We are a leading provider of workforce optimization software and services that enable companies to optimize workforce performance in their customer service operations. Our Impact 360 solution consists of software products and services designed to optimize the workforce, processes and technology involved in the customer service function. These solutions may be deployed throughout a customer’s enterprise—including in contact centers, back offices and branch offices—to enable the customer to capture information derived from contacts with its customers, analyze the information in relation to key performance indicators, act upon the information to improve the overall customer experience, and manage the staffing, training and performance measurement of its personnel involved in all aspects of customer service.

Our Impact 360 solution is an integrated offering of software products that provide comprehensive workforce optimization functionality, including quality monitoring and high-volume compliance recording, workforce management, performance management and electronic learning, or e-learning. Our quality monitoring products record multimedia interactions, including traditional voice, Web chat and email, based on user-defined business rules to enable our customers to evaluate the performance of their customer service representatives, or “CSR”s, wherever they may be located in the enterprise. Our high-volume compliance applications are designed to record 100% of the voice conversations between CSRs and customers for purposes such as compliance recording and sales verification. Our workforce management products enable our customers to develop strategic staffing plans, deploy skilled resources and evaluate productivity of CSRs. Our performance management applications provide comprehensive analytics, including performance scorecards, and reports of customer interaction and CSR performance. Our e-learning applications deliver ongoing training tailored to CSR needs and competencies. We also provide consulting and implementation services, training and support to customers that use our software products.

We have more than 2,000 customers, including more than 60 Fortune 100 companies. Our solutions are used in a wide variety of industries worldwide, including financial services, communications services,

manufacturing, utilities, retail, transportation, travel and outsourcing. No individual customer accounted for 10% or more of our revenue in 2005, 2004 or 2003. We market and sell our products through both our direct sales force and through indirect channels. Our indirect sales channel includes reseller, distributor, original equipment manufacturer, or “OEM”, and similar arrangements with key vendors in the contact center workforce optimization market, such as Avaya, Cisco, Nortel and Siemens. We also have strategic relationships with systems integrators, including Accenture, British Telecommunications, CapGemini and EDS.

Industry Background and Trends

The workforce optimization solutions market has evolved in recent years to address the increasing challenges faced by enterprises in managing their customer service activities effectively. The overall goal of workforce optimization in the customer service function is to enable companies to balance the competing objectives of maximizing customer satisfaction and increasing revenue, while at the same time controlling customer service costs. Customer contact centers, help desks, and billing and order fulfillment departments regularly represent the key focal points for personal interaction between a business and its customers, making the effectiveness of the CSRs critical to the overall success of the business.

We believe several key trends are driving the workforce optimization market, including:

Voice over Internet Protocol (“VoIP”) technologies.    The convergence of voice and data communications technologies, most notably through the rapid adoption of VoIP, is changing the landscape of telecommunications infrastructure. VoIP, or IP telephony, is a software-based technology that enables the conversion of voice communications into data packets that can be routed over any IP-based network, as opposed to traditional circuit-switched voice transmission lines. Many companies are replacing legacy analog voice infrastructures in their contact centers with VoIP telephony infrastructure to realize the many benefits of IP-based communications, including reduced costs and enablement of advanced business communication applications. These equipment upgrades typically require new deployments of workforce optimization solutions designed to support IP environments. VoIP applications also permit the customer service function to extend beyond traditional contact centers by facilitating easier access to customer interaction information.

Software solutions running on open systems.    Organizations are increasingly seeking to deploy information technology and business software applications based on open standards that run on commercially available, non-proprietary hardware. The use of open systems, as opposed to applications that run on proprietary hardware systems offered by a single vendor, generally provides for lower cost of ownership and greater flexibility in their information technology infrastructures.

Integration of workforce optimization applications.    Increasingly, companies worldwide are seeking an integrated offering of workforce optimization applications, including quality monitoring and high-volume compliance recording, workforce management, performance management and e-learning. By integrating these applications, an enterprise can reduce costs by eliminating duplicative hardware, streamlining implementation and reducing administration requirements. Integration also makes the applications easier to use through a single unified graphical user interface. Most important, by integrating these applications under one framework, enterprises gain the ability to manage their workforce performance in a closed loop, including evaluating and analyzing complete customer interactions through multiple media, identifying opportunities and performance gaps, scheduling personnel based on strengths and weaknesses, applying targeted instruction for continuous improvement, integrating instruction into a workforce schedule, and compensating employees based on actual performance.

Increasing complexity of customer service operations.    Customer service operations at many organizations have become increasingly complex, driven by the demand for highly available and effective customer service. For example, contact centers have become the primary points of customer contact for

organizations, as the contact centers have evolved from providing solely inbound customer support to handling support, service, sales, bill payment and numerous other customer interactions. Organizations are facilitating customer service interactions across multiple media, including traditional voice, Web chat, instant messaging, guided browser sessions and e-mail, and are therefore challenged to maintain a consistently high level of customer service across all media channels. Moreover, as a result of recent trends toward offshore and outsourced contact center operations, managing and optimizing the quality of customer interactions has become more important, and more difficult, than ever.

Impact 360

Impact 360, our integrated workforce optimization solution, enables organizations to capture, analyze and act on cross-functional information concerning workforce performance, customer interactions and customer service processes. Impact 360 offers a unified framework for workforce optimization that provides organizations a holistic view of performance and enables them to leverage this information to provide more effective and efficient customer service. Our new solutions framework supports both traditional time division multiplexing, or TDM, switch environments and IP telephony environments and executes on standard operating systems and hardware platforms.

The integrated components of our workforce optimization solution encompass quality monitoring and high-volume compliance recording, workforce management, performance management and e-learning. Impact 360 is available as a fully integrated solution, in specific packages or as separate applications. Impact 360 provides numerous benefits to our customers, including reduced infrastructure costs, rapid implementation and central administration. More importantly, shared access to information across all functions in the customer service value chain enables our customers to make informed decisions that can generate cost savings, improve decision making and increase competitive advantages. We also offer related consulting and implementation services, training and support.

The components of our solution include:

Quality monitoring and high-volume compliance recording.    Our recording solutions enable the recording of a CSR’s multimedia interactions with a customer through traditional voice, Web chat, instant messaging, guided browser sessions and e-mail. The CSR’s voice interaction with a customer can be synchronized with the CSR’s corresponding computer desktop activities, such as data entry, screen navigation and data retrieval, for review and analysis by supervisors. Quality monitoring selectively records interactions based on user-defined business rules, while high-volume compliance recording stores all interactions between an organization’s CSRs and its customers for purposes such as legal or regulatory compliance and sales verification. Our solutions enable companies to evaluate the performance of CSRs, analyze the effectiveness of supporting systems and enhance the quality of service being delivered.

Workforce management.    Our workforce management solutions simplify the task of forecasting and scheduling, enabling contact centers to balance cost, service level and agent preferences. Users can analyze historical data to forecast future interaction volumes and service handle times in order to schedule the optimal number of agents, with the required skill sets, at the necessary times. As a result, organizations can reduce costs by staffing appropriately to meet workload demands, drive business growth, and improve employee effectiveness and retention.

Performance management.    Our performance management solutions provide comprehensive analysis of customer interaction and CSR performance. Leveraging performance scorecards with industry-accepted and user-defined key performance indicators, these solutions combine data derived from our evaluation application with data from other business systems, such as customer relationship management software, enterprise resource planning software and integrated telephony applications. Our solution also offers data visualization, search capabilities and speech analytics. Using our solutions, supervisors can obtain a quick, streamlined view of performance relative to strategic organizational objectives. The reporting, dynamic

analysis and performance scorecard capabilities of these solutions provide organizations with business intelligence that can lead to increased revenue, heightened service quality and improved operational efficiencies.

E-learning.    Our e-learning solutions deliver ongoing training tailored to CSR competencies in order to achieve continuous performance improvement. The e-learning management software tracks training completion and compiles transcripts to enhance CSR skills. When the e-learning applications are integrated with other Impact 360 components, a supervisor can review a recorded customer interaction, evaluate the CSR’s performance and prioritize customized training and lesson plans for the CSR. Our solution enables targeted learning content to be delivered directly to a CSR’s desktop through a series of standardized lessons or customized lessons created from recorded interactions. E-learning can enable companies to reduce employee turnover and to build customer loyalty through a more highly skilled and motivated workforce.

Customer 360

Customer 360 is our approach to services, training and support services that accompany our Impact 360 solutions. Our service and support offerings are designed to enable our customers to achieve a rapid return on investment and realize the maximum benefit our solutions provide by enabling organizations to optimize their contact center operations. Our services consist of implementation services, training, business consulting and customer support.

The initial implementation engagement for our Impact 360 solutions is typically completed within 30 to 60 days from the date the software agreement is signed by a new customer. Training services provide the skills and knowledge necessary to enable business and technical users to utilize the Impact 360 solutions. Training is provided at our global training centers, on-site at the customers’ location or via our web-based education and training management system. In addition, we offer customized training programs tailored to the specific needs of our customers.

Our business consulting services are designed to help customers gain the most value from the Impact 360 solution to optimize the people, processes and technology deployed throughout their contact center operations.  We achieve this through a series of workshops that focus on specific contact center business processes, performance optimization, calibration techniques, business utilization, business rules development and high-impact coaching.

The Customer 360 support operation provides customer support services including access to major and minor releases, service packs and hot fixes, remote diagnostics and installation. Customer support is offered in two distinct plans with services that range from 12 hour phone access Monday through Friday to 24 hours, 7 days a week. We provide support services via the telephone, e-mail and via an on-line knowledgebase of product-related information.

Our Strategy

Our objective is to be a leading provider of workforce optimization software and services to help global enterprises improve all aspects of customer service, from contact center customer interactions to remote and branch offices and underlying back office processes. Key elements of our strategy include the following:

Extend the breadth and depth of the Impact 360 solution.    We believe Impact 360 provides today’s most comprehensive, integrated offering of workforce optimization products designed to manage, analyze and improve the customer service function. We intend to continue investing in research and development to enhance the functionality, effectiveness and ease of use of our Impact 360 solution, as well as to expand the number of third-party applications with which our software can readily integrate.

Maximize sales to existing customers.    We have a large installed base of customers, many of which currently utilize only a subset of our workforce optimization products or have not deployed our products in all of their contact centers or elsewhere throughout their customer service operations. We believe these customers represent a significant opportunity for us to generate additional sales of complementary products and services. Impact 360 has been designed to enable cross-selling and upselling of additional products to customers already utilizing our software. During 2005, approximately 75% of our license revenue was generated by sales to existing customers.

Capitalize on the growing adoption of VoIP.    Our Impact 360 solution fully supports VoIP telephony infrastructure. As companies upgrade to VoIP telephony infrastructure in their customer service operations, they will typically need to upgrade their workforce optimization solutions. This dynamic provides us with a unique opportunity to displace competitive solutions with Impact 360, and we intend to aggressively pursue companies engaging in telephony infrastructure upgrades. In addition, because VoIP provides small and medium-sized businesses with a new opportunity to deploy workforce optimization solutions at a more reasonable price, we have the opportunity to sell Impact 360 to a segment of the market that has historically been unable to afford these solutions. In order to address this opportunity, we have created a version of Impact 360 specifically designed to meet the needs of small and medium-sized businesses.

Expand our indirect sales channel.    Historically, the majority of our sales have been driven by our direct sales force. In recent years, we have significantly bolstered our indirect sales channel through reseller, distributor and OEM arrangements with key hardware and service providers in the contact center market. For example, Avaya, an OEM provider, bundles our workforce optimization software products with sales of its converged communications (TDM and IP) infrastructure hardware solutions. We have also announced a similar OEM agreement with Nortel. We are also seeking to expand our relationships with and among systems integrators. In addition to broadening our overall sales leverage, we believe these channel partnerships provide an efficient means to enable us to penetrate one of the fastest growing segments in the contact center industry, the small and medium-sized business segment.

Expand our business through strategic acquisitions.    We intend to pursue acquisitions of businesses, technologies and products that will complement our existing operations and enhance our position in the workforce optimization market. Since 2003, we have completed two significant acquisitions. In 2003 we acquired Eyretel Plc, which strengthened our market presence internationally and expanded our capabilities in the compliance recording market, and in 2005 we acquired Blue Pumpkin Software, Inc. a leading provider of workforce management products.

Research and Development

We believe our software development capabilities are essential to our strategy of enhancing our core technology, developing additional applications, incorporating that technology and maintaining the competitiveness of our software. We devote a substantial portion of our resources to developing new software and features, extending and improving our software technology, debugging and quality testing our products and researching new technological initiatives in our market. We believe that our future success depends in part upon our ability to continue to enhance existing software, respond to changing customer requirements and develop and introduce new or enhanced software that incorporates new technological developments and emerging industry standards.

As of December 31, 2005, we had 270 associates (including over 176 contractors in Asia) engaged in research and development activities. Research and development expenditures, exclusive of acquired in-process research and development, for the years ended December 31, 2005, 2004 and 2003 were $26.7 million, $20.9 million and $18.0 million, respectively. We anticipate our research and development costs as a percentage of total revenue will decrease in 2006 as compared to 2005.

Competition

Our software and services compete in the emerging market for products that record and analyze customer interactions and provide electronic learning applications. This market is intensely competitive and experiences rapid changes in technology. We believe that we compete effectively and that we enjoy a competitive advantage based upon:

(1)          the functionality and quality of our products,

(2)          the ease of use and ability of our products to operate with a variety of hardware and software products,

(3)          our ability as a single vendor to offer a full suite of applications,

(4)          our ability to implement our products quickly,

(5)          the responsiveness of our customer support, and

(6)          our reputation in the marketplace.

Our competitors include:

·        traditional call-logging vendors;

·        quality monitoring suppliers to the contact center industry;

·        workforce management, forecasting and scheduling vendors to the call center industry;

·        electronic learning vendors;

·        business analytics vendors;

·        large telecom solution providers;

·        enterprise software vendors;

·        systems integrators and consulting firms; and

·        new, larger and more established entities that may acquire, invest in or form joint ventures with providers of  recording or performance enhancing software solutions.

In addition, we have developed, and intend to continue to develop, relationships with companies that resell our software, companies that integrate the software with their technology and products and companies that provide us with customer referrals or leads. Some of these companies have similar, and often more established, relationships with our competitors, and may recommend the products and services of competitors to customers instead of our software and services. In addition, through their relationships with us, these companies could learn about our software and the market for our software and services and could develop and sell competing products and services.

The principal competitive factors in our market include:

·        product performance, reliability and features;

·        ability to effectively integrate products into customers’ environments;

·        user scalability and open architecture;

·        third-party integration;

·        quality and speed of product implementation;

·        ease-of-use for customers;

·        analytic capabilities of the product;

·        how quickly new products and product enhancements can be brought to market;

·        customer support; and

·        pricing of products and services.

Our success will depend on our ability to compete effectively based on these factors. Further, we expect that competition will increase as other established and emerging companies enter our market and as new products, services and technologies are introduced. Increased competition may result in price reductions, lower gross margins and loss of market share. This could materially and adversely affect our business, financial condition and results of operations.

Proprietary Rights

General.    Our success depends to a significant degree on the legal protection of our software and other proprietary technology rights. We rely on a combination of patent, trade secret, copyright and trademark laws and confidentiality and non-disclosure agreements with employees and third parties to establish and protect our proprietary rights. These measures may not be sufficient to protect proprietary rights, and we cannot be certain that third parties will not misappropriate our technology and use it for their own benefit. Also, most of these protections do not preclude our competitors from independently developing products with functionality or features substantially equivalent or superior to our software. Any failure to protect our intellectual property could have a material adverse effect on our business.

Licenses.    Our licenses are designed to prohibit unauthorized use, copying and disclosure of our software technology. When we license our software to customers, we require license agreements containing confidentiality terms customary in the industry in order to protect our proprietary rights in the software. These agreements generally warrant that the software will materially comply with written documentation. We assert that we own the software we distribute and have not violated the intellectual property rights of others. We license our products in a format that does not permit the users to change the software code. In addition, because we treat the source code for our products as a trade secret, all employees and third parties who require access to the source code are first required to sign non-disclosure agreements.

Patents.    As of December 31, 2005, we had nineU.S. and three international patents We cannot assure you that we will file new patent, trademark or copyright applications, that any future applications will be approved, that any existing or future patents, trademarks or copyrights will adequately protect our intellectual property or that any existing or future patents, trademarks or copyrights will not be challenged by third parties.

Trademarks and service marks.    As of December 31, 2005, we had eight registered trademarks in the U.S. We also claim common law protections for other marks we use in our business. Competitors and other companies could adopt similar marks, or try to prevent us from using our marks, consequently impeding our ability to build brand identity and possibly leading to customer confusion. We are aware of certain uses, U.S. trademark registrations, and U.S. trademark applications for our “eQuality” trademark and its variations that predate our use and the April 30, 2002 issuance of the U.S. registration for our trademark eQuality®. It is possible that the owner of legal rights resulting from one or more of these prior uses, U.S. trademark registrations, or U.S. trademark applications will bring legal action to challenge our registration of and/or our continued use of the trademark eQuality®, and may also seek compensation for damages resulting from our use of our registered trademark if such challenging party prevails on such a claim. As a result, we cannot assure you that our registration of this trademark will be undisturbed, or that this use will not result in liability for trademark infringement, trademark dilution, and/or unfair competition.

Availability of Reports and Other Information.

Our corporate Web site is http://www.witness.com . We make available on this Web site, free of charge, access to our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Proxy Statement on Schedule 14A and amendments to those materials filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 as soon as reasonably practicable after we electronically submit such materials to the Securities and Exchange Commission. In addition, the Commission’s Web site is http://www.sec.gov. The Commission makes available on its Web site, free of charge, reports, proxy and information statements, and other information regarding issuers, such as us, that file electronically with the Commission. Information provided on our Web site or on the Commission’s Web site is not part of this Annual Report on Form 10-K

Item 1A.                 Risk Factors

Our future operating results may vary substantially from period to period. The price of our common stock will fluctuate in the future, and an investment in our common stock is subject to a variety of risks, including, but not limited to, the specific risks identified below. Inevitably, some investors in our securities will experience gains while others will experience losses depending on the prices at which they purchase and sell our securities. Prospective and existing investors should consider the following factors in evaluating our business or an investment in our securities. If any of the following or other risks actually occurs, our business, financial condition and results of operations could be adversely affected. In that case, the trading price of our common stock could decline.

Because our products have a long sales cycle, it is more difficult to plan our expenses and forecast our results; and our operating results may fail to meet investor expectations and may fluctuate materially from period to period, which may adversely affect our stock price.

It typically takes three to nine months from the time we qualify a sales lead until we sign a sales contract with the customer. As a result, it is difficult for us to predict the quarter in which a particular sale will occur. If our sales cycle unexpectedly lengthens for one or more large orders or a significant number of small orders, it would delay the timing of our revenue, but not the timing of most of our corresponding expenses. Lengthening of our sales cycle could also increase the total cost of a sale due to additional employee time and costs associated with the sale. Material changes in our sales cycle could cause our quarterly revenue or operating results to be below the expectations of investors, and the price of our common stock could fall substantially.

Our customers’ decision process regarding their purchase of our products and services is relatively long due to several factors, including:

·        the complex nature of our products, requiring our need to educate potential customers about the uses and benefits of our products;

·        competition for the corporate resources necessary to finance the purchase and implementation of our products;

·        customers’ budgeting and purchasing cycles;

·        economic factors;

·        the extent of customers’ evaluation and internal approval process often required before purchasing our products and services; and

·        delayed purchases due to announcements of new products or enhancements by our competitors or us.

If our products and services are not used and accepted by existing and prospective customers, our business and results of operations will be adversely affected.

The market for workforce optimization software, including software that records and analyzes customer interactions and that forecasts and schedules employees, is still developing. Our success depends on the use and acceptance of our software and services by existing and prospective customers. In addition, demand for our software remains uncertain because our existing and potential customers may:

·        not understand the benefits of using workforce optimization software generally or, more specifically, software which records and analyzes the interactions between a business and its customers or which optimizes the forecasting and scheduling of employees;

·        not achieve favorable results using our software;

·        experience technical difficulty in implementing our software;

·        use alternative methods such as online self-help to solve the same business problems our software is intended to address; or

·        close contact centers.

If we experience losses in the future, the market price of our common stock may be materially and adversely affected.

Throughout much of our history, we have experienced losses. As a result of our prior operating losses, we had an accumulated deficit of $42.3 million as of December 31, 2005. We need to generate sufficient revenue to achieve sustained profitability and avoid incurring losses again in the future.

Our quarterly results are difficult to predict and adverse fluctuations in operating results could cause our stock price to fall.

Our quarterly revenue and operating results are difficult to predict and could fluctuate significantly from period to period. In particular, we typically derive a significant portion of our software product revenue toward the end of each quarter and from a small number of relatively large orders. The delay or failure to close anticipated sales in a particular quarter could reduce our revenue in that quarter and subsequent quarters over which revenue for the sale could be recognized. In addition, because our revenue from installation and training services largely correlates with our product revenue, a decline in product revenue could also cause a decline in our professional services revenue in the same quarter or in subsequent quarters. Our quarterly revenue is difficult to forecast for several reasons, including the following:

·        changes in demand for our products and services;

·        the tendency of customers to delay software purchases until the end of the fiscal quarter;

·        lengthening of our customers’ budgeting and purchasing cycles;

·        timing of any acquisitions and related costs;

·        delays in installations of our software;

·        varying sales and implementation cycles for our products and services from customer to customer;

·        the failure of our customers to renew their maintenance service agreements;

·        the timing of hiring new services employees and the rate at which these employees become productive; and

·        the development and performance of our distribution channels.

As a result of these and other factors, we believe that quarter-to-quarter comparisons of our operating results may not be a good indicator of our future performance, and you should not rely on them to predict our future performance or the performance of our stock price. If our revenue or operating results fall below the expectations of investors or securities analysts, the price of our common stock would likely decline.

We may be unable to manage and expand our international operations, which may adversely affect our business and operating results.

We derived revenues of $84.6 million and $68.1 million in 2005 and 2004, respectively, from customers located outside the United States. Our operations outside of the United States at December 31, 2005, consisted of operations located in Australia, Brazil, Canada, China, Germany, India, Japan, Mexico, the Netherlands, Singapore, South Africa and the United Kingdom. We have also established relationships with a number of international resellers.

With our acquisitions of Blue Pumpkin in January 2005 and Optimis in May 2005 both of which have sales outside of North America, we have expanded our international operations, and we intend to continue to expand our international operations through additional acquisitions, internal business expansion and strategic business relationships. These efforts require significant management attention and financial resources. We may not be able to successfully penetrate international markets or, if we do, we may not be able to grow or to maintain adequate profit margins in these markets. Because of the complex nature of our international expansion, it may adversely affect our business and operating results. International expansion and sales are subject to many risks, including the following:

·        limited development of an international market for our software and services;

·        expanding and training our international sales force and support operations;

·        higher costs of employment in certain international locations;

·        difficulties in producing localized versions of our products;

·        political and economic instability;

·        potentially adverse tax consequences of operating in foreign countries;

·        import and export restrictions and tariffs;

·        longer payment cycles and difficulties in collecting accounts receivable;

·        currency fluctuations;

·        cultural differences which may affect workforce performance and sales processes;

·        difficulties and expenses associated with complying with a variety of foreign laws; and

·        unexpected changes in regulatory requirements.

As we further expand our operations outside the United States, we will also face new competitors and competitive environments. In addition to the risks associated with our domestic competitors, foreign competitors may pose an even greater risk, because they may possess a better understanding of their local markets and have better working relationships with local infrastructure providers and others. In particular, because telephone protocols and standards are unique to each country, local competitors will have more experience with, and may have a competitive advantage in, these markets. We may not be able to obtain similar levels of knowledge, which could place us at a significant competitive disadvantage. In addition, we

have limited experience in developing local language versions of our products or in marketing our products to international customers. We may not be able to successfully translate, market, sell, and deliver our products internationally.

If we are unable to maintain a productive direct sales force, our business and operating results could be adversely affected.

We believe that our future success will depend on maintaining a productive direct sales force. Historically, it has taken us up to six months to train new sales personnel before they reach an acceptable level of productivity. We have also experienced difficulty in recruiting sales personnel with experience in computer and telephone integration technologies. We cannot assure you that we will be able to continue to manage turnover and hire new sales personnel to meet our needs. If the personnel we hire are less qualified than we expect, it may take us more time to train them before they reach an acceptable level of productivity, which could increase our costs and reduce our revenue.

If we are unable to expand the distribution of our products through indirect sales channels, our business and operating results could be materially adversely affected.

Our strategy is to continue to increase the proportion of customers served through indirect sales channels, such as select resellers and a variety of strategic marketing alliances. Product revenue, excluding hardware revenue,  from our indirect sales channel represented approximately 41% and 32% of total product revenue in 2005 and 2004, respectively. We expect revenue from our indirect sales channel and, accordingly, our dependence on distribution partners, to increase as we establish relationships with companies to resell our software worldwide. We cannot assure you that we will be able to maintain productive relationships with our current partners, or that we will be able to establish similar relationships with additional resellers on a timely basis, if at all.

Some resellers with which we do business have similar, and often more established, relationships with our competitors, and may recommend the products and services of our competitors to customers instead of our software and services. We cannot provide assurance that these distribution partners will devote adequate resources to selling our software and services or that our resellers may not learn about our products and the market for our software and services and develop and sell competing products and services. As a result, our relationships with resellers could lead to increased competition for us.

Competition in our business could adversely affect our revenue, profitability and market share.

The market for products that record customer interactions, forecast and schedule employees, analyze performance and/or provide electronic learning is intensely competitive, evolving and is subject to rapid changes in technology. We believe our principal competitors include, but are not limited to:

·        traditional call-logging vendors;

·        quality monitoring suppliers to the contact center industry;

·        workforce management, forecasting and scheduling vendors to the call center industry;

·        electronic learning vendors;

·        business analytics vendors;

·        large telecom solution providers;

·        enterprise software vendors;

·        systems integrators and consulting firms; and

·        new, larger and more established entities that may acquire, invest in or form joint ventures with providers of recording or performance enhancing software solutions.

Many of our current and potential competitors have longer operating histories, more established business relationships, larger customer bases, a broader range of products and services, greater name recognition and substantially greater financial, technical, marketing, personnel, management, service, support and other resources than we do. As a result, our current and potential competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, take better advantage of acquisitions and other opportunities, devote greater resources to marketing and selling their products and services and adopt more aggressive pricing policies. We cannot assure you that our current or potential competitors will not develop products comparable or superior in terms of price and performance features to those developed by us.

In addition, many of our competitors market their products through resellers and companies that integrate their technology and products with those of the competitor. These resellers and technology partners often have strong business relationships with our customers and potential customers. For example, some of our competitors have better and more long standing relationships than we do with telephone switch vendors. Our competitors may use these business relationships to market and sell their products and compete for potential customers. It is also possible that resellers or technology partners may acquire or be acquired by one or more of our competitors, which would further solidify their business relationships.

We expect that competition will increase as other established and emerging companies enter our market and as new products, services and technologies are introduced. Increased competition may result in price reductions, lower gross margins and loss of market share, any of which could materially and adversely affect our business, financial condition and results of operations.

Our heavy reliance on sales of our quality monitoring and Workforce Management software exposes us to risks of obsolescence due to changes in competitive product offerings.

We have derived a substantial portion of our product revenues from sales of our quality monitoring and Workforce Management software products. We expect revenue from these products to continue to account for a significant portion of our revenue for the foreseeable future. As a result, any factors affecting the markets for these products could materially and adversely affect our business, financial condition and results of operations. We cannot assure you that the market will continue to demand our current products or that we will be successful in marketing any new or enhanced products. If our competitors release new products that are superior to our products in performance or price, demand for our products may decline. A decline in demand for our products as a result of competition, technological change or other factors would reduce our total revenues and adversely affect profitability.

If we fail to develop new software or improve our existing software, we may not be able to remain competitive.

The markets for our products are characterized by rapidly changing technology, frequent new product introductions and enhancements, changes in customer demands and evolving industry standards. Our existing products could be rendered obsolete if we fail to continue to advance our technology. We have also found that the technological life cycles of our products are difficult to estimate, partially because of changing demands of our customers. We believe that our future success will depend on our ability to continue to enhance our current product line while we concurrently develop and introduce new products that keep pace with competitive and technological developments. These developments require us to anticipate customers’ future needs and to continue to make substantial product development investments. Although we are presently developing a number of product enhancements to our product suites, we cannot assure you that these enhancements will be completed on a timely basis or gain customer acceptance. In

addition, failure to develop new software or improve existing software products may adversely affect our ability to maintain our maintenance renewal rate which could adversely affect our revenue.

We have recently introduced Impact 360, which combines a new software architecture with new combinations of our products. Our business concept in doing so is to create incremental value for our customers and to win business away from competitors whose product offerings are more limited and require the customer to make additional hardware purchases to obtain the solutions that our Impact 360 product offering provides in an integrated suite. While we plan and expect that this lower total cost of ownership will be well received in the marketplace, we can offer no assurance that our new Impact 360 offering will be successful. If our Impact 360 product offerings do not meet with commercial success, our business would be materially and adversely affected.

If our software development activities in the Asia-Pacific region are not successful, we may not be able to meet our development schedules.

During 2004, we expanded our software development capabilities in the Asia-Pacific region in order to optimize available research and development resources and better meet development timeframes. We have limited experience with remote software development activities. Accordingly, there are a number of risks associated with this activity, including:

·        delays or product errors due to miscommunication between our local development organization and the remote

·        development personnel affected by time, distance and language differences;

·        scheduling delays due to lengthy ramp-up time for our new development personnel;

·        products produced in the Asia-Pacific region that fail to meet our quality requirements;

·        high voluntary personnel turnover; and

·        foreign employment and labor laws with which we are not familiar.

Our inability to meet development schedules because of our reliance on developers in the Asia-Pacific region may affect our ability to enhance our current product line or introduce new products, which would have a material adverse affect on our financial results and could harm our reputation. The loss of key development personnel could have a material adverse effect on our product development process and adversely affect future product revenues.

Our liability to customers may be substantial if our products fail to perform properly.

Our software is used in a complex operating environment that requires its integration with computer and telephone networks and other business software applications. If our products fail to function as required, we may be subject to claims for substantial damages. Courts may not enforce provisions in our contracts that would limit our liability or otherwise protect us from liability for damages. Although we maintain general liability insurance coverage, including coverage for errors or omissions, this coverage may not continue to be available on reasonable terms or in sufficient amounts to cover claims against us. In addition, our insurer may disclaim coverage as to any future claim. If claims exceeding the available insurance coverage are successfully asserted against us, or our insurer imposes premium increases, large deductibles or co-insurance requirements on us, our business, financial position, and results of operations could be adversely affected.

If an original equipment manufacturer that is part of our indirect sales channel experiences technical difficulties, our product sales through that channel may be adversely affected.

Our indirect sales channel accounts for an increasingly large share of our total sales. When we sell our software through an original equipment manufacturer, or OEM, our software is embedded in the OEM’s product, which we sometimes refer to as the ‘environment’ for our software. When the OEM’s product uses our software, there is a risk that the ‘environment’ will fail or that it will not achieve the compatibility with our product that we and the OEM seek. If this happens, our software might not function properly, or the OEM might sell less of it, or both, which could have a material adverse effect on our revenues, operating cash flows and the growth of our business.

Our software may contain undetected errors or “bugs,” resulting in harm to our reputation and operating results.

Software products as complex as those offered by us might contain undetected errors or failures when first introduced or when new versions are released. We cannot assure you, despite testing by us and by current and prospective customers, that errors will not be found in new products or product enhancements after commercial release. Any errors found may cause substantial harm to our reputation and result in a loss in revenue and additional unplanned expenses to remedy any defects.

If our advanced compliance recording applications fail to record 100% of our customers’ interactions, we may be subject to liability and our reputation may be harmed.

Many of our customers use our advanced compliance recording applications to record and store interactions with customers to provide back-up and verification of transactions and to guard against risks posed by lost or misinterpreted voice communications. These customers rely on our applications to record, store and retrieve voice data in a timely, reliable and efficient manner. If our applications fail to record 100% of our customers’interactions or our customers are unable to retrieve the recordings when necessary, we may be subject to liability and our reputation may be harmed.

If we are unable to maintain the security of our systems, our business, financial condition and operating results could be harmed.

The occurrence or perception of security breaches in the operation of our business or suffered by third parties using our products could harm our business, financial condition and operating results. Our customers use our products to compile and analyze highly sensitive or confidential information. We may come into contact with such information or data when we perform support or maintenance functions for our customers. While we have internal policies and procedures for employees performing these functions, the perception that we have improperly handled sensitive, confidential information could have a negative effect on our business. If, in handling this information, we fail to comply with privacy or security laws, we could incur civil liability to government agencies, customers and individuals whose privacy is compromised. If personal information is received or used from sources outside the U.S., we could be subject to civil, administrative or criminal liability under the laws of other countries. In addition, while we implement sophisticated security measures, third parties may attempt to breach our security or inappropriately use our products through computer viruses, electronic break-ins and other disruptions. If successful, confidential information may be improperly obtained and we may be subject to lawsuits and other liability. Any internal or external security breaches could harm our reputation, and even the perception of security risks, whether or not valid, could inhibit market acceptance of our products.

Fluctuations in foreign currency exchange rates could affect our financial results.

We may experience gains and losses resulting from fluctuations in currency exchange rates. Moreover, in locations where we price our products in U.S. dollars, our sales could be affected adversely by declines

in foreign currencies relative to the dollar, thereby making our products more expensive in local currencies. In locations where we sell our products in local currencies, we could be competitively unable to increase our prices to reflect fluctuations in exchange rates. We do not use derivative instruments to manage our foreign exchange risk, and we cannot predict the impact that future exchange rate fluctuations may have on our results.

Certain provisions in agreements that we have entered into may expose us to liability for breach that is not limited in amount by the terms of the contract.

Certain contract provisions, principally confidentiality and indemnification obligations in certain of our license agreements, could expose us to risks of loss that, in some cases, are not limited by contract to a specified maximum amount. If we fail to perform to the standards required by these contracts, we could be subject to additional liability and our business, financial condition and results of operations could be materially and adversely affected.

If we fail to protect our intellectual property, third parties may use our technology for their own benefit.

Our success and ability to compete depends to a significant degree upon our proprietary technology. We rely on a combination of patent, trade secret, copyright and trademark laws and confidentiality agreements with employees and third parties to establish and protect our proprietary rights. These measures may not be sufficient to protect our proprietary rights, and we cannot be certain that third parties will not misappropriate our technology and use it for their own benefit. Also, most of these protections do not preclude our competitors from independently developing products with functionality or features substantially equivalent or superior to our software. Any infringement of our proprietary rights could negatively affect our future operating results.

As of December 31, 2005, we had eight registered trademarks in the U.S., nineU.S. and three international patents. We cannot assure you that we will file new patent or trademark applications, that any future applications will be approved, that any existing or future patents, trademarks or copyrights will adequately protect our intellectual property or that any existing or future patents, trademarks or copyrights will not be challenged by third parties.

We are aware of certain uses, U.S. trademark registrations, and U.S. trademark applications for our “eQuality” trademark and its variations that predate our use, and the April 2002 issuance of the U.S. registration for our trademark eQuality ® . It is possible that an owner of legal rights resulting from prior use, registrations, or applications will bring legal action to challenge our registration of and/or our use of the trademark eQuality ® , and may also seek compensation for damages resulting from our use this trademark. As a result, we cannot assure you that our registration of this trademark will be undisturbed, or that this use will not result in liability for trademark infringement, trademark dilution, and/or unfair competition.

Moreover, the laws of certain foreign countries do not protect our intellectual property rights to the same extent as do the laws of the United States. Furthermore, policing the unauthorized use of our products is difficult, and litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Litigation could result in substantial costs and diversion of resources and could negatively affect our future operating results.

Claims by other companies that our software infringes their intellectual property could require us to incur substantial costs or prevent us from selling our software or services.

It is possible that third parties will claim that we have infringed their current or future products. We expect that we and other participants in our industry will be increasingly subject to infringement claims as

the number of competitors and products grows. Any claims, with or without merit, which are generally uninsurable, could be time-consuming, result in costly litigation, require us to reengineer or redevelop our software, cause product shipment delays or require us to enter into royalty or licensing agreements, any of which could negatively affect our operating results. Any efforts to reengineer our software or obtain licenses from third parties may not be successful, could be extremely costly and would likely divert valuable management and product development resources.

For example, claims have been asserted against us in lawsuits involving Knowlagent, IEX, STS and NICE (as described in Item 3, “Legal Proceedings”, of Part I). We cannot assure you that we will be successful in defending against the claims that have been asserted or any other claims that may be asserted. We also cannot assure you that such claims will not have a material adverse effect on our business, financial condition, or operations. Defending infringement claims or other claims involves substantial costs and diversion of management resources. In addition, to the extent we are not successful in defending such claims, we may be subject to injunctions with respect to the use or sale of certain of our products or to liabilities for damages to the claimants or to customers to whom we have indemnification commitments, and we may be required to obtain licenses which may not be available on reasonable terms. In addition, we cannot assure you that legal action claiming patent infringement will not be commenced against us, or that we would prevail in litigation given the complex technical issues and inherent uncertainties in patent litigation. In addition, users of our software may become subject to claims if our software is alleged to infringe the intellectual property rights of others. These software users could attempt to hold us responsible for these claims and any resulting harm they suffer. If a patent claim against us were to be successful and we could not obtain a license on acceptable terms or license a substitute technology or redesign to avoid infringement, we may be prevented from distributing our software or required to incur significant expense and delay in developing non-infringing software. Such a result could have a material adverse effect on our business, financial condition and results of operations.

If we are unable to maintain the compatibility of our software with certain other products and technologies, our future business would be adversely affected.

Our software must integrate with software and hardware solutions provided by a number of our existing and potential competitors. For example, our products must integrate with phone switches made by the telephone switch vendors and computer telephony software applications offered by other software providers. These competitors or their business partners could alter their products so that our software no longer integrates well with them, or they could delay or deny our access to software releases that allow us to timely adapt our software to integrate with their products. If we cannot adapt our software to changes in necessary technology, it may significantly impair our ability to compete effectively, particularly if our software must integrate with the software and hardware solutions of our competitors.

If our professional services employees do not provide installation services effectively and efficiently, our customers may not use our installation services or may stop using our software.

Our customers ordinarily purchase installation, training and maintenance services together with our products. The functionality of our products is not dependent on our installation and training services. We believe that the speed and quality of installation services are competitive factors in our industry. If our installation services are not satisfactory to our customers, the customers may choose not to use our installation services or they may not license our software in the future. As a result, we would lose licensing and services revenue, and it could harm our reputation. In addition, our revenues realized from the performance of maintenance services are material to our operating results, and a failure to provide adequate maintenance support to our customers would result in reduced maintenance revenues and have an adverse effect on our operating results.

We may make acquisitions or investments that are not successful and that adversely affect our ongoing operations.

We may acquire or make investments in companies, products, services and technologies that we believe complement our business and assist us in quickly bringing new products to market. We have limited experience in making acquisitions and investments. As a result, our ability to identify and evaluate prospects, complete acquisitions and properly manage the integration of businesses is relatively unproven. If we fail to properly evaluate and execute acquisitions or investments, it may have a material adverse effect on our business and operating results. In making or attempting to make acquisitions or investments, we face a number of risks, including:

·        identifying suitable candidates, performing appropriate due diligence, identifying potential liabilities and negotiating acceptable terms;

·        reducing our working capital and hindering our ability to expand or maintain our business, if we make acquisitions using cash;

·        the potential distraction of our management, diversion of our resources and disruption of our business;

·        retaining and motivating key employees of the acquired companies;

·        managing operations that are distant from our current headquarters and operations;

·        entering into geographic markets in which we have little or no prior experience;

·        competing for acquisition opportunities with competitors that are larger than we are or have greater financial and other resources than we have;

·        accurately forecasting the financial impact of a transaction;

·        assuming liabilities of acquired companies, including litigation related to the operation of the business prior to the acquisition;

·        maintaining good relations with the customers and suppliers of the acquired company;

·        potentially dilutive issuances of securities as consideration for an acquisition;

·        effectively integrating acquired companies and achieving expected synergies; and

·        the impairment of the value of the assets acquired in any corporate acquisition.

If we need additional financing to maintain or expand our business, it may not be available on favorable terms, if at all.

Although we believe our current cash and borrowing capacity will be sufficient to meet our anticipated cash needs for at least the next 12 months and the foreseeable future, we may need additional funds to expand or meet all of our operating needs. If we need additional financing, we cannot be certain that it will be available to us on favorable terms, or at all. If we raise additional funds by issuing equity securities or convertible debt, the ownership interest of our stockholders could be significantly diluted, and any additional equity securities we issue may have rights, preferences or privileges senior to the rights of our stockholders. Also, the terms of any additional financing we obtain may significantly limit our future financing and operating activities. If we need funds and cannot obtain them on acceptable terms, we may be unable to:

·        develop and enhance our software to remain competitive;

·        take advantage of future opportunities, such as acquisitions;

·        respond to changing customer needs and our competitors’ innovations; or

·        attract and retain qualified key personnel.

Any of these events could significantly harm our business and financial condition and limit our growth.

Our inability to source hardware could harm our business.

A number of customers expect us to source hardware to support the implementation of our software. We seek to reduce the amount of hardware sales in the future and have transferred the fulfillment of hardware orders to third-party distributors. Thus, we are largely dependent on third parties for the supply of hardware components to our customers. If these hardware distributors experience financial, operational or quality assurance difficulties, or if there is any other disruption in our relationships, we may be required to locate alternative hardware sources. We are subject to the following risks due to our hardware distribution system:

·        cancellations of orders due to unavailability of hardware;

·        increased hardware prices, which may make our products less attractive; and

·        additional development expense to modify our products to work with new hardware configurations.

Even if we and/or our distributors are successful in locating alternative sources of supply, alternative suppliers could increase prices significantly. In addition, alternative components may malfunction or interact with existing components in unexpected ways. The use of new suppliers and the modification of our products to function with new systems would require testing and may require further modifications, which may result in additional expense, diversion of management attention and other resources, inability to fulfill customer orders or delay in fulfillment, reduction in quality and reliability, customer dissatisfaction, and other adverse effects on our reputation, business and operating results.

Failure to maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 could have a material adverse effect on our business, operating results and stock price.

The Sarbanes-Oxley Act of 2002 imposes certain duties on us and our executives, directors and attorneys. Our efforts to comply with the requirements of Section 404 have resulted in increased general and administrative expense and a diversion of management time and attention from revenue-generating activities to compliance activities, and we expect these efforts to require the continued commitment of significant resources. We have reported a material weakness in internal control over financial reporting which we found in connection with our evaluation of controls and procedures as of December 31, 2005. If we fail to maintain the adequacy of our internal controls, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting. Failure to maintain effective internal controls over financial reporting could result in investigation and/or sanctions by regulatory authorities, and could have a material adverse effect on our business and operating results, investor confidence in our reported financial information, and the market price of our common stock.

Our stock price has been volatile.

The market price of our common stock has been subject to significant fluctuations in response to variations in quarterly operating results and other factors. In addition, the stock market has experienced significant volatility that has particularly affected the market prices of equity securities of many technology companies and that often has been unrelated or disproportionate to the operating performance of these companies. Any announcement with respect to any adverse variance in revenue or earnings from levels generally expected by securities analysts or investors could have a significant adverse effect on the trading price of our common stock. In addition, factors such as announcements of technological innovations or

new products by us, our competitors or third parties, changing conditions in the customer relationship management software market, changes in the market valuations of similar companies, loss of a major customer, additions or departures of key personnel, changes in estimates by securities analysts, announcements of extraordinary events, such as acquisitions or litigation, or general economic conditions may have an adverse effect on the market price of our common stock.

We recently issued 4.7million new shares during our secondary offering of our Common stock. We also issued 2.1 million new shares and granted approximately 650,000 options to purchase shares of our common stock in connection with acquisitions in 2005, which will result in dilution to our existing stockholders and may cause our stock price to decline.

During our secondary offering of our common stock, we issued 4.7 million shares of common stock in December 2005. Also, as part of the merger consideration in our acquisition of Blue Pumpkin in January 2005, we issued a total of 2.1 million shares of common stock to former Blue Pumpkin shareholders. In addition, we issued employee stock options to purchase approximately 650,000 shares of common stock in connection with this acquisition and the acquisition of Optimis in May 2005. The issuance of a significant amount of additional shares of common stock results in dilution to our existing shareholders and could reduce our earnings per share, which in turn could negatively affect the market price of our common stock. A significant amount of common stock coming on the market at any given time could result in a decline in the price of our common stock or increased volatility.

Our performance may be negatively affected by macro-economic or other external influences.

Beginning in 2000, a declining United States economy adversely affected the performance of many businesses, especially within the technology sector. Reductions in the capital budgets of our customers and prospective customers have an adverse impact on our ability to sell our solutions. Until late in 2003, we continued to experience effects from a weak spending environment for information technology in both the United States and Europe, in the form of delayed and cancelled buying decisions by customers for our software, services and hardware, deferrals by customers of service engagements previously scheduled and pressure by our customers and competitors to discount our offerings. If the current improvements now being seen in the general business climate do not continue, this would likely have a material adverse effect on our business.

Government regulation of telephone and Internet monitoring could cause a decline in the use of our software, result in increased expenses for us or subject our customers and us to liability.

As the telecommunications industry continues to evolve, state, federal and foreign governments (including supranational governmental organizations such as the European Union) and industry associations may increasingly regulate the monitoring of telecommunications and telephone and Internet monitoring and recording products, such as our software. We believe that increases in regulation could come in the form of a number of different kinds of regulations, including regulations regarding privacy, protection of personal information such as Social Security numbers, credit card information and employment. For example, the State of California enacted the Database Security Breach Act, which requires any business that suffers a computer security breach to immediately notify customers in California if personal information has been compromised, and the Payment Card industry has adopted regulations that require additional security regarding the storage of consumers’ credit card numbers. The adoption of any new regulations or changes to existing regulations could cause a decline in the use of our software and could result in increased expense for us as we modify our software to accommodate these regulations. Moreover, these regulations could subject our customers or us to liability. Whether or not these regulations are adopted, if we do not adequately address the privacy concerns of consumers, companies

may be hesitant to use our software. If any of these events occur, it could materially and adversely affect our business.

If we are unable to attract and retain key personnel, our ability to effectively manage and grow our business would suffer.

Our success greatly depends on our ability to hire, train, retain and motivate qualified personnel, particularly in sales, marketing, research and development, service and support. We face significant competition for individuals with the skills required to perform the services we offer. If we are unable to attract and retain qualified personnel or if we experience high personnel turnover, it could prevent us from effectively managing and expanding our business.

Our success also depends upon the continued service of our executive officers, particularly our Chairman and Chief Executive Officer, David Gould, and our President and Chief Operating Officer, Nick Discombe. We have employment agreements with Mr. Gould and Mr. Discombe and limited non-compete agreements with most of our other executive officers. However, any of our executive officers and other employees could terminate his or her relationship with us at any time. The loss of the services of our executive officers or other key personnel, particularly if lost to competitors, could materially and adversely affect our business.

Our certificate of incorporation and bylaws, as well as Delaware law, may inhibit a takeover of our company, which could limit the price investors might be willing to pay for our securities.

Our amended and restated certificate of incorporation and bylaws, as well as Delaware law, contain provisions that might enable our management to resist a takeover of our company. For example, our stockholders cannot take action by written consent or call a special meeting to remove our board of directors. In addition, our directors serve for staggered terms, which makes it difficult to remove all our directors at once. Further, in October 2002, our board of directors approved, and we have implemented, a stockholder rights plan which has the effect of causing substantial dilution to a person or group that attempts to acquire us on terms not approved by the board of directors.

These anti-takeover provisions might discourage, delay or prevent a change in the control of our company or a change in our management. These provisions could also discourage proxy contests and make it more difficult for you and other shareholders to elect directors and take other corporate actions. The existence of these provisions could also limit the price that investors might be willing to pay in the future for our securitie s.

Item 1B.     Unresolved Staff comments

We have not received any written comments regarding our periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more before the end of our fiscal year ended December 31, 2005, thus, no issues remain unresolved.