new products and respond to changes in technology.

The market for our products is characterized by rapid technological change, evolving industry standards, changes in end-user requirements, and frequent new product introductions and enhancements. Our future success will depend in part upon our ability to enhance our existing products, to introduce new products and features to meet changing customer requirements and emerging industry standards, and to manage transitions from one product release to the next. We have from time to time experienced delays in introducing new products and product enhancements. There can be no assurance that we will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these new products and product enhancements. There also can be no assurance that we will successfully complete the development of new or enhanced products, that we will successfully manage the transition to future versions of G2, or to successor technology, or that our future products will achieve market acceptance. In addition, the introduction of products embodying new technologies and the emergence of new industry standards could render our existing products and products currently under development obsolete and unmarketable. From time to time, new products, capabilities, or technologies may be announced that have the potential to replace or shorten the life cycle of our existing product offerings. There can be no assurance that announcements of currently planned or other new product offerings will not cause customers to defer purchasing our existing products.

Our business may suffer if we fail to address the challenges associated with international operations.

Our international revenues represented 55% and 53% of our total revenues for the three-month period ending March 31, 2003 and 2002, respectively. We categorize our revenues according to product shipment destination, which therefore does not necessarily reflect the ultimate country of installation. The international portion of our business is subject to a number of inherent risks, including difficulties in building and managing international operations, difficulties in localizing products and translating documentation into local languages, fluctuations in the value of international currencies including the euro, fluctuating import/export duties and quotas, and unexpected regulatory, economic, or political changes in international markets. There can be no assurance that these factors will not adversely affect our business, results of operations, or financial condition.

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Our business may suffer if we fail to remain competitive with other companies offering similar products and services.

A number of companies offer products that perform certain functions of G2 for specific applications. In all of our markets, there is competition from “point solutions”, real-time and expert system products, and internally developed software. There are commercially available software development tools that software application developers or potential customers could use to build software that has functionality similar to our products.

Certain companies, such as Objective Systems Integrators, Inc., Micromuse, RiverSoft and Systems Management Arts (SMARTS), sell “point solutions” that compete with our expert operations management products with respect to specific applications or uses. Several companies, including Aspen Technologies, Ilog S.A., Pavilion and System Management Arts, offer expert operations management products with limited real-time, expert system, or fault isolation capabilities, but at lower price points than those provided by us. Many of these products often require extensive programming with languages such as C or C++ for complete implementation. Although we believe that these products offer a less productive development environment than G2 and that they lack the comprehensive capabilities of G2-based products, certain competitors in this category have greater financial and other resources than we do and might introduce new or improved products to compete with G2, possibly at lower prices.

Our software is also integrated into industry-specific solutions by value- added resellers. A number of software companies offer products that compete in specific application areas addressed by these value-added resellers, such as cement kiln control and refinery scheduling, and they could be successful in supplying alternatives to products based on our software.

Many of our customers have significant investments in their existing solutions and have the resources necessary to enhance existing products and to develop future products. These customers may develop and incorporate competing technologies into their systems or may outsource responsibility for such systems to others who do not use our products. There is no assurance that we can successfully persuade development personnel within these customers’ organizations to use G2-based products that can cost effectively compete with their internally developed products. Thus there could be a reduction in the need for our products and services that may limit our future opportunities.

We believe that continued investment in research and development and sales and marketing will be required to maintain our competitive position. There can be no assurance that competitors will not develop products or provide services that are superior to our products or services or achieve greater market acceptance. Competitive pressures faced by us could force us to reduce our prices, which could result in reduced profitability. There can be no assurance that we will be able to compete successfully against current and future sources of competition or that such competition will not have a material adverse effect on our business, results of operations, or financial condition.

Our software is complex and may contain undetected errors. Such errors could cause costly delays in product introduction or require costly software design modifications.

Complex software products such as those offered by us may contain unintended errors or failures commonly referred to as “bugs”. There can be no assurance that, despite significant testing by us and by current and potential customers, errors will not be found in new products after commencement of commercial shipments. Although we have not experienced material adverse effects resulting from any such errors or defects to date, there can be no assurance that errors or defects will not be discovered in the future that could cause delays in product introduction and shipments or require design modifications that could adversely affect our business, results of operations, or financial condition.

Because we rely heavily upon proprietary technology, our business could be adversely affected if we are unable to protect our proprietary technology or if third parties successfully assert infringement claims against us.

Our success is heavily dependent upon our proprietary technology. We rely upon a combination of trade secret, contract, copyright, patent, and trademark law to protect our proprietary rights in our products and technology. We enter into confidentiality and/or license agreements with our employees, third-party resellers, and end-users and limit access to and distribution of our software, documentation, and other proprietary information. In addition, we have placed technical inhibitors in our software that prevent such software from running on unauthorized computers. However, effective patent, copyright, and trade secret protection may not be available in every country in which our products are distributed. There can be no assurance that the steps taken by us to protect our proprietary technology will be adequate to prevent misappropriation of our technology by third parties, or that third parties will not be able to develop similar technology independently. In addition, there can be no assurance that third parties will not assert infringement claims in the future or that such claims will not be successful.

On August 2, 2001, we received a letter from a third party alleging that we are infringing one or more of their patents relating to neural networks expert systems and the control of processes. At this time, no formal legal action has been filed. While we believe that these allegations are without merit, there can be no assurance that the third party will not file formal legal action relating to its claims or, if formal legal action is filed, that our defense against those claims will be successful.

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ITEM 3.    Qualitative and Quantitative Disclosures About Market Risk

Investment Portfolio

We do not use derivative financial instruments in our investment portfolio. If we place our funds in other than demand deposit accounts we use instruments that meet high credit quality standards, such as money market funds, government securities, and commercial paper. We limit the amount of credit exposure to any one issuer. At March 31, 2003, substantially all of our funds were in demand deposit accounts.

Impact of Foreign Currency Rate Changes

Our contracts with customers are generally denominated in U.S. dollars or Euros and, in general, exchange rate fluctuations have not had a material impact on our consolidated financial position, results of operations or cash flows. We do not use foreign exchange forward contracts to hedge our foreign currency denominated receivables. There can be no assurance that changes in foreign currency rates, relative to the U.S. dollar, will not materially affect our consolidated results in the future.

ITEM 4.    Controls and Procedures.

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PART II. OTHER INFORMATION

ITEM 6.    Exhibits.

(a) Exhibits. The following exhibit is filed as part of this Report on Form 10-Q:

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SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

GENSYM CORPORATION

(Registrant)

/s/    JOHN M. BELCHERS                                

Dated May 15, 2002

John M. Belchers

Chief Financial Officer

(Principal Financial and

Accounting Officer)

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CERTIFICATION

I, Lowell B. Hawkinson, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Gensym Corporation (the “Company”);

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The Registrants’ other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

5. The Registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the Registrant’s auditors and to the audit committee of the registrant’s board of directors (or persons performing the equivalent function):

6. The Registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

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CERTIFICATION

I, John M. Belchers, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Gensym Corporation (the “Company”);

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The Registrants’ other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

5. The Registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the Registrant’s auditors and to the audit committee of the registrant’s board of directors (or persons performing the equivalent function):

6. The Registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

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EXHIBIT INDEX

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