(1) Represents minimum payments to one vendor providing outsourced software programming, quality assurance and technical documentation activities in India. The agreement is cancelable with 90 days notice.

Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations

We are a leading provider of Service Resolution Management (SRM) software solutions, primarily, knowledge-powered customer service solutions that provide information to resolve customer inquiries more efficiently, accurately, and consistently. Our applications enable organizations to improve the quality and efficiency of interactions with customers and partners across multiple communication points, including web contact, web collaboration, email, and telephone. As a result, our target market is comprised of large enterprises with a high volume of customer interactions, such as banks, telecommunications companies, high-tech manufacturers, healthcare organizations, and government agencies.

KANA is headquartered in the Silicon Valley in Menlo Park, California, with offices in Japan, Korea, and throughout the United States and Europe. Our revenue is primarily derived from the sale of our software and related maintenance and support of the software. To a lesser extent, we derive revenues from training and consulting. Our products are generally installed by our customers, using a system integrator, such as IBM, Accenture or Bearing Point. To a large degree, we rely on our relationships with these system integrators who co-develop, recommend, and install our software. This provides leverage in the selling phase, and also allows us to realize higher gross margins by selling primarily software licenses and support, which typically have higher margins than consulting and implementation services. However, since our applications are generally installed by our customers using a system integrator, the overall cost of implementing our software can be increased substantially, subjecting the prospective customers' purchase to more levels of required approval and scrutiny of projected cost savings in their customer service and marketing departments. Consequently, we face difficulty predicting the period in which sales to expected customers will occur, if at all, which results in greater uncertainty with respect to our future operating results. To the extent that significant sales occur earlier or later than anticipated, revenues for subsequent quarters may be lower or higher, respectively, than expected.

We have grown rapidly through acquisitions until recent years. These acquisitions provided us with much of the core technology used in our applications. In 2001 through 2003, we substantially reduced the scale of our operations as we began leveraging the service and development capabilities of system integrators, reduced costs and focused our product offerings.

In the past three and a half years, we have experienced a cautious purchasing environment in our industry. We feel that this is largely a reaction to the uncertain economy, which had a disproportionate effect on information technology spending. While general economic conditions began to stabilize and improve in the second half of 2003, we believe that our market continued to exhibit cautiousness and uncertainty and that as a result, many enterprises continued to be reluctant to invest in large software applications, particularly in our industry.

Since 1997, we have incurred substantial costs to develop our products and to recruit, train and compensate personnel for our engineering, sales, marketing, client services and administration departments. As a result, we have incurred substantial losses since inception. For the three and six months ended June 30, 2004, we recorded a net loss of $6.4 million and$10.5 million, respectively. As of June 30, 2004, we had an accumulated deficit of $4.3 billion, which included approximately $2.7 billion related to goodwill impairment charges in prior years. We expect our operating expenses in the second half of 2004 to be lower in absolute dollars than the same period of 2003 as a result of our personnel and facility cost reductions throughout 2003. We expect our cash and cash equivalents and short-term investments on hand will be sufficient to meet our working capital and capital expenditures needs for the next 12 months.

In the first quarter of 2003, we began implementing an outsourcing strategy, which involved subcontracting a significant portion of our software programming, quality assurance and technical documentation activities to Accenture, HCL, IBM and Bearing Point with staffing in India and China.

In November 2003, we announced the completion of an underwritten public offering of 4,080,000 shares of our common stock at a price to the public of $3.00 per share. We offered the common stock under our shelf registration statement. In addition to the 4,080,000 shares sold in the public offering, the underwriter exercised, in full, an option to purchase a maximum of 612,000 additional shares to cover over-allotments of shares. The proceeds from the offering, net of expenses, were approximately $13.1 million.

In February 2004, we completed the acquisition of Hipbone, Inc., a provider of online customer interaction solutions. The total purchase price approximated $1.4 million. As a result of this acquisition, we now offer Hipbone's Web collaboration, chat, co-browsing and file-sharing capabilities.

As of June 30, 2004, we had 206 full-time employees, which represents a slight decrease from 211 employees at December 31, 2003.

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and our related disclosure of contingent assets and liabilities. We continually evaluate our estimates, including those related to revenue recognition, collectibility of receivables, goodwill and intangible assets, income taxes, and restructuring. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. This forms the basis of judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies and the related judgments and estimates significantly affect the preparation of our consolidated financial statements:

Revenue Recognition. Revenue recognition rules for software companies are complex, and various judgments affect the recognition of revenues. The amount and timing of our revenue is difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter and could result in future operating losses.

License revenue is recognized when there is persuasive evidence of an arrangement, delivery to the customer has occurred, the arrangement does not require significant customization or modification of the software, the fee is fixed or determinable, and collectibility is reasonably assured.

In software arrangements that include rights to multiple software products and/or services, we allocate the total arrangement fee using the residual method, under which revenue is allocated to undelivered elements based on vendor-specific objective evidence of fair value of such undelivered elements with the residual amounts of revenue being allocated to the delivered elements. Elements included in multiple element arrangements primarily consist of software products, maintenance (which includes customer support services and unspecified upgrades), or consulting services. Vendor-specific objective evidence for software products and consulting services is based on the price charged when an element is sold separately or, in the case of an element not yet sold separately, the price established by authorized management if it is probable that the price, once established, will not change before market introduction. Vendor-specific objective evidence for maintenance is generally based on stated contractual renewal rates. Evaluating whether sufficient and appropriate vendor- specific objective evidence exists to use in allocating revenue to undelivered elements, and the interpretation of such evidence to determine the fair value of undelivered elements is subject to judgment and estimates that affect when and to what extent we may recognize revenues from a given contractual arrangement.

Probability of collection is based upon assessment of the customer's financial condition through review of their current financial statements or publicly-available credit reports. For sales to existing customers, prior payment history is also considered in assessing probability of collection. We exercise significant judgment in deciding whether collectibility is reasonably assured, and such judgments may materially affect the timing of our revenues and our results of operations.

Customer support revenues arise primarily from providing global support to our customers and partners, including phone and e-mail support and self-service solutions. Customer support service revenues are recognized ratably over the term of the contract, typically one year.

Consulting revenues are generated primarily by providing specific subject matter expertise as opposed to overall project management and are recognized as services are performed.

Revenues from training services are recognized as services are performed.

Collectibility of Receivables. In order to recognize revenue from a transaction, collectibility must be determined by management to be reasonably assured. If collectibility is not determined to be reasonably assured, amounts billed to customers are recorded as deferred revenue. For sales to existing customers, prior payment history is a factor in assessing probability of collection.

We make judgments as to our ability to collect outstanding receivables and provide allowances for receivables that may not be collectible. A considerable amount of judgment is required to assess the ultimate realization of receivables. In assessing collectibility, we consider the age of the receivable, our historical collection experience, current economic trends, and the current credit-worthiness of each customer. In the future, additional provisions for doubtful accounts may be needed and future results of operations could be materially affected.

Reserve for Loss Contract. For professional services arrangements involving a fixed fee, we assess whether a loss reserve is necessary, estimate the total expected costs of providing services necessary to complete the contract and compare these costs to the fees expected to be received under the contract. For example, we were party to a contract with a customer that provided for fixed fee payments in exchange for services upon meeting certain milestone criteria. Based on the analysis we performed in the fourth quarter of 2000, we expected the costs to complete the project to exceed the associated fees, and accordingly we recorded a loss reserve of $1.4 million in the quarter ended December 31, 2000. As a result of our restructuring in the third quarter of 2001, substantially all of the remaining professional services required under the contract were being provided by a third party, and we recorded an additional loss reserve of $6.1 million based upon an analysis of costs to complete these services. In the second quarter of 2002, we began discussions with the customer regarding the timing and scope of the project deliverables, which led to an amendment in August 2002 to the original contract. Based on the amendment and associated negotiations with a third-party integrator that had been providing implementation services to the customer, we recorded a charge of approximately $15.6 million to cost of services revenue in the second quarter of 2002 and in accordance with the terms of the amendment were relieved from providing any further implementation services under the contract. The amendment required that we transfer $6.9 million to an escrow account (which included $5.8 million previously reported as restricted cash) to compensate any third-party integrator for the continued implementation of the customer's system. The charge also included $8.5 million of fees that we had paid the third-party integrator prior to the amendment. During the second quarter of 2002, we received a scheduled payment of $4.0 million associated with the original agreement that we reported as deferred revenue. The $4.0 million is being recognized as revenue as we fulfill our support and training obligations. As of June 30, 2004, we had recognized $1.9 million of the $4.0 million as revenue, and $2.1 million remained in deferred revenue, of which $1.2 million relates to support and will be recognized in equal installments through the first quarter of 2006. The remaining $0.9 million relates to training and will be recognized as we perform training obligations, but not later than the third quarter of 2005 when the training credits expire.

Accounting for Internal-Use Software. Internal-use software costs, including fees paid to third parties to implement the software, are capitalized beginning when we have determined various factors are present, including among others, that technology exists to achieve the performance requirements, we have made a decision as to whether we will purchase the software or develop it internally, and we have authorized funding for the project. Capitalization of software costs ceases when the software implementation is substantially complete and is ready for its intended use, and the capitalized costs are amortized over the software's estimated useful life (generally five years) using the straight- line method. As of June 30, 2004, we had $9.6 million of capitalized costs of internal use software, net of $5.6 million accumulated depreciation.

When events or circumstances indicate the carrying value of internal use software might not be recoverable, we assess the recoverability of these assets by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating cash flows of these assets. The amount of impairment, if any, is recognized to the extent that the carrying value exceeds the projected discounted future operating cash flows and is recognized as a write down of the asset. In addition, if it is no longer probable that computer software being developed will be placed in service, the asset will be adjusted to the lower of its carrying value or fair value, if any, less direct selling costs. Any such adjustment would result in an expense in the period recorded, which could have a material adverse effect on our consolidated statement of operations. Based on our assessment as of June 30, 2004, we determined that no such impairment of internal-use software existed.

Restructuring. During 2001, we recorded significant liabilities in connection with our restructuring program. These reserves included estimates pertaining to contractual obligations related to excess leased facilities. We have a total of approximately 82,000 square feet of excess space available for sublease or renegotiation. Locations of the excess space include Menlo Park, California, Princeton, New Jersey and Marlow in the United Kingdom. Remaining lease commitment terms on these leases vary from seven to eight years. We are seeking to sublease or renegotiate the obligations associated with the excess space. We had estimated exit costs of $8.4 million in accrued restructuring costs relating to excess leased facilities as of June 30, 2004. We have worked with real estate brokers in each of the markets where the properties are located to help us estimate the amount and timing of potential sub-leases for the respective facilities. This process involves significant judgments regarding these markets. If we determine that any of these real estate markets continues to deteriorate, additional adjustments to this accrual may be required, which would result in additional restructuring expenses in the period in which such determination is made. For example, in December 2003, we recorded $1.7 million in restructuring costs related to a change in evaluation of real estate market conditions in the United Kingdom, and changes in sublease estimates based on communication from current and potential subtenants in the United States. Likewise, if any of these real estate markets strengthen, and we are able to sublease the properties earlier or at more favorable rates than projected, or if we are otherwise able to negotiate early termination of obligations on favorable terms, adjustments to the accrual may be required that would increase income in the period in which such determination is made. As of June 30, 2004, our estimate of accrued restructuring cost assumes receipt of $9.2 million in sublease payments that are not yet subject to any contractual arrangement and, in most cases, a potential sublessor has not been identified. We have assumed that the majority of these sublease payments will begin in 2005 through 2007 and continue through the end of the related leases.

Goodwill and Intangible Assets. Consideration paid in connection with acquisitions is required to be allocated to the acquired assets, including identifiable intangible assets, and liabilities acquired. Acquired assets and liabilities are recorded based on our estimate of fair value, which requires significant judgment with respect to future cash flows and discount rates. For intangible assets other than goodwill, we are required to estimate the useful life of the asset and recognize its cost as an expense over the useful life. We use the straight-line method to expense long-lived assets, which results in an equal amount of expense being recorded in each period. Amortization of goodwill ceased as of January 1, 2002 upon our adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. We are now required to test goodwill for impairment under certain circumstances and write down goodwill when it is impaired. We have determined that our consolidated results comprise one reporting unit for the purpose of impairment testing through June 30, 2004.

During the three months ended June 30, 2004 we performed our annual test for goodwill impairment as required by SFAS 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). We completed our evaluation and concluded that goodwill was not impaired as the fair value of KANA exceeded its carrying value, including goodwill. The amount of goodwill as of June 30, 2004 was $8.6 million. Future events could cause us to conclude that impairment indicators exist and that goodwill and other intangible assets associated with our acquired businesses are impaired.

We continually monitor for any potential indicators of impairment of goodwill and we have determined that no such indicators have arisen during 2004. Any further impairment loss could have a material adverse impact on our financial condition and results of operations.

Income Taxes. We estimate our income taxes in each of the jurisdictions in which we operate as part of the process of preparing our consolidated financial statements. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as net operating loss carryforwards, and stock-based compensation, for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We then assess the likelihood that our net deferred tax assets will be utilized to offset future taxable income and to the extent we believe that such offset is not likely, we establish a valuation allowance. We have concluded that a full valuation allowance was required for all periods presented. While we have considered future taxable income in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would be made, increasing our income in the period in which such determination was made. Pursuant to the Internal Revenue Code, the amounts of and benefits from net operating loss carryforwards may be impaired or limited in certain circumstances. Events which cause limitations in the amount of net operating losses that we may utilize include, but are not limited to, a cumulative change of more than 50% ownership of the company, as defined, over a three year period. The portion of the net operating loss and tax credit carryforwards subject to potential expiration has not been included in deferred tax assets.

Contingencies and Litigation. We are subject to lawsuits and other claims and proceedings. We assess the likelihood of any adverse judgments or outcomes to these matters as well as ranges of probable losses. A determination of the amount of loss contingency required, if any, for these matters are made after careful analysis of each individual matter. The required loss contingencies may change in the future as the facts and circumstances of each matter changes.

The following table sets forth selected data for the indicated periods. Percentages are expressed as a percentage of total revenues (in thousands).

                                                      Three Months Ended                         Six Months Ended
                                                          June 30,                                   June 30,
                                              -------------------------------------      -------------------------------------
                                                       2004                2003                   2004                2003
Revenues:                                     -----------------   -----------------      -----------------   -----------------
     License..............................   $   1,049      11 % $   3,183      26 %    $   5,632      25 % $  12,534      42 %
     Service..............................       8,563      89       8,872      74         17,235      75      17,630      58
                                              --------- -------   --------- -------      --------- -------   --------- -------
Total revenues............................       9,612     100      12,055     100         22,867     100      30,164     100
                                              --------- -------   --------- -------      --------- -------   --------- -------
Cost of revenues:
     License..............................         219       2         507       4          1,005       4       1,425       5
     Service*.............................       2,324      24       2,708      22          4,881      21       5,070      17
                                              --------- -------   --------- -------      --------- -------   --------- -------
Total cost of revenues....................       2,543      26       3,215      27          5,886      26       6,495      22
                                              --------- -------   --------- -------      --------- -------   --------- -------
Gross profit..............................       7,069      74       8,840      73         16,981      74      23,669      78
                                              --------- -------   --------- -------      --------- -------   --------- -------
Operating expenses:
  Sales and marketing*....................       5,897      61       7,887      65         12,350      54      15,324      51
  Research and development*...............       5,078      53       5,943      49         10,062      44      12,023      40
  General and administrative*.............       2,181      23       2,941      24          4,197      18       5,576      18
  Amortization of stock-based compensation         361       4       1,678      14            904       4       3,065      10
  Amortization of identifiable intangibles          33      --         253      --             52      --       1,453       5
                                              --------- -------   --------- -------      --------- -------   --------- -------
Total operating expenses..................      13,550     141      18,702     152         27,565     121      37,441     124
                                              --------- -------   --------- -------      --------- -------   --------- -------
Operating loss............................      (6,481)    (67)     (9,862)    (82)       (10,584)    (46)    (13,772)    (46)
Other income (expense), net...............          75       1          17      --            158       1         107      --
Income tax expense........................          (9)     --         (49)     --            (75)     --         (94)     --
                                              --------- -------   --------- -------      --------- -------   --------- -------
Net loss..................................   $  (6,415)    (66)%    (9,894)    (82)%    $ (10,501)    (45)%   (13,759)    (46)%
                                              ========= =======   ========= =======      ========= =======   ========= =======


* Excludes amortization of deferred stock based compensation

                                       Three Months Ended   Six Months Ended
                                              June 30,          June 30,
                                           2004    2003      2004    2003
                                        -------  -------  -------  -------
Cost of service ...................... $    27  $   124       67  $   227
Sales and marketing ..................     143      664      358    1,214
Research and development .............     134      621      335    1,134
General and administrative ...........      57      269      144      490
                                        -------  -------  -------  -------
Total ................................ $   361  $ 1,678      904  $ 3,065
                                        =======  =======  =======  =======

                                                                  Payments due by period
                                                --------------------------------------------------
                                                          Less than    1-3       3-5     More than
 Contractual Obligations:                        Total    1  year     years     years    5 years
                                                ------   ----------- --------   -------  ---------
 Line of Credit                            $    3,427  $    3,427  $      --  $     -- $       --

 Non-cancelable Operating Lease Obligation     23,288       3,203     12,134     5,686      2,265

 Less: Sublease Income                         (1,812)       (163)      (860)     (574)      (215)

 Purchase Obligations (1)                         840         840         --        --         --
                                             ---------   ---------   --------   -------  ---------
                                           $   25,743  $    7,307  $  11,274  $  5,112 $    2,050
                                            ==========  ==========  =========  ======== ==========