PHASE FORWARD INC - 10-Q Quarterly Report

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 000-50839

Phase Forward Incorporated

(Exact name of registrant as specified in its charter)


Delaware (State or other jurisdiction of		04-3386549 (I.R.S. Employer
incorporation or organization)		Identification No.)

880 Winter Street		02451
Waltham, Massachusetts
(Address of principal executive offices)		(Zip Code)

(888) 703-1122
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes o No x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

Yes o No x

As of July 30, 2004, the registrant had 31,902,226 shares of Common Stock outstanding.

Part I – Financial Information

Item 1. Condensed Consolidated Financial Statements

Phase Forward Incorporated and Subsidiaries

Condensed Consolidated Balance Sheets

(unaudited)

(in thousands, except per share amounts)


	As of			As of
	December 31,			June 30,
	2003			2004
Assets
Current assets:
Cash and cash equivalents	$	19,046		$	26,370
Accounts receivable, net of allowance of $425 and $477 in 2003 and 2004, respectively		22,947			15,347
Deferred set up costs, current portion		1,115			1,109
Prepaid commissions and royalties, current portion		2,192			3,703
Prepaid expenses and other current assets		1,434			1,922

Total current assets		46,734			48,451

Property and equipment, net		5,299			5,053
Restricted cash, net of current portion		1,611			—
Deferred set up costs, net of current portion		697			672
Prepaid commissions and royalties, net of current portion		2,527			2,359
Goodwill		23,780			22,758
Other assets		196			1,285

Total assets	$	80,844		$	80,578

Liabilities and Stockholders’ (Deficit) Equity
Current Liabilities:
Lines of credit	$	2,500		$	2,500
Current portion of notes payable		2,218			2,684
Accounts payable		947			1,184
Accrued expenses		10,973			10,577
Restructuring accrual		1,989			1,445
Deferred revenue, current portion		33,050			32,346
Accrued dividend payable		—			4,700

Total current liabilities		51,677			55,436

Notes payable, net of current portion		1,970			2,170
Restructuring accrual, net of current portion		497			—
Deferred revenue, net of current portion		4,738			2,812
Deferred rent		288			960

Total liabilities		59,170			61,378

Commitments and contingencies (Note 8)
Redeemable convertible preferred stock at redemption value		123,951			127,787
Redeemable convertible preferred stock warrant		169			169
Stockholders’ (deficit) equity:
Common stock, $.01 par value:
Authorized—32,804 and 100,000 shares in 2003 and 2004, respectively Issued—3,602 and 3,704 shares in 2003 and 2004, respectively		36			37
Additional paid-in capital		—			—
Subscription receivable		(627	)		(113	)
Deferred stock-based compensation		(2,333	)		(2,922	)
Treasury stock, 37 shares at cost in 2003 and 2004		(111	)		(111	)
Accumulated other comprehensive loss		(500	)		(609	)
Accumulated deficit		(98,911	)		(105,038	)

Total stockholders’ (deficit) equity		(102,446	)		(108,756	)

Total liabilities and stockholders’ (deficit) equity	$	80,844		$	80,578

See accompanying notes.

Phase Forward Incorporated and Subsidiaries

Condensed Consolidated Statements of Operations

(unaudited)

(in thousands, except per share amounts)


	Three Months						Six Months
	Ended						Ended
	June 30,						June 30,
	2003			2004			2003			2004
Revenues:
License	$	5,164		$	6,357		$	9,930		$	12,523
Service		9,512			11,336			19,693			22,132

Total revenues		14,676			17,693			29,623			34,655
Costs of revenues:
License		681			448			1,329			870
Service(1)		6,837			6,842			14,187			13,623

Total cost of revenues		7,518			7,290			15,516			14,493
Gross margin:
License		4,483			5,909			8,601			11,653
Service		2,675			4,494			5,506			8,509

Total gross margin		7,158			10,403			14,107			20,162

Operating expenses:
Sales and marketing(1)		3,258			3,536			6,431			6,841
Research and development(1)		2,609			3,018			5,192			5,954
General and administrative(1)		2,424			2,903			5,042			5,546

Total operating expenses		8,291			9,457			16,665			18,341

Income (loss) from operations		(1,133	)		946			(2,558	)		1,821
Other income (expense):
Interest income		31			67			59			172
Interest expense		(93	)		(128	)		(185	)		(210	)
Other income (expense)		306			87			143			71

Total other income		244			26			17			33

Income (loss) before provision for income taxes		(889	)		972			(2,541	)		1,854
Provision for income taxes		33			542			136			1,041

Net income (loss)		(922	)		430			(2,677	)		813
Accretion of preferred stock and dividend declared		1,918			6,618			3,836			8,536

Net loss applicable to common stockholders	$	(2,840	)	$	(6,188	)	$	(6,513	)	$	(7,723	)

Net loss per share applicable to common stockholders - basic and diluted	$	(0.85	)	$	(1.70	)	$	(1.95	)	$	(2.15	)

Weighted average number of common shares used in net loss per share calculations — basic and diluted		3,348			3,646			3,332			3,598

(1) Amounts include stock based expenses, as follows:
Costs of service revenues	$	2		$	24		$	2		$	50
Sales and marketing		20			40			25			79
Research and development		40			83			41			179
General and administrative		—			326			—			611

Total stock based expenses	$	62		$	473		$	68		$	919

See accompanying notes.

Phase Forward Incorporated and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(unaudited)

(in thousands)


	Six Months Ended
	June 30,
	2003			2004
Operating activities
Net income (loss)	$	(2,677	)	$	813
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		2,820			1,492
Stock-based compensation		68			919
Foreign currency exchange gain		(145	)		(38	)
Provision for allowance for doubtful accounts		—			65
Non-cash income tax expense		—			1,022
Deferred rent		(30	)		664
Changes in assets and liabilities:
Accounts receivable		5,836			7,495
Deferred costs		(345	)		(1,310	)
Prepaid expenses and other current assets		32			(474	)
Accounts payable		(530	)		229
Accrued expenses		(790	)		(1,465	)
Deferred revenue		(3,096	)		(2,647	)

Net cash provided by operating activities		1,143			6,765

Investing activities
Purchase of property and equipment		(1,795	)		(1,240	)
Decrease in restricted cash, net		310			1,611
Decrease (increase) in other assets		182			(13	)

Net cash provided by (used in) investing activities		(1,303	)		358

Financing activities
Proceeds from issuance of notes payable and borrowings under lines of credit		681			1,932
Payments on lines of credit and notes payable		(1,911	)		(1,266	)
Stock issuance costs		—			(1,075	)
Repurchase of restricted common stock		(111	)		—
Proceeds from issuance of common stock		80			90
Proceeds from repayment of subscriptions receivable		—			514

Net cash provided by (used in) financing activities		(1,261	)		195

Effect of exchange rate changes on cash and cash equivalents		162			6

Net change in cash and cash equivalents		(1,259	)		7,324
Cash and cash equivalents at beginning of year		17,960			19,046

Cash and cash equivalents at end of period	$	16,701		$	26,370

Non-cash financing activities
Accretion of Series B, C, and D redeemable convertible preferred stock to redemption value	$	3,836		$	3,836

Declaration of Special Dividend	$	—		$	4,700

See accompanying notes.

Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements
(unaudited)
(in thousands, except share and per share amounts)

1. Organization and Basis of Presentation

Organization

Phase Forward Incorporated (the “Company”) is a provider of integrated enterprise-level electronic data capture, data management and adverse event reporting software solutions for use in the clinical trial component of the Company’s customers’ global research and development initiatives. The Company offers software products, services and hosted solutions to pharmaceutical, biotechnology and medical device companies, as well as academic institutions, clinical research organizations and other entities engaged in clinical trials.

The Company has operations in the United States, United Kingdom, France, Germany, Japan and Australia.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements included herein have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted pursuant to such SEC rules and regulations. Nevertheless, the management of the Company believes that the disclosures herein are adequate to make the information presented not misleading. In the opinion of management, the unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and reflect all material adjustments (consisting only of those of a normal and recurring nature) which are necessary to present fairly the consolidated financial position of the Company as of June 30, 2004, the results of its operations for the three and six months ended June 30, 2003 and 2004 and its cash flows for the six months ended June 30, 2003 and 2004. These condensed consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Registration Statement No. 333-113594 on Form S-1. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the year ending December 31, 2004.

On July 15, 2004, the Company sold 5,250,000 shares of common stock at $7.50 per share in an initial public offering (IPO) resulting in net proceeds of $34,600 after deducting underwriters’ discounts and estimated offering-related expenses. These proceeds were received by the Company on July 20, 2004. In connection with the IPO, all of the outstanding shares of the Company’s preferred stock (and a warrant to purchase preferred stock) were converted into an equal number of shares of common stock (and a warrant to purchase common stock). Because the offering closed after June 30, 2004, the results of the offering are not reflected in the accompanying unaudited condensed consolidated financial statements. A summary of the terms of the offering can be found in the Company’s Registration Statement No. 333-113594 on Form S-1 as filed with the SEC.

Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

2. Accounting Policies

Principles of Consolidation

The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

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

Revenue Recognition and Deferred Setup Costs

The Company derives revenues from software licenses and services. License revenue is derived principally from the sale of multi-year software term licenses of the Company’s InForm, Clintrial and Clintrace software products. Service revenue is derived from the Company’s delivery of the hosted solution of its InForm software product, consulting services and customer support, including training.

The components of revenue are as follows:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2003		2004		2003		2004
License	$	5,164	$	6,357	$	9,930	$	12,523
Application hosting services		4,899		6,689		10,102		12,601
Consulting services		1,147		1,215		2,319		2,779
Customer support		3,466		3,432		7,272		6,752

Total	$	14,676	$	17,693	$	29,623	$	34,655

The Company recognizes software license revenue in accordance with Statement of Position (SOP) No. 97-2, Software Revenue Recognition, as amended, issued by the American Institute of Certified Public Accountants, while revenues resulting from application hosting services are recognized in accordance with Emerging Issues Task Force (EITF) Issue No. 00-03 Application of AICPA Statement of Position 97-2 to Arrangements that include the Right to Use Software Stored on Another Entity’s Hardware and Securities and Exchange Commission’s (SEC) Staff Accounting Bulletin (SAB) Nos. 101 and No. 104, Revenue Recognition. On August 1, 2003, the Company adopted EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. This adoption did not have, and is not expected to have in future reporting periods, a material impact on the Company’s financial position or results of operations.

Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

Customers generally have the ability to terminate application hosting, consulting and training service agreements upon 30 days notice to the Company. Multiple element arrangements, including license and services agreements, and certain application hosting services can generally be terminated by either party for material breach of obligations generally not corrected within 30 days after notice of the breach.

The Company recognizes revenue when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service has been provided to the customer; (3) the collection of fees is probable; and (4) the amount of fees to be paid by the customer is fixed or determinable.

The Company generally enters into software term licenses with its customers for three to five year periods. These arrangements typically include multiple elements: a software license, consulting services and customer support. The Company bills its customers in accordance with the terms of the underlying contract. Generally, the Company bills the annual license fee for the first year of a multi-year contract in advance and bills the license fees for the subsequent years on the anniversary date. The Company’s payment terms are generally net 30 days.

The Company’s software license revenue is earned from the sale of off-the-shelf software requiring no significant modification or customization subsequent to delivery to the customer. Consulting services, which can also be performed by third-party consultants, are deemed to be non-essential to the functionality of the software and typically are for trial configuration, implementation planning, loading of software, building simple interfaces and running test data and documentation of procedures.

The Company generally bundles customer support with the software license for the entire term of the license. As a result, the Company generally recognizes revenues for all elements, including consulting services, ratably over the term of the software license and support arrangement. The Company allocates the revenue recognized for these arrangements to the different elements based on management’s estimate of the relative fair value of each element. For its term-based licenses, the Company allocates to consulting services the anticipated service effort and value throughout the term of the arrangement at an amount that would have been allocated had those services been sold separately to the customer. The remaining value is allocated to license and support services, with 10% of this amount allocated to support services. The Company has allocated the estimated fair value to its multiple element arrangements to provide meaningful disclosures about each of its revenue streams. The costs associated with the consulting and customer support services are expensed as incurred. There are instances in which the Company sells software licenses based on usage levels. These software licenses can be based on estimated usage, in which case the license fee charged to the customer is fixed based on this estimate. When the fee is fixed, the revenue is recognized ratably over the contractual term of the arrangement. If the fee is based on actual usage, and therefore variable, the revenue is recognized in the period of use. Revenues from certain follow-on consulting services, which are sold separately to customers with existing software licenses and are not considered part of a multiple element arrangement, are recognized as the services are performed.

In addition to making its software products available to customers through licenses, the Company offers its InForm electronic data capture software product through a fully-hosted, turnkey deployment. Revenues resulting from application hosting services consist of three stages for each clinical trial. The first stage includes trial and application setup, including design of electronic case report forms and edit checks, implementation of the system and server configuration. The second

Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

stage consists of application hosting and related support services. The third stage, database lock, consists of services required to close out, or lock, the database for the clinical trial. Services provided for the first and third stages are provided on a fixed fee based upon the complexity of the trial and system requirements. Services for the second stage are charged separately as a fixed monthly fee. The Company recognizes revenue from application hosting and related services over the hosting period. Fees charged and costs incurred for the trial system design, setup and implementation are deferred and capitalized as applicable, until the start of the hosting period. These revenues and costs are recognized and amortized, as applicable, ratably over the estimated hosting period. The capitalized costs include incremental direct costs with third parties and certain internal direct costs of the trial and application setup, as defined under Statement of Financial Accounting Standards (SFAS) No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Indirect Costs of Leases. These costs include salary and benefits associated with direct labor costs incurred during trial setup, as well as third-party subcontract fees and other contract labor costs. Work performed outside the original scope of work is contracted for separately as an additional fee and is generally recognized over the remaining term of the hosting period.

In the event that an application hosting customer cancels a clinical trial and its related statement of work, all deferred revenue is recognized and all deferred setup costs are expensed and certain termination related fees may be charged.

The Company capitalized $719 and $849 of deferred setup costs and amortized $946 and $880 during the six months ended June 30, 2003 and 2004, respectively. The amortization of deferred setup costs is a component of cost of services.

The Company continues to sell the Clintrial and Clintrace software products to certain existing customers as perpetual software licenses with the option to purchase customer support. The Company does not sell perpetual licenses to new customers. The Company has established vendor specific objective evidence of fair value for the customer support in these arrangements. Accordingly, the license revenue is recognized upon delivery of the software and when all other revenue recognition criteria are met. The customer support is recognized ratably over the term of the underlying support arrangement. The Company continues to generate customer support and maintenance revenue from its perpetual license customer base. Training revenue is recognized as earned.

Deferred revenue represents amounts billed or cash received in advance of revenue recognition.

Provisions for estimated losses on uncompleted contracts are made on a contract-by-contract basis and are recognized in the period in which such losses become probable and can be reasonably estimated. To date, the Company has not experienced any material losses on uncompleted application hosting contracts.

In November 2001, the EITF of the Financial Accounting Standards Board (FASB) issued EITF Issue No. 01-14, Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred. EITF Issue No. 01-14 requires reimbursable out-of-pocket expenses incurred to be characterized as revenue in the income statement. The Company included $526 and $424 of reimbursable out-of-pocket expenses in service revenue and cost of service revenue in the six months ended June 30, 2003 and 2004, respectively.

Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

Prepaid Sales Commissions and Royalties

The Company capitalized $1,278 and $1,580 of commissions and amortized to sales and marketing expense $703 and $1,249 during the six months ended June 30, 2003 and 2004, respectively. The Company capitalized $828 and $2,201 of royalties and amortized to cost of revenues $815 and $1,189 during the six months ended June 30, 2003 and 2004, respectively.

Net Loss Per Share

Basic net loss per common share was determined by dividing net loss applicable to common stockholders by the weighted average common shares outstanding during the period. Weighted average shares outstanding exclude unvested restricted common stock. The Company’s potentially dilutive shares, which include outstanding common stock options, warrants, and redeemable convertible preferred stock also have not been included in the computation of diluted net loss per share for all periods as the result would be anti-dilutive. The calculation of basic and diluted net loss per share is as follows:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2003			2004			2003			2004
Net loss applicable to common stockholders	$	(2,840	)	$	(6,188	)	$	(6,513	)	$	(7,723	)
Computation of basic and diluted net loss per share:
Weighted average shares outstanding		3,421,805			3,676,748			3,410,321			3,633,898
Less: Weighted average unvested restricted common shares outstanding		(73,316	)		(30,399	)		(78,681	)		(35,764	)

Shares used in computing net loss per share		3,348,489			3,646,349			3,331,640			3,598,134

Net loss per share applicable to common stockholders - - basic and diluted	$	(0.85	)	$	(1.70	)	$	(1.95	)	$	(2.15	)

Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

The following common share equivalents and unvested restricted shares have been excluded from the computation of diluted weighted average shares outstanding as of June 30, 2003 and 2004, as they would be anti-dilutive.


	As of June 30,
	2003		2004
Redeemable convertible preferred stock		22,841,157		22,841,157
Options outstanding		4,220,111		4,457,525
Unvested restricted shares		67,971		25,035
Warrant		34,330		34,330

Foreign Currency Translation

The financial statements of the Company’s foreign subsidiaries are translated in accordance with No. 52, Foreign Currency Translation. The reporting currency for the Company is the U.S. dollar (dollar). The functional currency of the Company’s subsidiaries in the United Kingdom, France, Japan and Australia are the local currencies of those countries. Accordingly, the assets and liabilities are translated into U.S. dollars using the exchange rate in effect at each balance sheet date. Revenue and expense accounts are generally translated using an average rate of exchange during the period. Foreign currency translation adjustments are accumulated as a component of other comprehensive loss as a separate component of stockholders’ deficit. Gains and losses arising from transactions denominated in foreign currencies are primarily related to intercompany accounts that have been determined to be temporary in nature and cash and accounts receivable denominated in non–functional currencies. The Company has recorded foreign currency gains of approximately $308 and $54 in the three months ended June 30, 2003 and 2004, respectively, and approximately $145 and $38 in the six months ended June 30, 2003 and 2004, respectively, and such gains are included in other income (expense) in the accompanying condensed consolidated statements of operations.

Cash and Cash Equivalents

The Company accounts for its investments in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Under SFAS No. 115, securities that the Company has the positive intent and ability to hold to maturity are reported at amortized cost, which approximates market value, and are classified as held-to-maturity. The Company considers all highly liquid investments with original maturities of 90 days or less at the time of purchase to be cash equivalents. At December 31, 2003 and June 30, 2004, cash equivalents primarily consisted of money market funds that were readily convertible to cash.

At December 31, 2003, the Company had approximately $1,611 of restricted cash held in certificates of deposit as collateral for letters of credit related to facility leases. The certificates of deposit matured and the collateral for the letters of credit is now reflected as a reduction in the amount available under the line of credit.

Phase Forward Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements (continued)
(unaudited)
(in thousands, except share and per share amounts)

Cash and cash equivalents as of December 31, 2003 and June 30, 2004 were as follows:


	December 31, 2003
Description	Contracted Maturity	Amortized Cost		Fair Market Value
Cash and cash equivalents		$	14,927	$	14,927
Money market funds	0-3 months		4,119		4,119

Total		$	19,046	$	19,046


	June 30, 2004
Description	Contracted Maturity	Amortized Cost		Fair Market Value
Cash and cash equivalents		$	14,897	$	14,897
Money market funds	0-3 months		9,648		9,648
Certificate of deposit	1 month		1,825		1,825

Total		$	26,370	$	26,370

The Company has had no realized gains or losses to date on the sale of money market funds. The numbers contained in the foregoing table do not include $34,600 of net proceeds from the Company’s initial public offering, which were received by the Company on July 20, 2004, after the end of the second quarter of 2004.

Stock-Based Compensation

In January 2003, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123, which provides alternative methods of transition for a voluntary change to


		Page
		Number
Part I — Financial Information
Item 1.	Condensed Consolidated Financial Statements (unaudited);
	Condensed Consolidated Balance Sheets as of December 31, 2003 and June 30, 2004		3
	Condensed Consolidated Statements of Operations for the three months and six months ended June 30, 2003 and 2004		4
	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2003 and June 30, 2004		5
	Notes to Condensed Consolidated Financial Statements		6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		19
Item 3.	Quantitative and Qualitative Disclosures about Market Risk		50
Item 4.	Controls and Procedures		51
Part II — Other Information
Item 1.	Legal Proceedings		52
Item 2.	Change in Securities and Use of Proceeds		52
Item 3.	Defaults upon Senior Securities		53
Item 4.	Submission of Matters to a Vote of Security Holders		53
Item 5.	Other Information		54
Item 6.	Exhibits and Reports on Form 8-K		54
Signatures			55
Exhibit Index			56
SECTION 302 CERTIFICATION CEO
SECTION 302 CERTIFICATION CFO
SECTION 906 CERTIFICATION CEO
SECTION 906 CERTIFICATION CFO

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