UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

Commission file number: 000-50463

Callidus Software Inc.

(Exact name of registrant as specified in its charter)

Callidus Software Inc.

160 West Santa Clara Street, Suite 1500

San Jose, CA 95113

(Address of principal executive offices, including zip code)

(408) 808-6400

(Registrant’s Telephone Number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, $0.001 par value

      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 requirements for the past 90 days.     Yes þ          No o

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to this Form 10-K.     o

      Indicate by check mark if the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended).     o

      The aggregate market value of the voting and non-voting stock held by non-affiliates of the Registrant, based on the closing sale price of the Registrant’s common stock on June 30, 2004, as reported on the Nasdaq National Market, was approximately $39.6 million. Shares of common stock held by each executive officer and director and by each person who may be deemed to be an affiliate of the Registrant have been excluded from this computation. The determination of affiliate status for this purpose is not necessarily a conclusive determination for other purposes. As of March 24, 2005, the Registrant had 26,079,739 shares of its common stock, $0.001 par value, issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

      The Registrant is incorporating by reference into Part III of this Annual Report on Form 10-K portions of its Proxy Statement for its 2005 Annual Meeting of Stockholders to be held on June 7, 2005.

CALLIDUS SOFTWARE INC.

ANNUAL REPORT ON FORM 10-K

For the Fiscal Year Ended December 31, 2004

TABLE OF CONTENTS

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

      This Annual Report on Form 10-K, including the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section in Item 7 of this report, and other materials accompanying this Annual Report Form 10-K contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to our future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements include, but are not limited to, statements concerning the following: our ability to compete effectively with our competitors; levels of future revenues; expected gross margins; future operating expenses; the impact of quarterly fluctuations of revenue and operating results; our expectations regarding third-party service providers and strategic partners; future acquisitions; levels of capital expenditures; staffing and expense levels; the adequacy of our capital resources to fund operations and growth; our expectations regarding our executive hiring goals; and our expectations with respect to the impact of changes in our accounting for share-based compensation. These statements involve known and unknown risks, uncertainties and other factors that may cause industry trends or our actual results, level of activity, performance or achievements to be materially different from any future results, level of activity, performance or achievements expressed or implied by these statements. For a detailed discussion of these risks and uncertainties, see the “Business” and “Factors That Could Affect Future Results” sections in Items 1 and 7 of this Annual Report on Form 10-K. We undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Annual Report on Form 10-K.

PART I

Callidus Software Inc.

      Incorporated in Delaware in 1996, Callidus Software Inc. is a leading provider of Enterprise Incentive Management (EIM) software systems to global companies across multiple industries. Large enterprises use EIM systems to model, administer, analyze and report on incentive compensation, or pay-for-performance plans which compensate employees and business partners for the achievement of targeted quantitative and qualitative objectives, such as sales quotas, product development milestones and customer satisfaction. We provide a suite of software products that enable companies to access applicable transaction data, allocate compensation credit to appropriate employees and business partners, determine relevant compensation measurements, payment amounts and timing, and accurately report on compensation results. By facilitating effective management of complex pay-for-performance programs, our products allow our customers to increase productivity, improve profitability and achieve competitive advantage. Our product suite is based on our proprietary technology and extensive expertise in pay-for-performance programs and provides the flexibility and scalability required to meet the dynamic EIM requirements of large, complex businesses across multiple industries.

Products

      Our EIM product suite models, administers, analyzes and reports on key aspects of the incentive compensation process. Our core products combine a flexible rules-based architecture with grid-based computing, providing customers with reliable, flexible and highly scalable solutions for EIM programs. Our products are Java-based, enabling efficient implementation on any operating system, and all of our products are designed to be operated by business users and compensation professionals rather than IT administrators. Our product suite features user-defined security combined with a complete audit trail, allowing for reduced errors in incentive compensation, enhanced trust and confidence between operational and finance personnel and reduced cost of incentive compensation programs.

      TrueComp automates the modeling, design, administration, reporting and analysis of pay-for-performance programs for enterprise level sales and distribution organizations. Our customers use TrueComp to design, test and implement sales compensation plans that reward on the profitability of the sale, discourage excessive sales discounts, encourage team selling and promote new product introduction or other sales activities the company wishes to encourage. TrueComp enables our customers to accurately acquire and reflect all relevant sales data, apply it precisely to each payee’s pay-for-performance program and automate the day-to-day activities associated with administering transaction-driven, variable incentive compensation. TrueComp provides a flexible, user-maintainable system that can be modified easily to align direct or indirect sales compensation with corporate goals and shareholder value.

      TrueComp consists of four principal modules: TrueComp Integration collects and integrates the different data feeds used to compile the applicable sales data; TrueComp Repository serves as the database; TrueComp Manager serves as our rules-based engine; and the TrueComp Grid is our proprietary computing architecture. TrueComp’s modular, structured approach to defining compensation plans avoids the reliability and maintenance issues associated with internally developed solutions and enables systematic administration over a high volume of transactions and varied compensation plans that is not attainable using manual methods. TrueComp guides users through the process of paying variable compensation by a graphical and intuitive rule editor, which is usable by compensation analysts without coding or scripting skills. TrueComp was initially shipped in the second quarter of 1999 and to date has accounted for a substantial majority of our revenues.

      TrueInformation is a self-service, web-based reporting portal that provides visibility into incentive compensation systems throughout the organization. TrueInformation provides reporting capabilities, enabling management to access a comprehensive model of pay-for-performance programs. By providing timely and accurate compensation information throughout the enterprise, TrueInformation engenders trust and confidence among operational and finance personnel, thereby improving morale and operational results while reducing errors that increase the costs of incentive compensation. TrueInformation includes user-defined security parameters that allow for appropriate controls on dissemination of sensitive compensation data and is accessed through an intuitive web-based interface that offers ease of use throughout the organization. TrueInformation was initially shipped in the fourth quarter of 2002.

      TrueResolution is a rules-based application that streamlines and automates the resolution of incentive compensation disputes, thereby reducing the associated cost and diversion of management and sales resources. Scaleable for the largest sales channel organizations, TrueResolution eliminates manual, error-prone sales operation processes and allows dispute resolution to be initiated from the field where the majority of disputes originate. TrueResolution automates functions such as changes, transfers and splits to territory assignments, quota adjustments, organizational changes and payee information updates. TrueResolution enables sales professionals and business partners to submit and track their claims through a completely web-based self-service workflow process, which automates the evaluation, routing, resolution and approval of day-to-day requests and consistently communicates payment and resolution status to sales people. TrueResolution keeps management informed of changes that may affect compensation, produces an audit trail for all requests and resolutions, reduces errors and the risk of fraud and promotes enforcement of enterprise policies. TrueResolution was initially shipped in the second quarter of 2002.

Technology

      Our products are based on our proprietary TrueComp Manager rules engine, which is implemented on our scalable TrueComp Grid computing architecture. This technology offers our customers high degrees of functionality and flexibility coupled with scalability and reliability that are designed to maximize the return on investment in their EIM systems.

Customers

      While our products can serve the pay-for-performance program needs of all companies, we have focused principally on five key markets: insurance, banking, telecommunications, distribution and technology, manufacturing and life sciences. Because we license our products to customers on a perpetual basis, our quarterly product license revenues are substantially dependent on sales of our products to new customers. In 2004, IBM accounted for more than 10% of our total revenues, including instances where IBM acted as a reseller of our products. In 2003, no single customer accounted for 10% or more of our revenues. In 2002, DIRECTV and Sprint accounted for more than 10% of our revenues. Revenues have mainly been generated in the United States in the past three years representing 91%, 91% and 79% of our total revenues in 2004, 2003 and 2002, respectively. The remaining amounts of revenue in each of the past three years have been generated in Europe and the Asia Pacific region.

Services

      We provide a full range of services to our customers, including professional services, maintenance and technical support and educational services.

      Professional Services. We provide integration and configuration services to our customers and partners. These services include the installation of our software, identification and sourcing of legacy data, configuration of TrueComp rules necessary to create compensation plans, creation of custom reports, integration of our other products including TrueResolution and TrueInformation and other general testing and tuning services for our software. Our customers have the ability to select us or one of our implementation partners to perform the installation and other professional services work they desire. We may also provide services to our implementation partners to aid them in certain projects or training programs. The professional services work we perform is generally done on a time and materials basis.

      Maintenance and Technical Support. We have maintenance and technical support centers in the United States, the United Kingdom and Australia. We currently offer two levels of support, including standard and premium, which are generally contracted for a period of one year. Under each of these levels of support, our customers are provided with on-line access to our customer support database, telephone support and all product enhancements and new releases. In the case of premium support, our customers are provided with access to a Callidus support engineer 24 hours a day, 7 days a week. In addition, our customers who subscribe to standard or premium support can purchase an on-site resource support option.

      Education Services. We offer our customers a full range of education services including computer and web-based training, classroom training and on-site customer training. We provide classes for all of our products to our customers and provide educational services to our partners on a scheduled and as-requested basis.

Sales and Marketing

      We sell and market our software through a direct sales force and in conjunction with our partners. In the United States, we have sales offices in Austin, Atlanta, Chicago, New York and San Jose. Outside the United States, we have sales offices in London and Sydney.

      Sales. Our direct sales force, consisting of account executives, subject matter experts, technical pre-sales engineers and field management, is responsible for the sale of our products to global enterprises across multiple industries and is organized into geographic and industry territories. Our telesales department is responsible for sales lead generation and first line customer contact, while our non-quota carrying customer advocacy group is responsible for post-sales customer support. These services include informing our customers of new Callidus products, managing user groups and maintaining proactive contact with our customers.

      Marketing. Our marketing activities include traditional product marketing functions such as production of both hardcopy and on-line product and company promotional material, gathering of customer and partner input for new product features and creation of sales product demonstrations. We generate awareness of our company and sales leads for our products through print and web-based advertising, seminars, direct mail and

customer and partner events. Additionally, we maintain an extensive web site that is used to educate our customers and prospects about our products and services.

Strategic Relationships

      We actively promote and maintain strategic relationships with systems integration partners. These relationships provide customer referrals and co-marketing opportunities that expand our contacts with potential customers. In addition, these relationships allow us to leverage our business model by subcontracting or outsourcing integration and configuration services required to allow us to expand license sales.

      In August 2003, we became an IBM Strategic Alliance Partner for Enterprise Incentive Management. Under our agreement with IBM, we co-market our products globally to banking, insurance and telecommunications customers. During 2004, we expanded our agreement with IBM to cover the pharmaceutical and health sciences market. We optimize our products to operate on IBM product platforms including Websphere, DB/2 and AIX. Our relationship with IBM is non-exclusive and either of us may enter into similar relationships with other parties.

      During 2004, we also entered into an agreement with Accenture, under which Accenture provides systems integration and configuration services to our customers. We also maintain relationships with the Alexander Group International, Compensation Technologies and Iconixx Corporation. These partners also provide compensation consulting and professional services that include the implementation of our products.

Research and Development

      Our research and development organization consists of experienced software engineers, software quality engineers and technical writers. We organize the development staff along product lines, with an engineering services group providing centralized support for technical documentation and advanced support. We employ advanced software development tools including automated testing, performance monitoring, source code control and defect tracking systems. In 2004, 2003 and 2002, we recorded research and development expenses of $13.4 million, $11.0 million and $11.1 million, respectively.

Competition

      Our principal competition comes from established ERP vendors including Oracle, PeopleSoft (acquired by Oracle in December 2004) and SAP, CRM vendors including Siebel Systems, pure-play EIM vendors including Centive and Synygy and internally developed software solutions. We believe that the principal competitive factors affecting our market are:

      We believe that we compete effectively with the established ERP and CRM companies due to our established market lead, domain expertise, rules-based application software and highly scalable software architecture. EIM systems are generally not part of these vendors’ core product offerings, whereas we believe we have more fully developed the domain expertise required to meet the dynamic requirements of today’s complex pay-for-performance programs.

      We believe that we compete effectively with the pure-play EIM system vendors due to our established market leadership, robust, scalable architecture and commitment to customer service. While each of the pure-play EIM system vendors has domain knowledge of the EIM market, we believe that we have developed superior scalability demanded by the telecommunications, retail banking and insurance markets. Additionally, we have created substantial product differentiation by adding features into our products that are specific to each of our target markets.

      We also believe that our products offer a more cost-effective and complete alternative to internally developed solutions. These solutions are generally expensive, inflexible and difficult to maintain for large companies with complex pay-for-performance programs, thereby increasing total cost of ownership and limiting the ability to implement pay-for-performance programs that effectively address targeted business objectives.

      Although we believe that our products and services currently compete favorably with those of our competitors, the market for EIM products is new and rapidly evolving. Many of our competitors and potential competitors have significantly greater financial, technical, marketing, service and other resources than we have. Many of these companies also have a larger installed base of users, have longer operating histories or have greater name recognition than we have. Our competitors may also be able to respond more quickly than we can to changes in customer requirements or may announce new products, services or enhancements that better meet the needs of customers or changing industry standards. In addition, if one or more of our competitors were to merge or partner with another of our competitors, the change in the competitive landscape could adversely affect our ability to compete effectively. Increased competition may cause price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, results of operations and financial condition.

Intellectual Property

      Our success and ability to compete is dependent, in part, on our ability to develop and maintain the proprietary aspects of our technology and operate without infringing upon the proprietary rights of others. We rely primarily on a combination of copyright, trade secret, confidentiality procedures, contractual provisions and other similar measures to protect our proprietary information. Due to the rapidly changing nature of applicable technologies, we believe that the improvement of existing products, reliance upon trade secrets and unpatented proprietary know-how and development of new products are generally more advantageous than patent and trademark protection and recently started a patent registration program within the United States. We have an ongoing trademark registration program pursuant to which we register some of our product names, slogans and logos in the United States and in some foreign countries.

      We also use contractual provisions to protect our intellectual property rights. We license our software directly to customers. These license agreements, which address our technology, documentation and other proprietary information, include restrictions intended to protect and defend our intellectual property. These licenses are generally non-transferable and are perpetual. We also require all of our employees, contractors and many of those with whom we have business relationships to sign non-disclosure and confidentiality agreements.

      In December 2003, we acquired from Cezanne Software a non-exclusive, fully-paid, royalty-free license to copy, create modify and enhance certain software source-code related to our TruePerformance product. In June 2004, we discontinued our TruePerformance product and recorded a $1.8 million impairment charge in connection with the discontinuance.

      Some of our other products also include third-party software that we obtain the rights to use through license agreements. While this software comprises important elements of our product offerings, these applications are commercially available and we are aware of substitute applications that we could integrate with our products that are also commercially available on reasonable terms. In certain cases we also believe we could develop substitute technology to replace these products if these third-party licenses were no longer available on reasonable terms.

Employees

      As of December 31, 2004, we had a total of 294 employees. Of those employees, 60 were in sales and marketing, 70 were in research and development, 137 were in professional services, technical support and training, and 27 were in finance and administration. We consider our relationship with our employees to be good and have not experienced interruptions of operations due to labor disagreements.

Executive Officers

      The following table sets forth certain information with respect to our executive officers as of March 1, 2005:

      David B. Pratt has served as our President and Chief Executive Officer since June 2004. Mr. Pratt has served on the Plumtree Software board of directors since December 2003 and The SETI Institute board of directors since May 2003. From October 2002 to February 2003, Mr. Pratt served as Interim President and Chief Executive Officer of AvantGo, Inc. From April 2002 to October 2002, Mr. Pratt volunteered as Interim President and Chief Executive Officer of the YMCA of the Mid-Peninsula and remains a member of its board of directors. From January 2000 to March 2001, Mr. Pratt served as President and Chief Executive Officer of gForce Systems, an enterprise software company focusing on e-learning. Prior to joining gForce, Mr. Pratt was Executive Vice President and Chief Operating Officer of Adobe Systems, Inc. from May 1988 to January 1998. From October 1987 to April 1988, Mr. Pratt was Executive Vice President and Chief Operating Officer of Logitech, Inc., a manufacturer of computer input devices. From February 1986 to March 1987, Mr. Pratt served as Senior Vice President and Chief Operating Officer of Quantum Corporation. Mr. Pratt holds an M.B.A. from the University of Chicago and a Bachelor of Science degree in Electrical Engineering from the Massachusetts Institute of Technology.

      Ronald J. Fior has served as our Vice President, Finance and Chief Financial Officer since September 2002. From December 2001 to July 2002, Mr. Fior served as Vice President of Finance and Chief Financial Officer for Ingenuity Systems, a bioinformatics software development company. From July 1998 until October 2001, Mr. Fior served as Chief Financial Officer and Vice President of Finance and Operations of Remedy Corporation, a software development company. Prior to this, Mr. Fior served for 13 years as Chief Financial Officer of numerous divisions and companies within the publishing operations of The Thomson Corporation, including the ITP Education Group and the International Thomson Publishing Group. Mr. Fior holds a Bachelor Commerce degree from the University of Saskatchewan and is a Chartered Accountant.

      Bertram W. Rankin has served as our Senior Vice President, Worldwide Marketing since June 2003. Prior to joining Callidus, Mr. Rankin served as Vice President of Marketing at NetManage, a supplier of host access and integration solutions to Fortune 1000 organizations, from October 2000 to May 2003. From July 1998 to October 2000, Mr. Rankin served as General Manager and Vice President, Marketing for Ricoh Silicon Valley, a software company and subsidiary of Ricoh Company. Mr. Rankin holds a M.B.A. from the Stanford Graduate School of Business and a B.A. in Economics from Harvard University.

      Robert W. Warfield has served as our Chief Technology Officer and Senior Vice President, Research and Development since December 2001. From 1998 to 2001, Mr. Warfield served as Executive Vice President of Products and Services and Chief Technology Officer at iMiner, an information mining company. From 1997 to 1998, Mr. Warfield served as Vice President of Research and Development at Rational Software, a provider of

software development applications. From 1996 to 1997, Mr. Warfield served as Vice President of Research and Development and Chief Technology Officer at Integrity QA Software, a provider of software development applications. Mr. Warfield holds a B.A. in Computer Science from Rice University.

      Richard D. Furino has served as our Vice President of Client Services since November 2003. From August 2001 to October 2003, Mr. Furino served as Senior Vice President of the Technology Solutions Group for Washington Mutual, a consumer finance and mortgage company. From March 2000 to May 2001, Mr. Furino served as Chief Technology Officer for Creative Planet, a privately owned internet start-up company. From February 1997 until February 2000, Mr. Furino served as President and COO for Countrywide Technology Solutions, an arm of an international joint venture established by Countrywide to originate and service loans in the United Kingdom. Prior to this, Mr. Furino served for two years as Vice President of Integration Services and Software Engineering for Great Western Bank and for four years as a Senior Manager at KPMG LLP. Mr. Furino holds a Master of Business Administration and Bachelor of Science Finance from California State University Long Beach.

      Brian E. Cabrera has served as our Vice President, Corporate Development and General Counsel since 2005. Since joining Callidus in 1999, Mr. Cabrera has served in various positions, including Vice President, Operations and General Counsel from 2002 to 2004, and Vice President, Human Resources and General Counsel from 1999 to 2002. From 1998 to 1999, Mr. Cabrera served as Chief Operations Counsel at PeopleSoft, Inc., an enterprise software company. From 1995 to 1998, Mr. Cabrera served as Senior Legal Counsel at Netscape, Inc., an internet software company and from 1993 to 1995, Mr. Cabrera served as Legal Counsel at Silicon Graphics, Inc., a computer hardware manufacturer. From 1989 to 1993, Mr. Cabrera was an associate with Bronson, Bronson & McKinnon, a law firm. Mr. Cabrera holds a Bachelor of Arts in Political Science and Philosophy and a Masters in Public Policy from the University of Southern California, as well as a Juris Doctorate from the University of Southern California Law School. Mr. Cabrera is licensed to practice law in the State of California.

Available Information

      We make available, free of charge, on our website (www.callidussoftware.com) our annual reports on Form 10-K, quarterly reports on From 10-Q, current reports on From 8-K and other periodic reports publicly available as soon as reasonably practicable after we have electronically filed or furnished such materials to the Securities and Exchange Commission.

      We lease our headquarters in San Jose, California which consists of approximately 53,000 square feet of office space. The lease on our San Jose headquarters expires in 2010. We also lease facilities in Austin, Atlanta, Chicago, New York, Sydney and London. We believe that our properties are in good operating condition and adequately serve our current business operations. We also anticipate that suitable additional or alternative space, including those under lease options, will be available at commercially reasonable terms for future expansion. See Note 6 to the Consolidated Financial Statements for information regarding our lease obligations.

      In July 2004, a purported securities class action complaint was filed in the United States District Court for the Northern District of California against us and certain of its present and former executives and directors. The suit alleges that Callidus and the executives and directors made materially false or misleading statements or omissions in violation of federal securities laws. The suit seeks damages on behalf of a purported class of individuals who purchased our stock during the period from November 19, 2003 through June 23, 2004. In October 2004, the court appointed a lead plaintiff. In November 2004, the lead plaintiff filed an amended complaint naming Messrs. Fior and Reed D. Taussig, our former Chairman and Chief Executive Officer, as well as Callidus as defendants and amending the purported class to include individuals who purchased our stock during the period from January 22, 2004 through June 23, 2004. In addition, in each of

July and October 2004, derivative complaints were also filed against us and certain of our present and former directors and officers in the California State Superior Court in Santa Clara, California and the United States District Court for the Northern District of California. The derivative complaints allege state law claims relating to the matters alleged in the purported class action complaint referenced above. The federal derivative case has been deemed related to the federal securities case and assigned to the same judge. In February 2005, the parties stipulated to a stay of the state derivative case in favor of the federal derivative case. In February 2005, we filed a motion to dismiss the amended complaint. The court has scheduled a hearing on our motion for May 6, 2005. We believe that the claims in the securities and derivative actions are without merit and intend to continue to vigorously defend against these claims.

      In addition, we are from time to time party to various other litigation matters incidental to the conduct of our business, none of which, at the present time is likely to have a material adverse effect on our future financial results.

      None.

PART II

      Our common stock has been traded on the Nasdaq National Market under the symbol “CALD” since our initial public offering in November 2003. The following table sets forth, for the periods indicated, the high and low closing sales prices reported on the Nasdaq National Market.

      As of March 24, 2005, there were 26,079,739 shares of our common stock issued and outstanding and held by 144 stockholders of record.

      We completed our initial public offering of 5,750,000 shares of common stock in November 2003. In the offering, we sold the shares at a price of $14.00 per share, which resulted in aggregate net proceeds of approximately $72.1 million, after deducting underwriting discounts and commissions and paying offering expenses.

      We continue to use the net proceeds of our initial public offering for working capital and general corporate purposes, capital expenditures, and potential acquisitions of complementary businesses, products and technologies. We have no present commitments or agreements with respect to any acquisition or investments. We have invested the net proceeds of the offering in interest-bearing, investment-grade securities. The amounts we actually spend will depend on a number of factors, including the amount of cash

generated or used by our operations, competitive and technological developments, marketing and sales activities and market acceptance of our products, and the rate of growth, if any, of our business.

      We have never declared or paid cash dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.

      In March 2003, we issued and sold an aggregate of 453,000 shares of our Series G Preferred Stock, which were converted upon the consummation of our initial public offering into 271,800 shares of our common stock, to eight accredited investors pursuant to Section 4(2) of the Securities Act.

      The following selected consolidated financial data should be read in conjunction with the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section and the Consolidated Financial Statements and Notes thereto included elsewhere in this annual report. The selected consolidated statement of operations financial data for each of the years in the three-year period ended December 31, 2004, and as of December 31, 2004 and 2003, are derived from our consolidated financial statements data that have been included in this annual report. The selected statement of operations data for each of the years in the two year period ended December 31, 2001 and the selected consolidated balance sheet data as of December 31, 2002, 2001 and 2000 are derived from our consolidated financial statements that have not been included in this annual report.

      The following discussion contains forward-looking statements that involve risks and uncertainties and should be read together with our consolidated financial statements, including the notes thereto, and other information included elsewhere in this Annual Report on Form 10-K. These forward-looking statements include, but are not limited to, statements concerning the following: our ability to compete effectively with our competitors; levels of future revenues; expected gross margins; future operating expenses; the impact of quarterly fluctuations of revenue and operating results; our expectations regarding third-party service providers and strategic partners; future acquisitions; levels of capital expenditures; staffing and expense levels; the adequacy of our capital resources to fund operations and growth; our expectations regarding our executive hiring goals; and our expectations with respect to the impact of changes in our accounting for share-based compensation. These statements involve known and unknown risks, uncertainties and other factors that may cause industry trends or our actual results, level of activity, performance or achievements to be materially different from any future results, level of activity, performance or achievements expressed or implied by these statements. For a detailed discussion of these risks and uncertainties, see the “Factors That Could Affect Future Results” sections of this Annual Report on Form 10-K.

Overview of 2004 Results

      We are a leading provider of Enterprise Incentive Management (EIM) software systems to global companies across multiple industries. Large enterprises use EIM systems to model, administer, analyze and report on incentive compensation, or pay-for-performance plans, which compensate employees and business partners for the achievement of targeted quantitative and qualitative objectives, such as sales quotas, product development milestones and customer satisfaction. We sell our EIM products both directly through our sales force and indirectly through our strategic partners pursuant to perpetual software licenses, and offer professional services, including configuration, integration and training, generally on a time and materials basis. We also generate maintenance and support revenues associated with our product licenses, which are recognized ratably over the term of the maintenance agreement.

      In 2004, our total revenues decreased 18% to $58.7 million from $71.7 million in 2003. This decline was the result of a 66% reduction in license revenues, partially offset by a 34% increase in maintenance and service revenues in 2004 compared to 2003. The adverse change in license revenues was driven by a variety of factors, including a lengthening of sales cycles, general weakness in our market and a trend toward smaller average transaction values. As a result of this substantial decline in higher-margin license revenues, as well as a $1.8 million impairment charge described below, our overall gross margin declined to 41% in 2004, compared to 61% in the prior year.

      Operating expenses increased 18%, to $50.5 million in 2004 compared to $42.7 million in 2003. Operating expenses in the first half of 2004 were $30.5 million compared to $20.0 million in the second half of 2004. The higher expenses in the first half of the year were the result of continued growth in our operations based on our expectation that license revenues would continue to increase from 2003 levels and a $2.0 million impairment charge described below. As a result of the decline in license revenues in the first half of the year, we undertook a restructuring action early in the third quarter that reduced our workforce by approximately 10% and made additional reductions in discretionary spending. The restructuring action resulted in a $1.5 million charge in the third quarter of 2004. As a result of these actions we were able to substantially reduce our cost structure in the second half of 2004 compared to the first half of 2004.

      In June 2004, in an effort to refocus our efforts on our core business and reduce expenses in light of the substantial decline in our license revenues, we discontinued our TruePerformance product line, and recorded a $1.8 million impairment charge against cost of revenues, representing the carrying value of the source code license we purchased in December 2003 for $2.0 million. We also recorded a $2.0 million charge for impairment of intangible assets associated with the acquisition of an assembled workforce of approximately 20 software developers we acquired in April 2004 for $2.2 million to continue the development of the TruePerformance product.

      As a result of the significant reduction in license revenues, higher operating expenses and the TruePerformance related charges discussed above, we incurred a net loss in 2004 of $25.5 million, compared with net income of $835,000 in 2003.

      Our future operating performance, including our ability to increase license revenues and return to profitability, is subject a number of risks and uncertainties. In particular, the market for EIM products is currently small, newly emerging, difficult to measure and did not achieve the growth we anticipated in 2004. Increased sales of our products will depend on our ability to convince potential customers of the value we believe our products can deliver as compared to their legacy systems for managing incentive compensation. If we are unable to convince potential customers of the value proposition of our products, and if our market does not improve, we may be unable to return to profitability or to levels of sales achieved in 2003. In addition to these risks, our future operating performance is subject to the risks and uncertainties described in “Factors that could affect future results.”

Application of Critical Accounting Policies and Use of Estimates

      Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The application of GAAP requires our management to make estimates that affect our reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. In many instances, we could have reasonably used different accounting estimates, and in other instances changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation of our financial condition or results of operations will be affected.

      In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application, while in other cases, management’s judgment is required in selecting among available alternative accounting standards that allow different accounting treatment for similar transactions. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Our management has reviewed these critical accounting policies, our use of estimates and the related disclosures with our audit committee. Please refer to Note 1 to the consolidated financial statements for a further description of our accounting policies.

      We generate revenues primarily by licensing software and providing maintenance and professional services to our customers. Our software arrangements typically include: (i) an end-user license fee paid in exchange for the use of our products in perpetuity, generally based on a specified number of payees, and (ii) a maintenance arrangement that provides for technical support and product updates, generally over a period of twelve months. If we are selected to provide integration and configuration services, then the software arrangement will also include professional services, generally priced on a time-and-materials basis. Depending upon the elements in the arrangement and the terms of the related agreement, we recognize license revenues under either the residual or the contract accounting method.

      Residual Method. License fees are recognized upon delivery when licenses are either sold separately from integration and configuration services, or together with integration and configuration services, provided that (i) the criteria described below have been met, (ii) payment of the license fees is not dependent upon performance of the integration and configuration services, and (iii) the services are not otherwise essential to the functionality of the software. We recognize these license revenues using the residual method pursuant to the requirements of Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-9, Software Revenue Recognition with Respect to Certain Transactions. Under the residual method, revenues are recognized when vendor-specific objective evidence of fair value exists for all of the undelivered

elements in the arrangement (i.e., professional services and maintenance), but does not exist for one or more of the delivered elements in the arrangement (i.e., the software product). Each license arrangement requires careful analysis to ensure that all of the individual elements in the license transaction have been identified, along with the fair value of each undelivered element.

      We allocate revenue to each undelivered element based on its respective fair value, with the fair value determined by the price charged when that element is sold separately. For a certain class of transactions, the fair value of the maintenance portion of our arrangements is based on stated renewal rates rather than stand-alone sales. The fair value of the professional services portion of the arrangement is based on the hourly rates that we charge for these services when sold independently from a software license. If evidence of fair value cannot be established for the undelivered elements of a license agreement, the entire amount of revenue from the arrangement is deferred until evidence of fair value can be established, or until the items for which evidence of fair value cannot be established are delivered. If the only undelivered element is maintenance, then the entire amount of revenue is recognized over the maintenance delivery period.

      Contract Accounting Method. For arrangements where services are considered essential to the functionality of the software, such as where the payment of the license fees is dependent upon performance of the services, both the license and services revenues are recognized in accordance with the provisions of SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. We generally use the percentage-of-completion method because we are able to make reasonably dependable estimates relative to contract costs and the extent of progress toward completion. However, if we cannot make reasonably dependable estimates, we use the completed-contract method. If total cost estimates exceed revenues, we accrue for the estimated loss on the arrangement.

      For all of our software arrangements, we will not recognize revenue until persuasive evidence of an arrangement exists and delivery has occurred, the fee is fixed or determinable and collection is deemed probable. We evaluate each of these criteria as follows:

      A customer typically prepays maintenance for the first twelve months, and the related revenues are deferred and recognized over the term of the initial maintenance contract. Maintenance is renewable by the customer on an annual basis thereafter. Rates for maintenance, including subsequent renewal rates, are typically established based upon a specified percentage of net license fees as set forth in the arrangement.

      Professional services revenues primarily consist of integration and configuration services related to the installation of our products and training revenues. Our implementation services do not involve customization to, or development of, the underlying software code. Substantially all of our professional services arrangements are on a time-and-materials basis. To the extent we enter into a fixed-fee services contract, a loss will be recognized any time the total estimated project cost exceeds project revenues.

      Certain arrangements result in the payment of customer referral fees to third parties that resell our software products. In these arrangements, license revenues are recorded, net of such referral fees, at the time the software license has been delivered to a third-party reseller and an end-user customer has been identified.

      We must make estimates of the uncollectibility of accounts receivable. The allowance for doubtful accounts, which is netted against accounts receivable on our balance sheets, totaled approximately $320,000 at December 31, 2004 and approximately $187,000 at December 31, 2003. We record an increase in the allowance for doubtful accounts when the prospect of collecting a specific account receivable becomes doubtful. Management specifically analyzes accounts receivable and historical bad debts experience, customer creditworthiness, current economic trends, international situations (such as currency devaluation) and changes in our customer payment history when evaluating the adequacy of the allowance for doubtful accounts. Should any of these factors change, the estimates made by management will also change, which could affect the level of our future provision for doubtful accounts. Specifically, if the financial condition of our customers were to deteriorate, affecting their ability to make payments, an additional provision for doubtful accounts may be required and such provision may be material.

      We generally guarantee that our services will be performed in accordance with the criteria agreed upon in the statement of work. Should these services not be performed in accordance with the agreed upon criteria, we would provide remediation services until such time as the criteria are met. In accordance with Statement of Financial Accounting Standards (SFAS) 48, Revenue Recognition When Right of Return Exists, management must use judgments and make estimates of sales return reserves related to potential future requirements to provide remediation services in connection with current period service revenues. When providing for sales return reserves, we analyze historical experience of actual remediation service claims as well as current information on remediation service requests as they are the primary indicators for estimating future service claims. Material differences may result in the amount and timing of our revenues if for any period actual returns differ from management’s judgments or estimates. The sales return reserve balance, which is netted against our accounts receivable on our balance sheets, was approximately $537,000 at December 31, 2004 and approximately $647,000 at December 31, 2003.

      In accordance with FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we assess potential impairments to intangible assets when there is evidence that events or changes in circumstances indicate that the carrying amount of an asset may not be recovered. In 2004, as a result of a decline in financial performance, we assessed whether the purchased technology and other intangible assets acquired from Cezanne Software were impaired. We compared the carrying amount of the asset group to its estimated undiscounted future cash flows. Based on this assessment, we determined the asset group had no value and recorded an impairment charge of $1.8 million as a cost of revenues and $2.0 million as an operating expense. The $1.8 million impairment related to unamortized capitalized software costs. The $2.0 million impairment consisted of a $1.9 million impairment to an assembled workforce intangible asset and an approximately $66,000 impairment of a favorable lease asset. Our judgments regarding the existence of impairment indicators and future cash flows related to intangible assets are based on operational performance, market conditions, and other factors. Although there are inherent uncertainties in this assessment process, the estimates and assumptions we use are consistent with our internal planning.

      We have adopted SFAS 123, Accounting for Stock-Based Compensation, but in accordance with SFAS 123, we have elected not to apply fair value-based accounting for our employee stock option plans. Instead, we measure compensation expense for our employee stock option plans using the intrinsic value method prescribed by Accounting Principles Board Opinion (APB) 25, Accounting for Stock Issued to Employees, and related interpretations. We record deferred stock-based compensation to the extent the fair value of our common stock for financial accounting purposes exceeds the exercise price of stock options

granted to employees on the date of grant, and amortize these amounts to expense using the accelerated method over the vesting schedule of the options, which is generally four years. For options granted after our initial public offering, the fair value of our common stock is the closing price on the date of grant. For options which were granted prior to our initial public offering, the deemed fair value of our common stock was determined by our board of directors. The board of directors determined the deemed fair value of our common stock by considering a number of factors, including, but not limited to, our operating performance, significant events in our history, issuances of our convertible preferred stock, trends in the broad market for technology stocks and the expected valuation to be obtained in an initial public offering. Had different assumptions or criteria been used to determine the deemed fair value of the stock options, materially different amounts of stock compensation expenses could have been reported. We recorded deferred stock-based compensation of $0, $13.1 million and $0 in the years ended December 31, 2004, 2003 and 2002, respectively. We recorded stock-based compensation expense of $5.6 million, $4.6 million and $424,000 in the years ended December 31, 2004, 2003 and 2002, respectively. Based on deferred stock-based compensation recorded as of December 31, 2004, we expect to amortize $1.1 million in the first half of fiscal 2005. For the second half of fiscal 2005, we are still evaluating the impact of FASB Statement No. 123R, effective for interim and annual periods beginning after June 15, 2005, and we expect our stock-based compensation expense will significantly increase. Please see our “Recent Accounting Pronouncements” for additional discussion of FASB Statement No. 123R.

      As required by SFAS 123, as modified by SFAS 148, Accounting for Stock Based Compensation — Transition and Disclosure — an Amendment of FASB Statement No. 123, we provide pro forma disclosure of the effect of using the fair value-based method of measuring stock-based compensation expense. For purposes of the pro forma disclosure, we estimate the fair value of stock options issued to employees using the Black-Scholes option valuation model. This model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of subjective assumptions including the expected life of options and our expected stock price volatility. Therefore, the estimated fair value of our employee stock options could vary significantly as a result of changes in the assumptions used. See Note 1 to our consolidated financial statements included elsewhere in this Annual Report on From 10-K.

      We are subject to income taxes in both the United States and foreign jurisdictions and we use estimates in determining our provision for income taxes. This process involves estimating actual current tax liabilities together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are recorded on the balance sheet. Our deferred tax assets consist primarily of net operating loss carryforwards. We assess the likelihood that deferred tax assets will be recovered from future taxable income, and a valuation allowance is recognized if it is more likely than not that some portion of the deferred tax assets will not be recognized. We provided a full valuation allowance against our net deferred tax assets at December 31, 2004 and 2003. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future, an adjustment to the deferred tax assets would increase net income in the period such determination was made. Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgment that could become subject to audit by tax authorities in the ordinary course of business.

Recent Accounting Pronouncements

      In December 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123R (revised 2004), “Share-Based Payment” (“Statement 123R”), which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. Generally, the approach in Statement 123R is similar to the approach described in Statement 123. However, Statement 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the

income statement based on their fair values. Pro forma disclosure will no longer be an alternative. The new standard will be effective for us beginning in the quarter ending September 30, 2005.

      Upon the adoption of FASB No. 123R, we can elect to recognize stock-based compensation related to employees equity awards in our consolidated statements of operations using fair value based method on a modified prospective basis and disclose the pro forma effect on net income or loss assuming the use of fair value based method in the notes to the consolidated financial statements for periods prior to the adoption. Since we currently account for equity awards granted to our employees using the intrinsic value method under APB No. 25, we expect the adoption of FASB No. 123R will have a significant impact on our results of operations.

Results of Operations

Comparison of the Years Ended December 31, 2004 and 2003

      The table below sets forth the changes in revenue, cost of revenue and gross profit from fiscal 2003 to fiscal 2004 (in thousands, except percentage data):

      License Revenues. License revenues decreased 66% in fiscal 2004 compared to fiscal 2003 due to a decrease in average license value, fewer large dollar transactions being completed and a generally more challenging selling environment with longer selling cycles. The average license revenue per transaction in fiscal 2004 was $0.5 million compared to $1.0 million per transaction in fiscal 2003. In fiscal 2004, four customers accounted for transactions with $1.0 million or more of license revenue compared to 13 transactions in fiscal 2003. We attribute the decline in average license value and the decline in the number of large dollar transactions to a general weakness in our market. In 2005, we expect our license revenues to continue to fluctuate from quarter to quarter since we generally complete a relatively small number of transactions in a quarter and the prices on those software license sales can vary widely.

      Maintenance and Service Revenues. Maintenance and service revenues increased 34% in fiscal 2004 due to growth of recurring maintenance revenues, an expansion of our professional services organization, increased utilization of our consultants and a higher average billing rate for our services as compared to fiscal 2003. Our consultants are responsible for implementation, upgrades and other consulting services. We do not intend to

significantly expand our professional services organization in 2005, but rather will increase our use of system integration partners for the implementation of our software products.

      Cost of License Revenues. Cost of license revenues decreased 59% in fiscal 2004 primarily due to the lower level of license revenues in 2004 compared to 2003. Additionally, in 2004 we recorded $200,000 of amortization expense from purchased technology related to our TruePerformance product. As a percentage of license revenue, cost of license revenues increased to 6% in fiscal 2004 from 5% in fiscal 2003. The increase is primarily attributable to the mix between fixed royalty fees compared to variable royalty fees in third-party royalty costs in fiscal 2004 resulting from the lower average license value in fiscal 2004. We do not anticipate any changes to our third-party technology agreements in 2005. Accordingly, we expect to keep license gross margins at or above 95% for 2005.

      Cost of Maintenance and Service Revenues. Cost of maintenance and service revenues increased 25% in fiscal 2004 compared to fiscal 2003. The increase is primarily attributable to $4.4 million of higher personnel costs associated with a 37% increase in headcount. As a percentage of maintenance and service revenues, cost of maintenance and service revenues decreased to 70% in fiscal 2004 from 75% in fiscal 2003. The decrease was primarily attributable to our higher average billing rates and an increase in the overall utilization of our services organization. In the future, we expect to keep maintenance and service gross margins between 29% and 31%.

      Impairment of Purchased Technology. We discontinued our TruePerformance product in July 2004. Based on our assessment of estimated undiscounted future cash flows, we determined the asset had no value. Accordingly, we recorded an impairment charge of $1.8 million related to our unamortized capitalized software costs. See Note 4 to our consolidated financial statements for further discussion.

      Gross Margin. Our overall gross margin decreased 41% in fiscal 2004 compared to 61% in fiscal 2003. The decrease in our gross margin is attributable primarily to the shift in revenue mix to lower margin maintenance and service revenues which represented 78% of our total revenues in fiscal 2004 compared to 48% of total revenues in fiscal 2003. In the future, we expect our gross margins to fluctuate depending on the mix of license versus maintenance and service revenues recorded.

      The table below sets forth the changes in operating expenses from fiscal 2003 to fiscal 2004 (in thousands, except percentage data):

      Operating Expenses. Operating expenses increased 18%, to $50.5 million in 2004 compared to $42.7 million in 2003. Operating expenses in the first half of 2004 were $30.5 million compared to $20.0 million in the second half of 2004. The higher expenses in the first half of the year were the result of continued growth in our operations based on our expectation that license revenues would continue to increase

from 2003 levels and a $2.0 million impairment charge. As a result of the decline in license revenues in the first half of the year, we undertook a restructuring action early in the third quarter that reduced our workforce by approximately 10% and made additional reductions in discretionary spending. As a result of these actions we were able to substantially reduce our cost structure in the second half of 2004 compared to the first half of 2004.

      Sales and Marketing. Sales and marketing expenses in fiscal 2004 decreased 1% compared to fiscal 2003 due primarily to a $3.0 million decline in commission expense as a result of lower license revenue. This decline was partially offset by a $2.5 million increase in personnel costs due to an increase in sales and marketing personnel of approximately 16 employees. We expect sales and marketing expenses to increase in the first quarter of 2005 compared to the fourth quarter of 2004 due to severance costs associated with the departure of our Senior Vice President, Operations, recruiting costs for a new Vice President of Sales, and our annual sales conference.

      Research and Development. Research and development expenses increased 22% in fiscal 2004 compared to fiscal 2003. Research and development expenses in 2004 included $1.7 million of personnel costs and amortization expense related to our TruePerformance development team in Italy, which was shut-down in the third quarter of 2004, and a $1.2 million increase of personnel costs associated with an increase in headcount of approximately 15 employees to our United States research and development team. The remainder of the fluctuation in research and development expenses between fiscal 2004 and fiscal 2003 resulted from other individually insignificant items. We expect our research and development expenses to decrease in fiscal 2005 due to the termination of the TruePerformance development team offset by a slight increase of United States headcount.

      General and Administrative. General and administrative expenses increased 19% in fiscal 2004 compared to fiscal 2003. The increase in general and administrative expenses is primarily attributable to a $0.9 million increase in personnel costs associated with an increase in headcount of approximately 7 employees and an $0.8 million increase in professional fees associated with being a public company. We expect general and administrative expenses to increase in 2005 primarily due to external audit and professional fees to document and test our compliance with section 404 of the Sarbanes-Oxley Act.

      Impairment of Intangible Assets. In connection with our decision to discontinue the TruePerformance product, we recorded an impairment charge consisting of $1.9 million related to the write-off of the purchased assembled workforce and approximately $66,000 of a favorable lease in fiscal 2004.

      Restructuring expenses. During 2004, we undertook a restructuring plan which included discontinuing our TruePerformance product line and eliminating 36 positions or 10% of our workforce, including our TruePerformance development team in Italy. We recorded restructuring charges of $1.5 million in fiscal 2004, most of which related to employee termination costs. All restructuring costs were paid in 2004.

      Stock-based Compensation. Stock-based compensation expense increased 22% from fiscal 2004 compared to fiscal 2003. The increase in stock-based compensation in fiscal 2004 was primarily related to a charge of $1.7 million resulting from the modification of stock options associated with the resignation of our former president and chief executive officer. In the first half of 2005, we expect stock-based compensation to be approximately $1.1 million, which includes a $160,000 charge in the first quarter of 2005 for the modification of stock options associated with the resignation of our Senior Vice President, Operations. In addition, beginning in the quarter ending September 30, 2005 we will be required to comply with the new accounting standard, FASB Statement No. 123R, which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement at the time of the grant based on their fair values. We are in the process of assessing the impact this revised standard will have on our financial results. We currently expect that the impact will be material.

      The table below sets forth the changes in other items from fiscal 2003 to fiscal 2004 (in thousands, except percentage data):

      Interest expense decreased 76% from fiscal 2004 compared to fiscal 2003. Interest expense paid on outstanding debt decreased by approximately $140,000 due to lower average outstanding balances in 2004 compared to 2003. Amortization of loan discounts associated with warrants granted in connection with our credit facility also decreased by $240,000 in 2004 compared to 2003. The warrants have been fully amortized as of December 31, 2004.

      Interest and other income, net increased 505% in fiscal 2004 compared to fiscal 2003. The increase was primarily attributable to the interest income generated from investments of the net proceeds received from our initial public offering in November 2003.

      The provision for income taxes decreased 72% in fiscal 2004 compared to fiscal 2003. The provision relates to income taxes currently payable on income generated from non-U.S. tax jurisdictions and state net worth taxes. The decrease was a result of generating income in the prior year compared to current year losses. We maintained a full valuation allowance against our deferred tax assets based on the determination that it was more likely than not that the deferred tax assets would not be realized.

Comparison of the Years Ended December 31, 2003 and 2002

      The table below sets forth the changes in revenue, cost of revenue and gross profit from fiscal 2002 to fiscal 2003 (in thousands, except percentage data):

      License Revenues. License revenues in fiscal 2003 increased 282% compared to fiscal 2002. The increase in license revenues was the result of sales to new customers resulting from the growth in our direct sales force, customer referrals from new partner relationships and an improved economic environment. The average license revenue per transaction in fiscal 2003 was $1.0 million compared to $0.9 million per transaction in fiscal 2002. In fiscal 2003, 13 customers accounted for transactions with $1.0 million or more of license revenue compared to four transactions in fiscal 2002. The increase in license revenues to 52% in 2003 from 37% in 2002 as a percentage of total revenue was due to strong software license revenue growth and a lower revenue growth rate in our services organization due to an increased use of third-party implementation partners performing the integration and configuration services in connection with new product sales.

      Maintenance and Service Revenues. Maintenance and service revenues in fiscal 2003 increased 104% compared to fiscal 2002. The increase in maintenance and service revenues was attributable to an increase in integration and configuration services for new customers and, to a lesser extent, increased maintenance fees associated with increased product sales. The decrease in maintenance and service revenues to 48% in 2003 from 63% in 2002 as a percentage of total revenues was, as discussed above, due to increased use of third-party implementation partners performing the integration and configuration services associated with new license sales.

      Cost of License Revenues. Cost of license revenues in fiscal 2003 increased 135% compared to fiscal 2002. The increase was attributable to third-party royalty costs associated with the higher volume of license sales in 2003. As a percentage of license revenues, cost of license revenues was 5% in 2003 compared with 8% in 2002. The lower cost of license revenues as a percentage of license revenues was due to increased sales of products that carry lower third-party royalties, resulting in a lower average royalty cost per license.

      Cost of Maintenance and Service Revenues. Cost of maintenance and service revenues increased 81% in fiscal 2003 compared to fiscal 2002. The increase was primarily due to $4.6 million of higher personnel costs associated with increased headcount, $2.7 million in higher fees paid to sub-contractors that we use to supplement our work force and $1.7 million in higher travel expenses relating to the increase in integration and configuration services. As a percentage of maintenance and service revenues, cost of maintenance and service revenues decreased to 75% in 2003 from 85% in 2002. The decrease as a percentage of maintenance and service revenues is attributable to higher utilization rates of service personnel who bill for their services on an hourly basis and fixed overhead costs being applied to a larger amount of revenues.

      Gross Margin. Our overall gross margin increased to 61% in 2003 from 43% in 2002. The improvement in our gross margin is attributable primarily to the shift in revenue mix to higher margin license revenues, which represented 52% of total revenues for 2003, compared to 37% of total revenues for 2002. To a lesser extent, the improvement was also attributable to the individual improvements in our license margin and our maintenance and service margin discussed above.

      The table below sets forth the changes in operating expenses from fiscal 2002 to fiscal 2003 (in thousands, except percentage data):

      Sales and Marketing. Sales and marketing expenses in fiscal 2003 increased 54% compared to fiscal 2002. Increases to our sales and marketing headcount led to an increase in personnel expense of $3.1 million. Commission expense increased by $1.6 million due to the higher license and maintenance sales. Marketing program fees increased by $1.6 million due to increased advertising and promotional activities. In addition, sales and marketing travel and other ancillary costs increased by approximately $1.0 million due to the increased headcount of approximately 40 employees.

      Research and Development. Research and development expenses in fiscal 2003 decreased 1% compared to fiscal 2002. The lower level of research and development expense in 2003 was primarily attributable to an outsourced development project in 2002 that resulted in higher contractor fees of approximately $406,000 and higher overhead costs of approximately $626,000 in 2002. These decreases were offset by higher personnel expense of approximately $877,000 in 2003 associated with increased headcount of approximately 15 employees.

      General and Administrative. General and administrative expenses in fiscal 2003 increased 25% compared to fiscal 2002. The increase was primarily attributable to an increase of $1.0 million in personnel expense associated with increased headcount of approximately 10 employees and an increase of approximately $178,000 in professional fees for legal services.

      Stock-based Compensation. Stock-based compensation in fiscal 2003 increased 979% compared to fiscal 2002. Total stock-based compensation expense in 2003 consisted of approximately $952,000 of stock-based compensation recorded in connection with the issuance of Series G Preferred Stock, which upon our initial public offering was converted into 271,800 shares of our common stock, to certain of our executive officers and key employees at a discount to the deemed fair value of such stock for financial accounting purposes and $3.7 million of amortization of deferred stock-based compensation.

      The table below sets forth the changes in other items from fiscal 2002 to fiscal 2003 (in thousands, except percentage data):

      Interest expense in fiscal 2003 decreased 14% compared to fiscal 2002. Interest expense paid on our line of credit and loans decreased by approximately $280,000 due to lower average outstanding balances in 2003 compared to 2002. This decrease was offset by approximately $200,000 of amortization of loan discounts associated with warrants granted in connection with our credit facility renewed in March 2003.

      Interest and other income, net increased 47% in fiscal 2003 compared to fiscal 2002. Interest and other income, net consists primarily of interest income on bank and investment balances, which increased due to higher average balances outstanding in 2003 compared to 2002.

      We recorded a provision for income taxes of approximately $267,000 in 2003. The provision relates to income taxes currently payable on income generated in non-U.S. tax jurisdictions and state and federal income taxes payable due to limits on the amount of net operating losses that may be applied against income generated in 2003 under current tax regulations. In 2002, no provision for income taxes was recorded due to our net loss position and no income was generated in non-U.S. tax jurisdictions.

      We recorded a transitional impairment loss of approximately $123,000 in January 2002 upon the adoption of SFAS 142, Goodwill and Other Intangible Assets. The transitional impairment loss was based on an assessment of the implied fair value of goodwill at the time of adoption. The impairment loss reduced the carrying value of goodwill we recorded in connection with our acquisition of The Rob Hand Consulting Group in 1999 to zero as of January 1, 2002.

Liquidity and Capital Resources

      From our inception in September 1996 through our initial public offering in November 2003, we funded our operations primarily through the issuance of convertible preferred stock that provided us with aggregate net proceeds of $84.2 million. In November 2003, we realized net proceeds of $72.1 million from the issuance and sale of common stock in our initial public offering. As of December 31, 2004, we had $7.7 million of cash and cash equivalents and $52.2 million of short-term investments.

      Net Cash Provided by/ Used in Operating Activities. Net cash used in operating activities was $16.5 million in 2004 compared with net cash provided by operating activities of $1.5 million in 2003 and net

cash used in operating activities of $8.8 million in 2002. The significant cash receipts and outlays for the three periods are as follows (in thousands):

      Net cash used in operating activities increased $18.0 million in 2004 compared to 2003. The increase was primarily attributable to an increase in personnel costs of $7.9 million due to an increase of 30% in our average headcount and $2.9 million primarily due to the increased use of outside contractors in our services organization, as well as $3.5 million decrease in cash collection resulting from the decline in our revenues in 2004. Third-party royalty payments also increased in part due to a royalty agreement that required us to make a $1.0 million pre-payment for a third-party software product that is utilized in our software.

      Net Cash Provided by/ Used in Investing Activities. Net cash provided by investing activities was $6.1 million in 2004 compared with net cash used of $67.5 million in 2003 and $668,000 in 2002. Net proceeds from the sale of investments provided $10.0 million in 2004. Our principal use of cash in investing activities during 2003 was in connection with net purchases of investments of $63.2 million. Purchases of equipment, software, furniture and leasehold improvements were $2.3 million, $2.2 million and $657,000 in 2004, 2003 and 2002, respectively, to support the growth in our business and improve our infrastructure. In 2003, we also purchased a perpetual license to software code related to our now terminated TruePerformance product for $2.0 million and, in 2004, we paid an additional $2.0 million to Cezanne Software to acquire an assemble workforce of software developers that worked on our TruePerformance product. The entire TruePerformance development team has now been terminated.

      Net Cash Provided by Financing Activities. Cash provided by financing activities was $0.9 million in 2004 compared with $69.9 million in 2003 and $10.3 million in 2002. In 2004, net cash received from the exercise of stock options and shares purchased under the employee stock purchase plan was $1.5 million, which amount was partially offset by payments of $0.7 million on our outstanding debt. In 2003, net cash provided by financing activities included net cash received from our initial public offering of $72.1 million offset by net payments on our line of credit and long-term debt of $3.5 million. In 2002, net cash provided by financing included net proceeds of $8.9 million from the issuance of preferred stock offset by net payments on our line of credit and long-term debt of $1.3 million.

      The following table summarizes our contractual cash obligations and commercial commitments (in thousands) at December 31, 2004 and the effect such obligations are expected to have on liquidity and cash flow in future periods.

      In 2004, we had access to a revolving line of credit that permitted borrowings of up to $10.0 million. We did not make any borrowings under this line of credit. The line of credit expires in March 2005 and will not be renewed. The line of credit and outstanding loans require us to maintain certain financial covenants. As of December 31, 2004, we were in compliance with all such covenants. We have no off-balance sheet arrangements, with the exception of operating lease commitments that have not been recorded in our consolidated financial statements.

      Other obligations include one letter of credit outstanding at December 31, 2004, totaling approximately $390,000 related to our San Jose office.

      We believe our existing cash balances and credit facilities will be sufficient to meet our anticipated short and long term cash requirements as well as the contractual obligations listed above. Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending to support product development efforts, the expansion of sales and marketing activities, the timing of introductions of new products and enhancement to existing products, and the continuing market acceptance of our products.

Factors That Could Affect Future Results

      We operate in a dynamic and rapidly changing environment that involves numerous risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Annual Report on Form 10-K. Prospective and existing investors are strongly urged to carefully consider the various cautionary statements and risks set forth in this Annual Report on Form 10-K and in our other public filings.

      We incurred net losses of $25.5 million and $19.1 million in fiscal 2004 and 2002, respectively, and had net income of approximately $835,000 in fiscal 2003. While we have taken steps to reduce our expense levels to better track with our revenues we expect to incur a loss in fiscal 2005 and cannot assure you that we will be able to achieve and sustain profitability on a quarterly or annual basis. If we cannot increase our quarterly license revenues, our future results of operations and financial condition will be harmed.

      We have recently engaged an executive search firm for purposes of hiring a permanent chief executive officer and are also in the process of hiring a new vice president of sales. In June 2004, Reed D. Taussig, who had served as our president and chief executive officer since 1997, resigned from Callidus and its board of directors and David B. Pratt, who joined our board of directors in May 2004, was appointed interim president and chief executive officer. In September 2004, Daniel J. Welch, senior vice president of EMEA and general

manager of TruePerformance left the company and in February 2005, Christopher W. Cabrera, senior vice president, operations, also resigned. In addition, other recent changes included promoting Richard Furino to vice president, client services in April 2004.

      Our success will depend to a significant extent on our ability to hire an effective chief executive officer and vice president of sales, to assimilate these changes in our leadership team and to retain the services of our executive officers, and other key employees. If we lose the services of one or more of our executives or key employees, if we fail to successfully hire an effective chief executive officer and vice president of sales and assimilate these changes in our management team or if one or more of our executives or key employees decides to join a competitor or otherwise compete directly or indirectly with us, this could harm our business and could affect our ability to successfully implement our business plan.

      Our revenues, particularly our license revenues, are difficult to forecast and are likely to fluctuate significantly from quarter to quarter due to a number of factors, many of which are outside of our control. For example, in fiscal 2004, our license revenues were substantially lower than expected due to delays in purchasing by our customers and failures to close transactions resulting in a net loss for the year.

      Factors that may cause our quarterly revenue and operating results to fluctuate include:

      In addition, we make assumptions and estimates as to the timing and amount of future revenues in budgeting our future operating costs and capital expenditures. Specifically, our sales personnel monitor the status of all proposals, including the estimated closing date and potential dollar amount of such transactions. We aggregate these estimates periodically to generate our sales forecasts and then evaluate the forecasts to identify trends in our business. Although we have reduced our expenses for future quarters to better align our

costs with expected revenues, our costs are relatively fixed in the short term and a substantial portion of our license revenue contracts are completed in the latter part of a quarter. As a result, failure to complete one or more license transactions at the end of a quarter would cause our quarterly results of operations to be worse than anticipated, which could adversely affect our stock price.

      If we are unable to substantially increase our license revenues, we many be unable to achieve and sustain profitability. Our quarterly license revenues are dependent upon a relatively small number of transactions involving sales of our products to new customers, and to date recurring license revenues from existing customers have not comprised a substantial part of our revenues. As such, variations in the rate and timing of conversion of our sales prospects into revenues could result in our failure to meet revenue objectives in future periods, as has been the case in fiscal 2004. In addition, based upon the terms of our customer contracts, we recognize the bulk of our license revenues for a given sale either at the time we enter into the agreement and deliver the product, or over the period in which we perform any services that are essential to the functionality of the product. Unexpected changes in the size of transactions or other contractual terms late in the negotiation process or changes in the mix of contracts we enter into could therefore materially and adversely affect our license revenues in a quarter. Delays or reductions in the amount of customers’ purchases would adversely affect our revenues, results of operations and financial condition and could cause our stock price to decline.

      The trading price of our common stock has in the past and may in the future be subject to wide fluctuations in response to a number of factors, including those listed in this “Risk Factors” section of this Annual Report on Form 10-K and others such as:

      For example, following our preliminary announcement of anticipated quarterly revenues and operating results in March 2004, and the resignation of our chief executive officer and our announcement regarding operating results for the quarter ended June 30, 2004, our stock price declined dramatically. Any further adverse announcement about our business or adverse developments in our market, or the economy generally could cause our stock price to decline further.

      The sales cycles for our products have historically been between six and twelve months for the majority of our sales, and in some cases have taken longer. In addition, we have recently been experiencing lengthening of our selling cycles. It is therefore difficult to predict the quarter in which a particular sale will occur and to plan our expenditures accordingly. The period between our initial contact with a potential customer and its purchase of our products and services is relatively long due to several factors, including:

      The delay or failure to complete sales in a particular quarter would reduce our revenues in that quarter, as well as any subsequent quarters over which revenues for the sale would likely be recognized. If our sales cycle unexpectedly lengthens in general or for one or more large orders, it would adversely affect the timing of our revenues. If we continue to experience delays on one or more large orders, as we have in fiscal 2004, our operating results will continue to be adversely affected.

      While we experienced a sharp decline in license revenues in fiscal 2004, our maintenance and service revenues were largely in line with our expectations. A substantial portion of our maintenance and services revenues are derived from providing professional integration and configuration services associated with product licenses sold in prior periods. As such, if we are unable to increase sales of our product licenses, our services revenue will decline as well.

      Our ability to successfully implement our business plan and comply with regulations, including Sarbanes-Oxley Act of 2002, requires an effective planning and management process. We expect that we will need to continue to improve existing, and implement new, operational and financial systems, procedures and controls to manage our business effectively in the future. Any delay in the implementation of, or disruption in the transition to, new or enhanced systems, procedures or controls, could harm our ability to accurately forecast sales demand, manage our supply chain and record and report financial and management information on a timely and accurate basis.

      Our maintenance and service revenues, which include fees for consulting, implementation, maintenance and training, were 78%, 48% and 63% of our revenues in fiscal years 2004, 2003 and 2002, respectively. Our maintenance and service revenues have substantially lower gross margins than our license revenues. The decrease in the percentage of total revenues represented by license revenues in fiscal 2004 as compared to

fiscal 2003 adversely affected our overall gross margins and contributed to a net loss for the year. Failure to increase our higher margin license revenues in the future would again adversely affect our gross margin and operating results.

      Maintenance and service revenues as a percentage of total revenues have varied significantly from period to period due to fluctuations in licensing revenues, economic changes, change in the average selling prices for our products and services, our customers’ acceptance of our products and our sales force execution. In addition, the volume and profitability of services can depend in large part upon:

We expect maintenance and services revenue to continue to make up a substantial majority of our overall revenues for the foreseeable future and any erosion of our margins for our maintenance and service revenues would adversely affect our operating results.

      Our ability to successfully implement our business plan and comply with regulations, including Sarbanes-Oxley Act of 2002, requires an effective planning and management process. We expect that we will need to continue to improve existing, and implement new, operational and financial systems, procedures and controls to manage our business effectively in the future. Any delay in the implementation of, or disruption in the transition to, new or enhanced systems, procedures or controls, could harm our ability to accurately forecast sales demand, manage our supply chain and record and report financial and management information on a timely and accurate basis.

      Our customers may require large, enterprise-wide deployments of our products, which require a substantial degree of technical implementation and support. It may be difficult for us to manage the timeliness of these deployments and the allocation of personnel and resources by us or our customers. Failure to successfully manage this process could harm our reputation and cause us to lose existing customers, face potential customer disputes or limit the number of new customers that purchase our products, which could adversely affect our revenues and increase our technical support and litigation costs.

      Our software license customers have the option to receive implementation, maintenance, training and consulting services from our internal professional services organization or from outside consulting organizations. In the future, we may be required to increase our use of third-party service providers to help meet our implementation and service obligations. If we require a greater number of third-party service providers than we currently have available, we will be required to negotiate additional arrangements, which may result in lower gross margins for maintenance or service revenues.

      If a customer selects a third-party implementation service provider and such implementation services are not provided successfully and in a timely manner, our customers may experience increased costs and errors, which may result in customer dissatisfaction and costly remediation and litigation, any of which could adversely impact our operating results and financial condition.

      The enterprise application software market is characterized by:

      To keep pace with technological developments, satisfy increasingly sophisticated customer requirements and achieve market acceptance, we must enhance and improve existing products and we must also continue to introduce new products and services. Accelerated product introductions and short product life cycles require high levels of expenditures for research and development that could adversely affect our operating results. Further, any new products we develop may not be introduced in a timely manner and may not achieve the broad market acceptance necessary to generate significant revenues. For example, we introduced our TruePerformance product in the first quarter of 2003 and discontinued this product in June 2004 due to an effort to focus our efforts on our core business and reduce expenses in light of the substantial declines in our license revenues. In connection with the discontinuation of the TruePerformance product line, we recorded impairment and restructuring charges of approximately $5.3 million in the third quarter of 2004. If we are unable to successfully develop new products or enhance and improve our existing products or if we fail to position and/or price our products to meet market demand, our business and operating results will be adversely affected.

      We derive a substantial majority of our revenues from TrueComp and related products and services, and revenues from these products and services are expected to continue to account for a substantial majority of our revenues for the foreseeable future. Because we generally sell licenses to our products on a perpetual basis and deliver new versions and enhancements to customers who purchase maintenance contracts, our future license revenues are substantially dependent on sales to new customers. In addition, substantially all of our TrueInformation product sales have historically been made in connection with TrueComp sales. As a result of these factors, we are particularly vulnerable to fluctuations in demand for TrueComp. Accordingly, if demand for TrueComp and related products and services declines significantly, our business and operating results will, as was in the case in 2004, be adversely affected.

      Our products are complex and, accordingly, they may contain errors, or “bugs,” that could be detected at any point in their product life cycle. Errors in our products could materially and adversely affect our reputation, result in significant costs to us and impair our ability to sell our products in the future. Customers relying on our products to calculate and pay incentive compensation may have a greater sensitivity to product errors and security vulnerabilities than customers for software products in general. The costs incurred in correcting any product errors may be substantial and would adversely affect our operating margins. While we plan to continually test our products for errors and work with customers through our customer support services organization to identify and correct bugs, errors in our products may be found in the future.

      Because our customers depend on our software for their critical business functions, any interruptions could result in:

      While our software license agreements typically contain limitations and disclaimers that purport to limit our liability for damages for errors in our software, such limitations and disclaimers may not be enforced by a court or other tribunal or otherwise effectively protect us from such claims.

      We have experienced, and expect to continue to experience, intense competition from a number of software companies. We compete principally with vendors of EIM software, enterprise resource planning software, and customer relationship management software. Our competitors may announce new products, services or enhancements that better meet the needs of customers or changing industry standards. Increased competition may cause price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on our business, results of operations and financial condition.

      Many of our enterprise resource planning competitors and other potential competitors have significantly greater financial, technical, marketing, service and other resources than we have. Many of these companies also have a larger installed base of users, longer operating histories or greater name recognition than we have. Some of our competitors’ products may also be more effective than our products at performing particular EIM system functions or may be more customized for particular customer needs in a given market. Even if our competitors provide products with more limited EIM system functionality than our products, these products may incorporate other capabilities, such as recording and accounting for transactions, customer orders or inventory management data. A product that performs these functions, as well as some of the functions of our software solutions, may be appealing to some customers because it would reduce the number of different types of software used to run their business. Further, our competitors may be able to respond more quickly than we can to changes in customer requirements.

      Our products must be integrated with software provided by a number of our existing or potential competitors. These competitors could alter their products in ways that inhibit integration with our products, or they could deny or delay access by us to advance software releases, which would restrict our ability to adapt our products to facilitate integration with these new releases and could result in lost sales opportunities.

      The intensely competitive market in which we do business may require us to reduce our prices. If our competitors offer deep discounts on certain products or services in an effort gain market share or to sell other software or hardware products, we may be required to lower prices or offer other favorable terms to compete successfully. Any such changes would be likely to reduce our margins and could adversely affect our operating results. Some of our competitors may bundle software products that compete with ours for promotional purposes or as a long-term pricing strategy or provide guarantees of prices and product implementations. These practices could, over time, limit the prices that we can charge for our products. If we cannot offset price reductions with a corresponding increase in the number of sales or with lower spending, then the reduced revenues resulting from lower prices would adversely affect our margins and operating results.

      Many of our potential customers have begun to outsource technology projects offshore to take advantage of lower labor costs, and we believe that this trend will continue. Due to the lower labor costs in some countries, these customers may demand lower hourly rates for the professional services we provide, which may erode our margins for our maintenance and service revenues or result in lost business.

      We depend on our direct sales force for most of our sales and have made significant expenditures in past periods to expand our sales force. Despite our efforts to expand our sales force, however, we have also experienced sales force attrition. For example, our head of sales, resigned effective February 28, 2005. While it is our goal to hire and retain qualified replacements, we face intense competition for sales personnel in the software industry, and cannot be sure that we will be successful in hiring a new vice president of sales or retaining key sales individuals in accordance with our plans. If we fail to successfully maintain a strong sales force, our future sales will be adversely affected.

      We have relationships with third-party consulting firms, systems integrators and software vendors. These third parties may provide us with customer referrals, cooperate with us in marketing our products and provide our customers with systems implementation services or overall program management. However, we do not have formal agreements governing our ongoing relationship with certain of these third-party providers and the agreements we do have generally do not include obligations with respect to generating sales opportunities or cooperating on future business. Should any of these third parties go out of business or choose not to work with us, we may be forced to increase the development of those capabilities internally, incurring significant expense and adversely affecting our operating margins. Any of our third-party providers may offer products of other companies, including products that compete with our products. We could lose sales opportunities if we fail to work effectively with these parties or they choose not to work with us.

      We may in the future acquire or make investments in other complementary companies, products, services and technologies. Such acquisitions and investments involve a number of risks, including:

      These factors could have a material adverse effect on our business, results of operations and financial condition or cash flows, particularly in the case of a larger acquisition or multiple acquisitions in a short period of time. From time to time, we may enter into negotiations for acquisitions or investments that are not ultimately consummated. Such negotiations could result in significant diversion of management time, as well as out-of-pocket expenses.

      The consideration paid in connection with an investment or acquisition also affects our financial condition and operating results. If we were to proceed with one or more significant acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available cash to consummate such acquisitions. To the extent we issue shares of stock or other rights to purchase stock, including options or other rights, existing stockholders may be diluted and earnings per share may decrease. In addition, acquisitions may result in the incurrence of debt, large one-time write-offs (such as of acquired in-process research and development costs) and restructuring charges. They may also result in goodwill and other intangible assets that are subject to impairment tests, which could result in future impairment charges.

      For instance, in December 2003, we purchased a non-exclusive license to copy, create, modify, and enhance the source code for our TruePerformance product, and in May 2004, we acquired a part of the development team of Cezanne Software in order to continue the development of the TruePerformance product. However, given our lower revenue projections and our plan to lower expenses, we made the decision to discontinue the TruePerformance product in June of 2004 and recorded a total impairment of intangible assets charge of $3.8 million as well as restructuring charges of approximately $1.5 million.

      Our success depends on our ability to hire, train and retain qualified employees and to manage our employee base effectively. Competition for qualified personnel is intense, particularly in the San Francisco Bay area where our headquarters is located, and the high cost of living increases our recruiting and compensation costs. We cannot assure you that we will be successful in hiring, training or retaining qualified personnel. If we are unable to do so, our business and operating results will be adversely affected.

      In July 2004, a purported class action lawsuit was filed against us and certain of our current directors and officers, by or on behalf of persons claiming to be our shareholders and persons claiming to have purchased or otherwise acquired our securities during the period from November 19, 2003 through June 23, 2004. In addition, in each of July and October 2004 derivative lawsuits were filed against us and certain of our current directors and officers. In February 2005, the parties stipulated to a stay of the state derivative case in favor of the federal derivative case. In February 2005, the Company filed a motion to dismiss the amended complaint. The court has scheduled a hearing on the Company’s motion for May 6, 2005. Additional lawsuits may be filed against us in the future. We currently have director and officer insurance to cover claims that may arise in connection with these lawsuits and we believe that the claims are without merit. However, in the event of an adverse result in one of these cases, the Company’s insurance may not be sufficient to satisfy a damage award and thus such an adverse result could have a material negative financial impact on the Company. Regardless of the outcome of any of these actions, however, it is likely that such actions will cause a diversion of our management’s time and attention.

      We rely on a combination of copyrights, trademarks, service marks, trade secret laws and contractual restrictions to establish and protect our proprietary rights in our products and services. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Despite our precautions, it may be possible for unauthorized third parties to copy our products and use information that we regard as proprietary to create products and services that compete with ours. Some license provisions protecting against unauthorized use, copying, transfer and disclosure of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries. Further, the laws of some countries do not protect proprietary rights to the same extent as the laws of the United States. To the extent that we engage in international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase.

      We enter into confidentiality or license agreements with our employees and consultants and with the customers and corporations with whom we have strategic relationships and business alliances. No assurance can be given that these agreements will be effective in controlling access to and distribution of our products and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our products. Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management resources, either of which could seriously harm our business.

      From time to time, we receive claims that our products or business infringe or misappropriate the intellectual property of third parties. Our competitors or other third parties may challenge the validity or scope of our intellectual property rights. We believe that software developers will be increasingly subject to claims of infringement as the functionality of products in our market overlaps. A claim may also be made relating to technology that we acquire or license from third parties. If we were subject to a claim of infringement, regardless of the merit of the claim or our defenses, the claim could:

      We may also be required to indemnify our customers and third-party systems integrators for third-party products that are incorporated into our products and that infringe the intellectual property rights of others. Although many of these third parties are obligated to indemnify us if their products infringe the rights of others, this indemnification may not be adequate.

      In addition, from time to time there have been claims challenging the ownership of open source software against companies that incorporate open source software into their products. We use a limited amount of open source software in our products and may use more open source software in the future. As a result, we could be subject to suits by parties claiming ownership of what we believe to be open source software. Any of this litigation could be costly for us to defend, have a negative effect on our results of operations and financial condition or require us to devote additional research and development resources to change our products.

      We license technology from several software providers for our rules engine, analytics and web viewer. We anticipate that we will continue to license technology from third parties in the future. This software may not continue to be available on commercially reasonable terms, if at all. Some of the products we license from third parties could be difficult to replace, and implementing new software with our products could require six months or more of design and engineering work. The loss of any of these technology licenses could result in delays in the license of our products until equivalent technology, if available, is developed or identified, licensed and integrated. In addition, our products depend upon the successful operation of third-party products in conjunction with our products, and therefore any undetected errors in these products could prevent the implementation or impair the functionality of our products, delay new product introductions and/or injure our reputation. Our use of additional or alternative third-party software would require us to enter into license agreements with third parties, which could result in higher royalty payments and a loss of product differentiation.

      Some potential customers may have already made a substantial investment in other third-party or internally developed software designed to model, administer, analyze and report on pay-for-performance programs. These companies may be reluctant to abandon these investments in favor of our software. In addition, information technology departments of potential customers may resist purchasing our software solutions for a variety of other reasons, particularly the potential displacement of their historical role in creating and running software and concerns that packaged software products are not sufficiently customizable for their enterprises. If the market for our products does not grow for any of these reasons, our revenues may be harmed.

      If one or more of our competitors were to merge or partner with another of our competitors, the change in the competitive landscape could adversely affect our ability to compete effectively. Our competitors may also establish or strengthen cooperative relationships with our current or future systems integrators, third-party compensation consulting firms or other parties with whom we have relationships, thereby limiting our ability to promote our products and limiting the number of consultants available to implement our software. Disruptions in our business caused by these events could reduce our revenues.

      We may in the future expand our international operations. Any international expansion would require substantial financial resources and a significant amount of attention from our management. International operations involve a variety of risks, particularly:

      We have limited experience in marketing, selling and supporting our products and services abroad. If we invest substantial time and resources in order to grow our international operations and are unable to do so successfully and in a timely manner, our business and operating results could be seriously harmed.

      Our business communications, infrastructure and facilities are vulnerable to damage from human error, physical or electronic security breaches, power loss and other utility failures, fire, earthquake, flood, sabotage, vandalism and similar events. Although the source code for our software products is held by escrow agents outside of the San Francisco Bay Area, our internal-use software and back-up are both located in the San Francisco Bay Area. If a natural or man-made disaster were to hit this area, we may lose all of our internal-use software data. Despite precautions, a natural disaster or other incident could result in interruptions in our service or significant damage to our infrastructure. In addition, failure of any of our telecommunications providers could result in interruptions in our services and disruption of our business operations. Any of the foregoing could impact our provision of services and fulfillment of product orders, and our ability to process product orders and invoices and otherwise timely conduct our business operations.

      Our current officers, directors and entities affiliated with us together beneficially owned a significant portion of the outstanding shares of common stock as of December 31, 2004. As a result, if some of these persons or entities act together, they have the ability to control all matters submitted to our stockholders for approval, including the election and removal of directors, amendments to our certificate of incorporation and bylaws and the approval of any business combination. This may delay or prevent an acquisition or cause the market price of our stock to decline. Some of these persons or entities may have interests different than yours.

      Our certificate of incorporation and bylaws contain provisions that could make it harder for a third party to acquire us without the consent of our board of directors. For example, if a potential acquirer were to make a hostile bid for us, the acquirer would not be able to call a special meeting of stockholders to remove our board of directors or act by written consent without a meeting. In addition, our board of directors has staggered terms, which means that replacing a majority of our directors would require at least two annual meetings. The acquirer would also be required to provide advance notice of its proposal to replace directors at any annual meeting, and would not be able to cumulate votes at a meeting, which would require the acquirer to hold more shares to gain representation on the board of directors than if cumulative voting were permitted. In addition, we are a party to a stockholder rights agreement, which effectively prohibits person from acquiring more than 15% (subject to certain exceptions) of our common stock without the approval of our board of directors.

      Furthermore, Section 203 of the Delaware General Corporation Law limits business combination transactions with 15% stockholders that have not been approved by the board of directors. All of these factors make it more difficult for a third party to acquire us without negotiation. These provisions may apply even if the offer may be considered beneficial by some stockholders.

      Our board of directors could choose not to negotiate with an acquirer that it did not believe was in our strategic interests. If an acquirer is discouraged from offering to acquire us or prevented from successfully completing a hostile acquisition by these or other measures, you could lose the opportunity to sell your shares at a favorable price.

      Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in interest rates and foreign exchange rates. We do not hold or issue financial instruments for trading purposes.

      Interest Rate Risk. We invest our cash in a variety of financial instruments, consisting primarily of investments in money market accounts, high quality corporate debt obligations or United States government obligations. Our investments are made in accordance with an investment policy approved by our Board of Directors. All of our investments are classified as available-for-sale and carried at fair value, which is determined based on quoted market prices, with net unrealized gains and losses included in “Accumulated other comprehensive income” in the accompanying consolidated balance sheets.

      Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities, that typically have a shorter duration, may produce less income than expected if interest rates fall. Due in part to these factors, our investment income may decrease in the future due to changes in interest rates. At December 31, 2004, the average maturity of our investments was approximately seven months and all investment securities had maturities of less than twenty-four months. The following table presents certain information about our financial instruments at December 31, 2004 that are sensitive to changes in interest rates (in thousands, except for interest rates):

      Our exposure to market risk also relates to the increase or decrease in the amount of interest expense we must pay on our outstanding debt instruments. We had a revolving line of credit that expired in March 2005 for borrowings up to $10.0 million and outstanding term loans with variable interest rates based on the lender’s prime rate and prime rate plus 0.50%, respectively. The risk associated with fluctuating interest expense is limited to these debt instruments. Due to our outstanding debt balance of $0.5 million as of December 31, 2004, we do not believe that any change in the prime rate would have a significant impact on our interest expense.

      Foreign Currency Exchange Risk. Our revenues and our expenses, except those related to our United Kingdom, German and Australian operations, are generally denominated in United States dollars. For the year ended December 31, 2004, we earned approximately 9% of our revenue from our international operations. As a result, we have relatively little exposure to currency exchange risks and foreign exchange losses have been minimal to date. We expect to continue to do a majority of our business in United States dollars. We have not entered into forward exchange contracts to hedge exposure denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. In the future, if we believe our foreign currency exposure has increased, we may consider entering into hedging transactions to help mitigate that risk.

      The response to this item is submitted as a separate section of this Annual Report on Form 10-K beginning on page F-1.

      None.

Item 9A.                           Controls and Procedures

      Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Annual Report on Form 10-K, have concluded that as of the end of the period covered by this report, our disclosure controls and procedures were adequate and designed to ensure that material information related to us and our consolidated subsidiaries would be made known to them by others within these entities.

      None.

PART III

      Certain information required by Part III of Form 10-K is omitted from this Annual Report on Form 10-K because we will file a definitive proxy statement within 120 days after the end of our fiscal year pursuant to Regulation 14A for our annual meeting of stockholders, currently scheduled for June 7, 2005, and the information included in the proxy statement shall be incorporated herein by reference when it is filed with the Securities and Exchange Commission.

PART IV

      (a) Consolidated financial statements, consolidated financial statements schedule and exhibits

INDEX TO EXHIBITS

SIGNATURES

      Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused report to be signed on its behalf by the undersigned thereunto duly authorized on March 29, 2005.

      Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated below.

CALLIDUS SOFTWARE INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Callidus Software Inc.

      We have audited the accompanying consolidated balance sheets of Callidus Software Inc. and subsidiaries (the Company) as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

      We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

      In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Callidus Software Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America.

Mountain View, California

January 19, 2005

CALLIDUS SOFTWARE INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amount)