Selectica, Inc.
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

For the quarterly period ended June 30, 2003

COMMISSION FILE NUMBER 0-29637

SELECTICA, INC.

(Exact name of registrant as specified in its charter)
     
DELAWARE   77-0432030
(State of incorporation)   (IRS employer identification no.)

3 WEST PLUMERIA DRIVE, SAN JOSE, CA 95134

(Address of principal executive offices)

(408) 570-9700

(Registrant’s telephone number, including area code)

     Indicate by a check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]

     Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Exchange Act. YES [X] NO [_]

     The number of shares outstanding of the registrant’s common stock, par value $0.0001 per share, as of July 31, 2003, was 31,429,177.

 


TABLE OF CONTENTS

PART I: FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED BALANCE SHEETS
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4: CONTROLS AND PROCEDURES
PART II OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS
ITEM 3: DEFAULTS UPON SENIOR SECURITIES
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5: OTHER INFORMATION
ITEM 6: EXHIBITS AND REPORT ON FORM 8-K
SIGNATURES
EXHIBIT INDEX
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2


Table of Contents

FORM 10-Q
SELECTICA INC.
INDEX

                 
PART I  
FINANCIAL INFORMATION
       
ITEM 1:  
Financial Statements (unaudited)
       
       
Condensed Consolidated Balance Sheets as of June 30, 2003 and March 31, 2003
    3  
       
Condensed Consolidated Statements of Operations for the three months ended June 30, 2003 and 2002
    4  
       
Condensed Consolidated Statements of Cash Flows for the three months ended June 30, 2003 and 2002
    5  
       
Notes to Condensed Consolidated Financial Statements
    6  
ITEM 2:  
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    16  
ITEM 3:  
Quantitative and Qualitative Disclosures about Market Risk
    38  
ITEM 4:  
Controls and Procedures
    39  
PART II  
OTHER INFORMATION
       
ITEM 1:  
Legal Proceedings
    40  
ITEM 2:  
Changes in Securities and Use of Proceeds
    41  
ITEM 3:  
Defaults Upon Senior Securities
    41  
ITEM 4:  
Submission of Matters to a Vote of Security Holders
    41  
ITEM 5:  
Other Information
    41  
ITEM 6:  
Exhibits and Reports on Form 8-K
    42  
Signatures     43  
Certifications        

 


Table of Contents

PART I: FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS

SELECTICA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
(UNAUDITED)

                   
      June 30,   March 31,
      2003   2003 *
     
 
Assets
               
Current assets:
               
 
Cash and cash equivalents
  $ 42,491     $ 54,993  
 
Short-term investments
    51,394       54,224  
 
Accounts receivable, net of allowance for doubtful accounts of $369 and $741, respectively
    1,699       3,485  
 
Prepaid expenses and other current assets
    3,802       3,863  
 
Investments, restricted – short term
    1,288       1,288  
 
   
     
 
 
Total current assets
    100,674       117,853  
Property and equipment, net
    4,690       5,274  
Other assets
    733       710  
Long-term investments
    23,722       13,134  
Investments, restricted – long term
    178       178  
 
   
     
 
Total assets
  $ 129,997     $ 137,149  
 
   
     
 
Liabilities and Stockholders’ Equity
               
Current liabilities:
               
 
Accounts payable
  $ 1,158     $ 936  
 
Accrued payroll and related liabilities
    1,858       1,932  
 
Other accrued liabilities
    2,835       3,377  
 
Deferred revenues
    10,941       16,486  
 
   
     
 
Total current liabilities
    16,792       22,731  
Other long term liabilities
    1,363       1,338  
Commitments and contingencies
               
Stockholders’ equity:
               
 
Preferred stock
           
 
Common stock
    4       4  
 
Additional paid-in capital
    284,540       284,454  
 
Deferred compensation
    (986 )     (1,869 )
 
Stockholder notes receivable
    (730 )     (730 )
 
Accumulated deficit
    (150,962 )     (149,114 )
 
Accumulated other comprehensive loss
    20       7  
 
Treasury stock
    (20,044 )     (19,672 )
 
   
     
 
 
Total stockholders’ equity
    111,842       113,080  
 
   
     
 
Total liabilities and stockholders’ equity
  $ 129,997     $ 137,149  
 
   
     
 


*   Amounts derived from audited financial statements at the date indicated

See accompanying notes.

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SELECTICA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

                     
        Three Months Ended
       
        June 30,
       
        2003   2002
       
 
Revenues:
               
 
License
  $ 4,704     $ 2,387  
 
Services
    7,083       7,248  
 
   
     
 
   
Total revenues
    11,787       9,635  
Cost of revenues:
               
 
License
    264       231  
 
Services
    5,354       5,342  
 
   
     
 
   
Total cost of revenues
    5,618       5,573  
 
   
     
 
Gross profit
    6,169       4,062  
Operating Expenses:
               
 
Research and development
    3,223       3,566  
 
Sales and marketing
    3,994       5,509  
 
General and administrative
    1,299       1,447  
 
   
     
 
Total operating expenses
    8,516       10,522  
 
   
     
 
Loss from operations
    (2,347 )     (6,460 )
Interest and other income, net
    499       917  
 
   
     
 
Loss before provision for income taxes and cumulative effect of an accounting change
    (1,848 )     (5,543 )
Provision for income taxes
           
 
   
     
 
Loss before cumulative effect of an accounting change
    (1,848 )     (5,543 )
Cumulative effect of an accounting change to adopt SFAS 142
          (9,974 )
 
   
     
 
Net Loss
  $ (1,848 )   $ (15,517 )
 
   
     
 
Basic and diluted net loss per share before cumulative effect of an accounting change
  $ (0.06 )   $ (0.16 )
Cumulative effect of an accounting change
          (0.30 )
 
   
     
 
Basic and diluted, net loss per share
  $ (0.06 )   $ (0.46 )
 
   
     
 
Weighted-average shares of common stock used in computing basic and diluted net loss per share
    30,635       33,700  
 
   
     
 

See accompanying notes.

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SELECTICA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

                 
    Three Months Ended
    June 30,
   
    2003   2002
   
 
Operating activities
               
Net loss
  $ (1,848 )   $ (15,517 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation
    668       947  
Amortization of deferred compensation
    391       469  
Compensation expense related to variable accounting
    38       110  
Accelerated vesting of stock option to employees
    2        
Cumulative effect of an accounting change to adopt SFAS 142
          9,974  
Changes in assets and liabilities:
               
Accounts receivable
    1,786       (1,750 )
Prepaid expenses and other current assets
    61       (329 )
Other assets
    (23 )     (20 )
Accounts payable
    222       65  
Accrued payroll and related liabilities
    (74 )     (184 )
Other accrued liabilities
    (517 )     (308 )
Deferred revenues
    (5,545 )     2,034  
 
   
     
 
Net cash used for operating activities
    (4,839 )     (4,509 )
Investing activities
               
Capital expenditures
    (84 )     (116 )
Purchase of short term investments
    (10,301 )     (2,502 )
Proceeds from maturities of short-term investments
    23,350       6,131  
Purchase of long term investments
    (21,794 )     (15,292 )
Proceeds from maturities of long-term investments
    1,000       19,070  
 
   
     
 
Net cash provided by (used in) investing activities
    (7,829 )     7,291  
Financing activities
               
Cost of stock repurchase
    (372 )     (4,186 )
Proceeds from issuance of common stock, net of purchase
    538       117  
 
   
     
 
Net cash provided by (used in) financing activities
    166       (4,069 )
Net decrease in cash and cash equivalents
    (12,502 )     (1,287 )
Cash and cash equivalents at beginning of the period
    54,993       52,757  
 
   
     
 
Cash and cash equivalents at end of the period
  $ 42,491     $ 51,470  
 
   
     
 
Supplemental cash flow information
               
Deferred compensation related to cancelled stock options
  $ 492     $ 78  
Change in unrealized gain on available for sales securities
  $ 13     $ 139  

See accompanying notes.

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SELECTICA, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. Basis of Presentation

     The condensed consolidated balance sheet as of June 30, 2003, the condensed consolidated statements of operations and condensed consolidated statements of cash flows for the three months ended June 30, 2003 and 2002, respectively, have been prepared by the Company and are unaudited. In the opinion of management, all necessary adjustments (which include normal recurring adjustments) have been made to present fairly the financial position at June 30, 2003, and the results of operations and cash flows for the three months ended June 30, 2003 and 2002. Interim results are not necessarily indicative of the results for a full fiscal year. The consolidated balance sheet as of March 31, 2003 has been derived from the audited consolidated financial statements at that date.

     Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended March 31, 2003.

2. Summary of Significant Accounting Policies

Principles of Consolidation

     The consolidated financial statements include all the accounts of the Company and those of its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated.

Use of Estimates

     The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Foreign Currency Transactions

     Foreign currency transactions at foreign operations are measured using the U.S. dollar as the functional currency. Accordingly, monetary accounts (principally cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities) are remeasured into U.S. dollar using the foreign exchange rate at the balance sheet date. Operations accounts and non-monetary balance sheet accounts are remeasured at the rate in effect at the date of a transaction. The effects of foreign currency remeasurement are reported in current operations and were immaterial for all periods presented.

Concentrations of Credit Risk

     Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash, cash equivalents, short-term investments, long-term investments, restricted investments, and accounts receivable. The Company places its short-term, long-term and restricted investments in high-credit quality financial institutions. The Company is exposed to credit risk in the event of default by these institutions to the extent of the amount recorded on the balance sheet. As of June 30, 2003, the Company has invested in short-term and long-term investments including commercial paper, corporate notes/bonds, and government agency notes/bonds. Restricted investments include corporate bonds and term deposits. Accounts receivable are derived from revenue earned from customers primarily located in the United States. The Company performs ongoing credit evaluations of its customers’ financial condition and generally does not require collateral. The Company maintains reserves for potential credit losses, and historically, such losses have been immaterial.

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Cash Equivalents and Investments

     Cash equivalents consist of short-term, highly liquid financial instruments, principally money market funds, commercial paper, corporate notes and government agency notes with insignificant interest rate risk that are readily convertible to cash and have maturities of three months or less from the date of purchase. The fair value, based on quoted market prices, of cash equivalents is substantially equal to their carrying value at June 30, 2003 and March 31, 2003. The Company considers all investment securities with maturities of more than 3 months but less than one year to be short-term investments. Investments with maturities of more than one year are considered to be long-term investments.

     The Company classifies investments as available-for-sale at the time of purchase and periodically reevaluates such designation. Unrealized gains or losses on available-for-sale securities are included in accumulated other comprehensive loss in stockholders’ equity until their disposition. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in interest income. The cost of securities sold is based on the specific-identification method.

Allowance for Doubtful Accounts

     We evaluate the collectibility of our accounts receivable based on a combination of factors. When we believe a collectibility issue exists with respect to a specific receivable, we record an allowance to reduce that receivable to the amount that we believe to be collectible. For all other receivables, we record an allowance based on an assessment of the aging of such receivables, our historical experience with bad debts and the general economic environment.

Property and Equipment

     Property and equipment are stated at cost. Depreciation is computed using the straight-line method based on estimated useful lives. The estimated useful lives for computer software and equipment is three years, furniture and fixtures is five years, and leasehold improvements is the shorter of the applicable lease term or estimated useful life.

Revenue Recognition

     The Company enters into arrangements for the sale of 1) licenses of software products and related maintenance contracts; 2) bundled license, maintenance, and services; and 3) services on a time and material basis. In instances where maintenance is bundled with a license of software products, such maintenance term is typically one year.

     For each arrangement, the Company determines whether evidence of an arrangement exists, delivery has occurred, the fees are fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all of the criteria are met.

     Arrangements consisting of license and maintenance only. For those contracts that consist solely of license and maintenance the Company recognizes license revenues based upon the residual method after all elements other than maintenance have been delivered as prescribed by Statement of Position 98-9 “Modification of SOP No. 97-2 with Respect to Certain Transactions.” The Company recognizes maintenance revenues over the term of the maintenance contract as vendor-specific objective evidence of fair value for maintenance exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If vendor specific objective evidence does not exist to allocate the total fee to all undelivered elements of the arrangement, revenue is deferred until the earlier of the time at which (1) such evidence does exist for the undelivered elements, or (2) all elements are delivered. If unspecified future products are given over a specified term, we recognize license revenue ratably over the applicable period. We recognize license fees from resellers as revenue when the above criteria have been met and the reseller has sold the subject licenses through to the end-user.

     Arrangements consisting of license, maintenance and other services. Services can consist of maintenance, training and/or consulting services. Consulting services include a range of services including installation of off-the-shelf software, customization of the software for the customer’s specific application, data conversion and building of interfaces to allow the software to operate in customized environments.

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     In all cases, the Company assesses whether the service element of the arrangement is essential to the functionality of the other elements of the arrangement. In this determination the Company focuses on whether the software is off-the-shelf software, whether the services include significant alterations to the features and functionality of the software, whether the services involve the building of complex interfaces, the timing of payments and the existence of milestones. Often the installation of the software requires the building of interfaces to the customer’s existing applications or customization of the software for specific applications. As a result, judgment is required in the determination of whether such services constitute “complex” interfaces. In making this determination the Company considers the following: (1) the relative fair value of the services compared to the software, (2) the amount of time and effort subsequent to delivery of the software until the interfaces or other modifications are completed, (3) the degree of technical difficulty in building of the interface and uniqueness of the application, (4) the degree of involvement of customer personnel, and (5) any contractual cancellation, acceptance, or termination provisions for failure to complete the interfaces. The Company also considers the likelihood of refunds, forfeitures and concessions when determining the significance of such services.

     In those instances where the Company determines that the service elements are essential to the other elements of the arrangement, the Company accounts for the entire arrangement under the percentage of completion contract method in accordance with the provisions of SOP 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts.” The Company follows the percentage of completion method since reasonably dependable estimates of progress toward completion of a contract can be made. We estimate the percentage of completion on contracts utilizing hours incurred to date as a percentage of the total estimated hours to complete the project. Recognized revenues and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. To date, when the Company has been primarily responsible for the implementation of the software, services have been considered essential to the functionality of the software products and therefore license and services revenues have been recognized pursuant to SOP 81-1.

     For those contracts that include contract milestones or acceptance criteria the Company recognizes revenue as such milestones are achieved or as such acceptance occurs.

     In some instances the acceptance criteria in the contract require acceptance after all services are complete and all other elements have been delivered. In these instances the Company recognizes revenue based upon the completed contract method after such acceptance has occurred.

     For those arrangements for which the Company has concluded that the service element is not essential to the other elements of the arrangement the Company determines whether the services are available from other vendors, do not involve a significant degree of risk or unique acceptance criteria, and whether the Company has sufficient experience in providing the service to be able to separately account for the service. When the service qualifies for separate accounting the Company uses vendor-specific objective evidence of fair value for the services and the maintenance to account for the arrangement using the residual method, regardless of any separate prices stated within the contract for each element.

     Vendor-specific objective evidence of fair value of services is based upon hourly rates. As previously noted, the Company enters into contracts for services alone and such contracts are based upon time and material basis. Such hourly rates are used to assess the vendor-specific objective evidence of fair value in multiple element arrangements.

     In accordance with Statement of Position 97-2, “Software Revenue Recognition,” vendor-specific objective evidence of fair value of maintenance is determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate). Each license agreement offers additional maintenance renewal periods at a stated price. Maintenance contracts are typically one year in duration.

     Customer billing occurs in accordance with contract terms. Customer advances and amounts billed to customers in excess of revenue recognized are recorded as deferred revenues. Amounts recognized as revenue in advance of billing (typically under percentage-of-completion accounting) are recorded as unbilled receivables.

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Customer Concentrations

     A limited number of customers have historically accounted for a substantial portion of the Company’s revenues.

     Customers who accounted for at least 10% of total revenues were as follows:

                 
    Three Months Ended
    June 30,
   
    2003   2002
   
 
Customer A
    36 %      
Customer B
    15 %     *  
Customer C
    13 %     *  
Customer D
    10 %     21 %
Customer E
    *       16 %


*   Revenues were less than 10%.

     Customers who accounted for at least 10% of gross accounts receivable were as follows:

                 
    June 30,   March 31,
    2003   2003
   
 
Customer F
    29 %     20 %
Customer D
    23 %     13 %
Customer G
    19 %     *  
Customer A
    *       12 %


*   Customer account was less than 10% of gross accounts receivable.

Warranties and Indemnifications

     The Company generally provides a warranty for its software product to its customers and accounts for its warranties under SFAS No. 5, “Accounting for Contingencies”. The Company’s products are generally warranted to perform substantially in accordance with the functional specifications set forth in the associated product documentation for a period of 90 days. In the event there is a failure of such warranties, the Company generally is obligated to correct the product to conform to the product documentation or, if the Company is unable to do so, the customer is entitled to seek a refund of the purchase price of the product or service. The Company has not provided for a warranty accrual as of June 30, 2003 and March 31, 2003. To date, the Company has not refunded any amounts in relation to the warranty.

     The Company generally agrees to indemnify its customers against legal claims that the Company’s software infringes certain third-party intellectual property rights and accounts for its indemnification under SFAS 5. In the event of such a claim, the Company is obligated to defend its customer against the claim and to either settle the claim at the Company’s expense or pay damages that the customer is legally required to pay to the third-party claimant. In addition, in the event of the infringement, the Company agrees to modify or replace the infringing product, or, if those options are not reasonably possible, to refund the cost of the software. To date, the Company has not been required to make any payment resulting from infringement claims asserted against our customers. As such, the Company has not provided for an infringement accrual as of June 30, 2003.

Development Costs

     Software development costs incurred prior to the establishment of technological feasibility are included in research and development expenses. The Company defines establishment of technological feasibility as the completion of a working model. Software development costs incurred subsequent to the establishment of

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technological feasibility through the period of general market availability of the products are capitalized, if material, after consideration of various factors, including net realizable value. To date, software development costs that are eligible for capitalization have not been material and have been expensed.

Accumulated Other Comprehensive Income

     Statement of Financial Accounting No. 130, “Reporting Comprehensive Income” (SFAS 130), establishes standards for reporting and displaying comprehensive net income and its components in stockholders’ equity. However, it has no impact on our net loss as presented in our financial statements. Accumulated other comprehensive loss is comprised of net unrealized gains on available for sale securities of $20,000 and $7,000 at June 30, 2003 and March 31, 2003, respectively.

Stock-Based Compensation

     The Company accounts for employee stock-based compensation under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and complies with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123) and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (SFAS 148). Under APB 25, compensation expense for fixed stock options is based on the difference between the fair market value of the Company’s stock and the exercise price of the option on the date of grant (Intrinsic Value Method), if any.

     The following table illustrates the effect on net loss and loss per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 (in thousands except per share amounts):

                   
      For three months ended
      June 30,
     
      2003   2002
     
 
Net loss, as reported
  $ (1,848 )   $ (15,517 )
 
Add: Stock-based employee compensation expense included in reported net loss
    431       579  
 
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards
    (5,425 )     (6,107 )
 
   
     
 
Pro forma net loss
  $ (6,842 )   $ (21,045 )
 
   
     
 
Loss per share:
               
 
Basic and diluted – as reported
  $ (0.06 )   $ (0.46 )
 
   
     
 
 
Basic and diluted – pro forma
  $ (0.22 )   $ (0.62 )
 
   
     
 

Segment Information

     Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker or group in deciding how to allocate resources and in assessing performance. The Company operates in one segment, Interactive Selling Solutions for electronic commerce. The Company primarily markets its products in the United States.

     Export revenues are attributable to countries based on the location of the customers. For the three months ended June 30, 2003, sales to international locations were derived primarily from the Canada, India, United Kingdom, Sweden, Japan and New Zealand. For the three months ended June 30, 2002, sales to international locations were derived primarily from the United Kingdom, Canada, Japan, Mexico and Sweden. None of international locations accounted for at least 10% of the total revenue.

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    For three months ended
    June 30,
   
    2003   2002
   
 
International revenues
    12 %     10 %
Domestic revenues
    88 %     90 %
 
   
     
 
Total Revenues
    100 %     100 %
 
   
     
 

     As of June 30, 2003 and March 31, 2003, the Company held long-lived assets outside of the United States with a net book value of approximately $1.6 million and $1.7 of million of which approximately $1.6 million and $1.6 million were in India, respectively.

3. Stockholder notes receivable

     As a result of the repurchase of common stock, which were originally issued in exchange for full recourse promissory notes, from certain key employees during the year ended March 31, 2002, the remaining outstanding shares representing 166,772 shares and approximately $384,000 in total outstanding notes, were deemed to be compensatory as of January 4, 2002 and became subject to variable accounting. We are required to revalue the stock options relating to these promissory notes each period which may result in additional compensation in future quarters. During the period ending June 30, 2003, the Company recorded total compensation expense of approximately $38,000 of which approximately $3,000 was included in cost of goods sold, approximately $1,000 was included in sales and marketing expense and approximately $34,000 was included in general and administrative expense. During the period ending June 30, 2002, the Company recorded total compensation expense of approximately $110,000 of which approximately $40,000 was included in cost of goods sold, approximately $1,000 was included in sales and marketing expense and approximately $69,000 was included in general and administrative expense.

4. Concurrent Transaction

     The company, from time to time, purchases professional services from a value added reseller. The Company records the cost of the professional services purchased as a reduction of license or services revenue recorded from reseller. For the three months ending June 30, 2003, the company recognized approximately $183,000 in license royalty revenue, which is net of approximately $68,000 professional services purchased by the Company. For the three months ending June 30, 2002, the company recognized approximately $24,000 as services revenue and did not purchase any professional services from the value added reseller.

5. Stockholders’ Equity

Deferred Compensation

     During the three months ending June 30, 2003, no options were granted to employees with exercise prices that were less than fair value. During the three months ending June 30, 2002, 6,500 options worth approximately $4,000 were granted to employees with exercise prices that were less than fair value. Such compensation will be amortized over the vesting period of the options, typically four years. For the three months ended June 30, 2003 and 2002, the Company amortized approximately $391,000 and $469,000 of deferred compensation, respectively.

Stock Repurchase

     During the period ending June 30, 2003, the Company repurchased 132,400 shares of its common stock at an average price of $2.91 in the open market at a cost of approximately $392,000 including brokerage fees. The aggregate of the purchases since the authorization by the Board of Directors was approximately 6.0 million shares at the cost of approximately $20.1 million including brokerage fees. This program was authorized by the Board of Directors in August 2001 to allow the Company to repurchase up to $30 million worth of stock in the open market subject to certain criteria as determined by the Board. This program expired in April 2003.

     In May 2003, the Board approved an additional stock buyback program to repurchase up to $30 million worth of stock in the open market subject to certain criteria as determined by the Board. To date, no shares have been repurchased.

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6. Income Taxes

     The Company did not record any income tax provision for the three months ended June 30, 2003 and 2002, respectively.

     FASB Statement No. 109 provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes our historical operating performance and the reported cumulative net losses in all prior years, we have provided a full valuation allowance against our net deferred tax assets. We intend to evaluate the realizability of the deferred tax assets on a quarterly basis.

7. Computation Of Basic And Diluted Net Loss Per Share

     Basic and diluted net loss per common share is presented in conformity with Statement of Financial Accounting Standards No. 128, “Earnings Per Share” (FAS 128), for all periods presented. In accordance with FAS 128, basic and diluted net loss per share have been computed using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase.

     The following table presents the computation of basic and diluted net loss per share:

                 
    Three months Ended June 30,
   
    2003   2002
   
 
    (in thousands, except
    per share amounts)
Net loss applicable to common stockholders
  $ (1,848 )   $ (15,517 )
 
   
     
 
Basic and diluted:
               
Weighted-average shares of common stock outstanding
    30,667       33,876  
Less weighted-average shares subject to repurchase
    (32 )     (176 )
 
   
     
 
Weighted-average shares used in computing basic and diluted net loss per share applicable to common stockholders
    30,635       33,700  
 
   
     
 
Basic and diluted net loss per share applicable to common stockholders
  $ (0.06 )   $ (0.46 )
 
   
     
 

     The Company excludes potentially dilutive securities from its diluted net loss per share computation when their effect would be antidilutive to net loss per share amounts. The following common stock equivalents were excluded from the net loss per share computation:

                 
    Three months Ended June 30,
   
    2003   2002
   
 
    (in thousands)
Options excluded due to the exercise price exceeding the average fair market value of the Company’s common stock during the period
    4,442       4,556  
Options excluded for which the exercise price was less than the average fair market value of the Company’s common stock during the period but were excluded as inclusion would decrease the Company’s net loss per share
    3,431       4,251  
Common shares excluded resulting from common stock subject to repurchase
    21       162  
 
   
     
 
Total common stock equivalents excluded from diluted net loss per common share
    7,894       8,969  
 
   
     
 

8. Comprehensive Loss

     The components of comprehensive loss, net of related income tax, for the three months ended June 30, 2003 and 2002 are as follows:

                 
    Three Months Ended
    June 30,
   
    2003   2002
   
 
    (in thousands)
Net loss
  $ (1,848 )   $ (15,517 )
Change in unrealized gain on available-for-sale securities
    13       139  
 
   
     
 
Comprehensive loss
  $ (1,835 )   $ (15,378 )
 
   
     
 

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9. Litigation

Class Action

     Between June 5, 2001 and June 22, 2001, four securities class action complaints were filed against the Company, certain of our officers and directors, and Credit Suisse First Boston Corporation (“CSFB”), as the underwriters of our March 13, 2000 initial public offering (“IPO”), in the United States District Court for the Southern District of New York. On August 9, 2001, these actions were consolidated before a single judge along with cases brought against numerous other issuers, their officers and directors and their underwriters, that make similar allegations involving the allocation of shares in the IPOs of those issuers. The consolidation was for purposes of pretrial motions and discovery only. On April 19, 2002, plaintiffs filed a consolidated amended complaint asserting essentially the same claims as the original complaints.

     The amended complaint alleges that the Company, the officer and director defendants and CSFB violated federal securities laws by making material false and misleading statements in the prospectus incorporated in our registration statement on Form S-1 filed with the SEC in March 2000 in connection with our IPO. Specifically, the complaint alleges, among other things, that CSFB solicited and received excessive and undisclosed commissions from several investors in exchange for which CSFB allocated to those investors material portions of the restricted number of shares of common stock issued in our IPO. The complaint further alleges that CSFB entered into agreements with its customers in which it agreed to allocate the common stock sold in our IPO to certain customers in exchange for which such customers agreed to purchase additional shares of our common stock in the after-market at pre-determined prices. The complaint also alleges that the underwriters offered to provide positive market analyst coverage for the Company after the IPO, which had the effect of manipulating the market for Selectica’s stock.

     On July 15, 2002, the Company and the officer and director defendants, along with other issuers and their related officer and director defendants, filed a joint motion to dismiss based on common issues. Opposition and reply papers were filed and the Court heard oral argument. Prior to the ruling on the motion to dismiss, on October 8, 2002, the individual officers and directors entered into a stipulation of dismissal and tolling agreement with plaintiffs. As part of that agreement, plaintiffs dismissed the case without prejudice against the individual defendants. The Court ordered the dismissal of the officers and directors without prejudice on October 9, 2002. The court rendered its decision on the motion to dismiss on February 19, 2003, denying dismissal of the Company.

     On June 25, 2003, a Special Committee of the Board of Directors of the Company approved a Memorandum of Understanding (the “MOU”) reflecting a settlement in which the plaintiffs agreed to dismiss the case against the Company with prejudice in return for the assignment by the Company of claims that the Company might have against its underwriters. No payment to the plaintiffs by the Company is required under the MOU. There can be no assurance that the MOU will result in a formal settlement or that the Court will approve the settlement that the MOU sets forth.

Shareholder Derivative Action

     On April 16, 2002, a shareholder derivative action was filed in the Superior Court of California, Santa Clara County, against certain of our officers and directors, against CSFB, as the underwriters of our IPO, and against the Company as nominal defendant. The action was filed by a shareholder purporting to assert on behalf of the Company claims for breach of fiduciary duty, aiding and abetting and conspiracy, negligence, unjust enrichment, and breach of contract, relating to the pricing of shares in the Company’s IPO. On June 6, 2002, the shareholder plaintiff filed an amended complaint dropping the breach of contract claim against CSFB and adding claims against

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CSFB for breach of an agent’s duty to its principal and for violation of the California Unfair Competition Law, based on alleged violations of certain rules of the National Association of Securities Dealers.

     On November 25, 2002, following the removal of the case to federal court and the subsequent remand of the case back to the state court, the Company and the officer and director defendants filed answers to the amended complaint, preserving certain defenses including defenses based on plaintiff’s lack of standing to bring the suit. Also on November 25, 2002, CSFB filed a motion to dismiss the case, on the grounds that the plaintiff lacks standing. That motion was heard on March 4, 2003, and on March 18, 2003 the Court issued an Order sustaining the motion but granting plaintiff 30 days to file an amended complaint.

     On April 18, 2003, the plaintiff filed a second amended complaint. This complaint adds new allegations as to standing, and also alleges certain additional facts supporting the various causes of action against the defendants. Specifically, plaintiff’s new complaint alleges that CSFB offered and provided, and the individual defendants accepted, improper “gratuities” in the form of allocations of IPO stocks of other companies, in order to influence the selection of CSFB as the underwriter of the Company’s IPO.

     On June 17, 2003, CSFB responded to this second amended complaint by filing a demurrer (motion to dismiss) on the grounds that the plaintiff lacks standing to bring the action. Also on June 17, 2003, the Company and the individual defendants responded to the second amended complaint by joining CSFB’s demurrer, while reserving other objections. The demurrer is currently scheduled to be heard on August 12, 2003.

     The Company believes that the securities class action allegations against the Company and our officers and directors are without merit and, if settlement of the action is not finalized, the Company intends to contest the allegations vigorously. However, the litigation is in its preliminary stages, and the Company cannot predict its outcome. The litigation process is inherently uncertain. If the outcome of the litigation is adverse to the Company and if, in addition, the Company is required to pay significant monetary damages, the Company’s business would be significantly harmed. The shareholder derivative litigation is also in its preliminary stages. At a minimum, the class action litigation as well as the shareholder derivative litigation could result in substantial costs and divert our management’s attention and resources, which could seriously harm our business.

10. Restructuring

     In the quarter ended March 31, 2001, the Company began restructuring worldwide operations to reduce costs and improve efficiencies in response to a slower economic environment. The restructuring costs were accounted for under EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit and Activity,” and were charged to operations when the criteria in EITF 94-3 were met. The first plan (“Plan 1”) was initiated and completed in the quarter ended March 31, 2001 and was comprised of severance and related benefits of $667,000 for the reduction of 30 heads in the areas of professional services, research and development, sales, marketing, and general administration. The second plan was initiated and completed in the quarter ended June 30, 2001 (“Plan 2”) and was comprised of severance and related benefits of $1.8 million for the reduction of 41 heads in the areas of professional services, research and development, sales, marketing, and general administration. The third plan (“Plan 3”) was initiated in July 2002 and was comprised of severance and related benefits of $1.7 million for the reduction of 38 heads in the areas of professional services, research and development, sales, marketing, and general administration and will be complete by the second quarter of 2004.

     Plan 1 reduced headcount by 6, 3, 11, and 10 for professional services, research and development, sales and marketing, and general administration, respectively. The anticipated savings for salaries and benefits on an annual basis is approximately $3.3 million. Plan 2 further reduced headcount by 5, 18, 17, and 1 for professional services, research and development, sales and marketing, and general administration, respectively. The anticipated savings for salaries and benefits on an annual basis is approximately $4.4 million. Plan 3 reduced headcount by 9, 7, 17, and 5 for professional services, research and development, sales and marketing, and general administration, respectively. The anticipated savings for salaries and benefits on an annual basis is approximately $3.5 million.

     During the three months period ending June 30, 2003, the Company has not recorded any restructuring charges and approximately $82,000 of severance and legal fees was paid to the terminated employees associated with the restructuring activities for Plan 3.

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     As of June 30, 2003, the balance of the reserve for restructuring was approximately $182,000, which was included in Other Accrued Liabilities in the accompanying consolidated balance sheet. The activity in the accrued restructuring balances from March 31, 2003 to June 30, 2003 is as follows:

     Severance and Related Benefits:

         
    (in thousands)
Accrual balance, March 31, 2003
  $ 264  
Payments for the year ended June 30, 2003 — Plan 3
    (82 )
 
   
 
Accrual balance, June 30, 2003
  $ 182  
 
   
 

11. Goodwill

     During the three months ending June 30, 2002, we wrote off approximately $10.0 million of the goodwill due primarily to the adoption of SFAS 142 and it is summarized as follows:

         
    (in thousands)
Goodwill, net as of March 31, 2002
  $ 9,974  
Amortization for the three months ending June 30, 2002
     
Cumulative effect of an accounting change to adopt SFAS 142
    (9,974 )
 
   
 
Goodwill, net as of June 30, 2002
  $  
 
   
 

12. Recent Accounting Pronouncements

     In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF No. 00-21). EITF No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services or rights to use assets. The provisions of EITF No. 00-21 will apply to revenue arrangements entered into after April 1, 2004. The Company is currently evaluating the effect that the adoption of EITF No. 00-21 will have on its results of operations and financial condition.

     In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46), an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” FIN 46 requires certain variable interest entities (“VIEs”) to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new VIEs created or acquired after January 31, 2003. For VIEs created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. Selectica has not invested in any new VIEs created after January 31, 2003. Selectica is currently evaluating the effect that the adoption of FIN 46 will have on its results of operations and financial condition.

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ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

In addition to historical information, this quarterly report contains forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those projected. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the section entitled “Management’s Discussion and Analysis” and “Risks Related to Our Business.” Actual results could differ materially. Important factors that could cause actual results to differ materially include, but are not limited to, the level of demand for Selectica’s products and services; the intensity of competition; Selectica’s ability to effectively manage product transitions and to continue to expand and improve internal infrastructure; and risks associated with potential acquisitions. For a more detailed discussion of the risks relating to Selectica’s business, readers should refer to the section later in this report entitled “Risks Related to Our Business.” Readers are cautioned not to place undue reliance on the forward-looking statements, including statements regarding the Company’s expectations, beliefs, intentions or strategies regarding the future, which speak only as of the date of this quarterly report. Selectica assumes no obligation to update these forward-looking statements.

Overview

     Selectica is a leading provider of Interactive Selling Solutions (ISS) software that enables enterprises to reduce costs and enhance revenue from complex product and services offerings. Our solutions unify customers’ business processes to correctly configure, price, and quote offerings across multiple distribution channels. As a result, we help improve profitability by reducing process costs, optimizing pricing, eliminating rework and concessions, and avoiding high-risk business. Businesses that deploy ISS are able to empower business managers to quickly and easily modify product, service and price information enterprise-wide to ensure proper margins and to stay ahead of changing market conditions. Our product architecture has been designed specifically for the Internet and provides scalability, reliability, flexibility and ease of use. Additionally, our Interactive Selling Solutions have been developed with an open architecture that leverages data in existing applications, such as enterprise resource planning, or ERP, systems. This allows for an easy-to-install application and reduced deployment time. Across a wide range of industries, Selectica’s ISS have demonstrated an ability to increase productivity, improve order accuracy, boost return on investment and establish and maintain a competitive advantage. Selectica’s customers represent manufacturing and service leaders including: ABB, Aetna, Blue Cross Blue Shield of Michigan, BMW of North America, British Telecom, Cisco, Dell, General Electric, Fireman’s Fund Insurance Company, Hitachi, IBM, Mitel, Rockwell Automation and Tellabs.

Critical Accounting Policies and Estimates

     We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States. These accounting principles require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. Our management is also required to make certain judgments that affect the reported amounts of revenues and expenses during the reporting period. We periodically evaluate our estimates including those relating to revenue recognition, impairment of intangible assets, allowance for doubtful accounts, litigation and other contingencies. The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our consolidated financial statements. We evaluate our estimates and judgments on an on-going basis. We base our estimates on historical experience and on assumptions that we believe to be reasonable under the circumstances. Our experience and assumptions form the basis for our judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may vary from what we anticipate and different assumptions or estimates about the future could change our reported results. We believe the following accounting policies are the most critical to us, in that they are important to the portrayal of our financial statements and they require our most difficult, subjective or complex judgments in the preparation of our consolidated financial statements:

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Revenues

     We enter into arrangements for the sale of 1) licenses of software products and related maintenance contracts; 2) bundled license, maintenance, and services; and 3) services on a time and material basis. In instances where maintenance is bundled with a license of software products, such maintenance term is typically one year.

     For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fees are fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all of the criteria are met.

     Arrangements consisting of license and maintenance only. For those contracts that consist solely of license and maintenance we recognize license revenues based upon the residual method after all elements other than maintenance have been delivered as prescribed by Statement of Position 98-9 “Modification of SOP No. 97-2 with Respect to Certain Transactions.” We recognize maintenance revenues over the term of the maintenance contract as vendor-specific objective evidence of fair value for maintenance exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If vendor specific objective evidence does not exist to allocate the total fee to all undelivered elements of the arrangement, revenue is deferred until the earlier of the time at which (1) such evidence does exist for the undelivered elements, or (2) all elements are delivered. If unspecified future products are given over a specified term, we recognize license revenue ratably over the applicable period. We recognize license fees from resellers as revenue when the above criteria have been met and the reseller has sold the subject licenses through to the end-user.

     Arrangements consisting of license, maintenance and other services. Services can consist of maintenance, training and/or consulting services. Consulting services include a range of services including installation of off-the-shelf software, customization of the software for the customer’s specific application, data conversion and building of interfaces to allow the software to operate in customized environments.

     In all cases, we assess whether the service element of the arrangement is essential to the functionality of the other elements of the arrangement. In this determination we focus on whether the software is off-the-shelf software, whether the services include significant alterations to the features and functionality of the software, whether the services involve the building of complex interfaces, the timing of payments and the existence of milestones. Often the installation of the software requires the building of interfaces to the customer’s existing applications or customization of the software for specific applications. As a result, judgment is required in the determination of whether such services constitute “complex” interfaces. In making this determination we consider the following: (1) the relative fair value of the services compared to the software, (2) the amount of time and effort subsequent to delivery of the software until the interfaces or other modifications are completed, (3) the degree of technical difficulty in building of the interface and uniqueness of the application, (4) the degree of involvement of customer personnel, and (5) any contractual cancellation, acceptance, or termination provisions for failure to complete the interfaces. We also consider the likelihood of refunds, forfeitures and concessions when determining the significance of such services.

     In those instances where we determine that the service elements are essential to the other elements of the arrangement, we account for the entire arrangement under the percentage of completion contract method in accordance with the provisions of SOP 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts.” We follow the percentage of completion method since reasonably dependable estimates of progress toward completion of a contract can be made. We estimate the percentage of completion on contracts utilizing hours incurred to date as a percentage of the total estimated hours to complete the project. Recognized revenues and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. To date, when we have been primarily responsible for the implementation of the software, services have been considered essential to the functionality of the software products and therefore license and services revenues have been recognized pursuant to SOP 81-1.

     For those contracts that include contract milestones or acceptance criteria we recognize revenue as such milestones are achieved or as such acceptance occurs.

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     In some instances the acceptance criteria in the contract require acceptance after all services are complete and all other elements have been delivered. In these instances we recognize revenue based upon the completed contract method after such acceptance has occurred.

     For those arrangements for which we have concluded that the service element is not essential to the other elements of the arrangement we determine whether the services are available from other vendors, do not involve a significant degree of risk or unique acceptance criteria, and whether we have sufficient experience in providing the service to be able to separately account for the service. When the service qualifies for separate accounting we use vendor-specific objective evidence of fair value for the services and the maintenance to account for the arrangement using the residual method, regardless of any separate prices stated within the contract for each element.

     Vendor-specific objective evidence of fair value of services is based upon hourly rates. As previously noted, we enter into contracts for services alone and such contracts are based upon time and material basis. Such hourly rates are used to assess the vendor-specific objective evidence of fair value in multiple element arrangements.

     In accordance with Statement of Position 97-2, “Software Revenue Recognition,” vendor-specific objective evidence of fair value of maintenance is determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate). Each license agreement offers additional maintenance renewal periods at a stated price. Maintenance contracts are typically one year in duration.

     To date we have not entered into arrangements solely for the license of our products and, therefore, we have not demonstrated vendor-specific objective evidence for the fair value of the license element.

     In all cases we classify revenues for these arrangements as license revenues and services revenues based on the estimates of fair value for each element.

     For the three months ended June 30, 2003, we recognized 38% of our revenues under the completed contract method, 26% under the percentage-of-completion method and 36% under the residual method. For the three months ended June 30, 2002, we recognized 37% of our revenues under the completed contract method, 62% under the percentage-of-completion method and 1% under the residual method.

     Customer billing occurs in accordance with contract terms. Customer advances and amounts billed to customers in excess of revenue recognized are recorded as deferred revenues. Amounts recognized as revenue in advance of billing (typically under percentage-of-completion accounting) are recorded as unbilled receivables.

Impairment of Goodwill and Intangible Assets

     Goodwill and intangible assets, which resulted from our business combinations accounted for as purchases, were recorded at amortized cost. We periodically reviewed the carrying amounts of these intangible assets for indications of impairment based on the operational performance of the acquired businesses and market conditions or sooner whenever events or changes in circumstances indicated the carrying values of such assets might not be recoverable. We considered some of the following factors important in deciding when to perform an impairment review: significant under-performance of a product line relative to budget; shifts in business strategies, which impacted the continued uses of the assets; significant negative industry or economic trends; and the results of past impairment reviews. If indications of impairment were present, we assessed the value of the intangible assets using estimates of future undiscounted cash flows. Impairment charges, if any, resulted in situations when the fair values of these assets were less than the carrying value. During fiscal year 2002, various restructuring activities as well as the overall economic conditions signaled an indication of possible impairment. We then analyzed the value of our various intangibles by comparing the carrying value of these assets to the undiscounted cash flows estimated to be generated by these assets. Based on this analysis there was no impairment during fiscal year 2002. Beginning in fiscal year 2003, the method for assessing potential impairments of intangibles was changed based on new accounting rules issued by the Financial Accounting Standards Board (FASB), and related implementation guidance. The application of these new rules indicated that the remaining balance of goodwill and intangibles totaling approximately $10.0 million as of April 1, 2002 was impaired which was recorded as a cumulative effect of an accounting change in the first quarter of fiscal year 2003.

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Allowance for Doubtful Accounts

     We evaluate the collectibility of our accounts receivable based on a combination of factors. When we believe a collectibility issue exists with respect to a specific receivable, we record an allowance to reduce that receivable to the amount that we believe to be collectible. For all other receivables, we record an allowance based on an assessment of the aging of such receivables, our historical experience with bad debts and the general economic environment.

Contingencies and Litigation

     We are subject to various proceedings, lawsuits and claims relating to product, technology, labor, shareholder and other matters. We are required to assess the likelihood of any adverse outcomes and the potential range of probable losses in these matters. The amount of loss accrual, if any, is determined after careful analysis of each matter, and is subject to adjustment if warranted by new developments or revised strategies.

Factors Affecting Operating Results

     A relatively small number of customers account for a significant portion of our total revenues. We expect that revenue will continue to depend upon a limited number of customers. If we were to lose a customer, it would have a significant impact upon future revenue. Customers who accounted for at least 10% of total revenues were as follows:

                 
    Three Months Ended
    June 30,
   
    2003   2002
   
 
Customer A
    36 %      
Customer B
    15 %     *  
Customer C
    13 %     *  
Customer D
    10 %     21 %
Customer E
    *       16 %


*   Revenues were less than 10%.

     To date, we have foreign activities in India, Canada and some European and Asian countries because we believe international markets represent a significant growth opportunity. We anticipate that our exposure to foreign currency fluctuations will continue since we have not adopted a hedging program to protect us from risks associated with foreign currency fluctuations. In addition, if the recent conflict between India and Pakistan continues to escalate, it could adversely affect our operations in India.

     We have a limited operating history upon which we may be evaluated. We have incurred significant losses since inception and, as of June 30, 2003, we had an accumulated deficit of approximately $151.0 million. We believe our success depends on the growth of our customer base and the development of the emerging Interactive Selling Solutions market.

     Due to the slowing of the U.S. economy, particularly in the area of technology infrastructure investment, and in an effort to achieve profitability, we underwent certain restructuring activities starting from the forth quarter of fiscal year 2001. The first plan (“Plan 1”) was initiated and completed in the quarter ended March 31, 2001 and was comprised of severance and related benefits of $667,000 for the reduction of 30 heads in the areas of professional services, research and development, sales, marketing, and general administration. The second plan was initiated and completed in the quarter ended June 30, 2001 (“Plan 2”) and was comprised of severance and related benefits of $1.8 million for the reduction of 41 heads in the areas of professional services, research and development, sales, marketing, and general administration. The third plan (“Plan 3”) was initiated in July 2002 and was comprised of severance and related benefits of $1.7 million for the reduction of 38 heads in the areas of professional services,

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research and development, sales, marketing, and general administration and will be complete by the second quarter of 2004.

     Plan 1 reduced headcount by 6, 3, 11, and 10 for professional services, research and development, sales and marketing, and general administration, respectively. The anticipated savings for salaries and benefits on an annual basis is approximately $3.3 million. Plan 2 further reduced headcount by 5, 18, 17, and 1 for professional services, research and development, sales and marketing, and general administration, respectively. The anticipated savings for salaries and benefits on an annual basis is approximately $4.4 million. Plan 3 reduced headcount by 9, 7, 17, and 5 for professional services, research and development, sales and marketing, and general administration, respectively. The anticipated savings for salaries and benefits on an annual basis is approximately $3.5 million. We plan to reduce our investment in research and development, sales and marketing, and general and administrative expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues.

     In view of the rapidly changing nature of our business and our limited operating history, we believe that period-to-period comparisons of revenues and operating results are not necessarily meaningful and should not be relied upon as indications of future performance. Our limited operating history makes it difficult to forecast future operating results. Additionally, despite our revenue growth in fiscal 2000 and during the first three quarters of fiscal 2001, we do not believe that historical growth rates are necessarily sustainable or indicative of future growth and we cannot be certain that revenues will increase. This was evidenced by declining results beginning with the fourth quarter of fiscal year 2001, slight growth in the first quarter of fiscal 2002 and then further declines in the remaining quarters of fiscal year 2002 and throughout fiscal 2003.

     In any given period our revenues are dependent on customer contracts booked during earlier periods. Because we typically recognize revenue in periods after contracts are entered into, a decline in the number of contracts booked during any particular period or the value of such contracts would cause a decrease in revenue in future periods. In recent months, the number and value of our bookings has continued to decrease significantly. If our bookings remain at current levels or if the value of such bookings decreases further, it will cause our revenues to decline in future periods which could significantly harm our business and operating results. While we plan to reduce our expenses to balance expense levels with projected revenues, if our bookings do not improve, we may not be able to sufficiently reduce our expenses, and this would adversely affect our operating results. Even if we were to achieve profitability in any period, we may not be able to sustain or increase profitability on a quarterly or annual basis.

Equity Transactions

     As a result of the repurchase of common stock from certain key employees during the year ended March 31, 2002 which were originally issued in exchange for full recourse promissory notes, the remaining outstanding shares representing 166,772 shares and approximately $384,000 in total outstanding notes, were deemed to be compensatory as of January 4, 2002 and became subject to variable accounting. We are required to revalue the stock options relating to these promissory notes each period which may result in additional compensation in future quarters. During the period ending June 30, 2003, the Company recorded total compensation expense of approximately $38,000 of which approximately $3,000 was included in cost of goods sold, approximately $1,000 was included in sales and marketing expense and approximately $34,000 was included in general and administrative expense. During the period ending June 30, 2002, the Company recorded total compensation expense of approximately $110,000 of which approximately $40,000 was included in cost of goods sold, approximately $1,000 was included in sales and marketing expense and approximately $69,000 was included in general and administrative expense.

     During the period ending June 30, 2003, the Company repurchased 132,400 shares of its common stock at an average price of $2.91 in the open market at a cost of approximately $392,000 including brokerage fees. The aggregate of the purchases since the authorization by the Board of Directors was approximately 6.0 million shares at the cost of approximately $20.1 million including brokerage fees. This program was authorized by the Board of Directors in August 2001 to allow the Company to repurchase up to $30 million worth of stock in the open market subject to certain criteria as determined by the Board. This program expired in April 2003.

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     In May 2003, the Board approved an additional stock buyback program to repurchase up to $30 million worth of stock in the open market subject to certain criteria as determined by the Board. To date, no shares have been repurchased.

Results of Operations

Revenues

                           
      Three Months Ended        
      June 30        
     
       
      2003   2002   Change
     
 
 
      (in thousands, except percentages)
License
  $ 4,704     $ 2,387       97 %
 
Percentage of total revenues
    40 %     25 %        
Services
  $ 7,083     $ 7,248       (2 )%
 
Percentage of total revenues
    60 %     75 %        
 
Total revenues
  $ 11,787     $ 9,635       22 %

     License. License revenues increased significantly in the three months period ended June 30, 2003 as compared to the three months period ended June 30, 2002 due primarily to a new customer which had signed a contract in December 2002 but all deliverables had not been completed until April 2003. Despite the license revenues growth in the period ended June 30, 2003, the slowdown in the economy has still caused a significant decrease in technology spending and negatively impacted the productivity of our sales force. We expect license revenues to continue to fluctuate in future periods as a percentage of total revenues.

     Services. Services revenues are comprised of fees from consulting, maintenance, training and out-of-pocket reimbursements. The service revenues for the three months period ended June 30, 2003 was comparable to the three months ended June 30, 2002. We expect services revenues to continue to fluctuate in future periods as a percentage of total revenues.

     Overall, we expect our revenues mix to continue to fluctuate on a quarter-to-quarter basis. We believe that the future revenues will continue to fluctuate due to the changing number and size of new customers, number of consulting projects and maintenance contracts, and general economic conditions.

Cost of revenues

                           
      Three Months Ended        
      June 30,        
     
       
      2003   2002   Change
     
 
 
      (in thousands, except percentages)
Cost of license revenues
  $ 264     $ 231       14 %
 
Percentage of license revenues
    6 %     10 %        
Cost of services revenues
  $ 5,354     $ 5,342       0 %
 
Percentage of services revenues
    76 %     74 %        

     Cost of License Revenues. Cost of license revenues consists of royalty fees associated with third-party software, the costs of the product media, duplication, packaging and delivery of our software products to our customers, which may include documentation, shipping and other data transmission costs. The increase of cost of license revenues was primarily due to increased license sales, which resulted in increase in the amount of royalty fees associated with third-party software and other sales associated costs. The decrease in the cost of license revenues as a percentage of related revenues in the current period as compared to the same period a year ago was also due primarily to the fact that we have certain fixed costs that are not dependent upon sales volume.

     Cost of Services Revenues. Cost of services revenues is comprised mainly of salaries and related expenses of our services organization plus certain allocated expenses. The cost of services revenues for the three months period ended June 30, 2003 was comparable with the three months period ended June 30, 2002. The consistency was due primarily to the reduction of the cost of services revenues as a result of our restructuring efforts offset by

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severance benefits paid to other terminated employees not associated with restructuring and recognition of the deferred costs related to older contracts. For the three months period ended June 30, 2003, we amortized approximately $127,000 for deferred compensation related to stock options, $3,000 for compensation related to variable accounting and $2,000 for compensation related to acceleration of stock option vesting. For the three months period ended June 30, 2002, we amortized approximately $174,000 for deferred compensation related to stock options and $40,000 for compensation related to variable accounting. We continue to focus on improving our services margins, however there are a few active implementations related to older contracts with lower profit margins for which the costs have not been recognized. These projects, which have staggered milestones, may have a negative impact on our cost of services revenues in the next few quarters. We expect cost of services revenues to fluctuate as a percentage of service revenues and we plan to reduce our investment in cost of services revenues in absolute dollars over the next year as necessary to balance expense levels with projected revenues.

Expenses

                           
      Three Months ended        
      June 30,        
     
       
      2003   2002   Change
     
 
 
      (in thousands, except percentages)
Research and development
  $ 3,223     $ 3,566       (10 )%
 
Percentage of total revenues
    27 %     37 %        
Sales and marketing
  $ 3,994     $ 5,509       (28 )%
 
Percentage of total revenues
    34 %     57 %        
General and administrative
  $ 1,299     $ 1,447       (10 )%
 
Percentage of total revenues
    11 %     15 %        

     Research and Development. Research and development expenses consist mainly of salaries and related costs of our engineering, quality assurance, technical publications efforts and certain allocated expenses. The decrease in research and development expenses was due primarily to the reduction of outside consultants and headcounts. For the three months period ended June 30, 2003 and 2002, we recorded approximately $61,000 and approximately $65,000, respectively, for amortization of deferred compensation related to stock options. We plan to reduce our investment in research and development in absolute dollars over the next year as necessary to balance expense levels with projected revenues.

     Sales and Marketing. Sales and marketing expenses consist mainly of salaries and related costs for our sales and marketing organization, sales commissions, expenses for trade shows, public relations, collateral sales materials, advertising and certain allocated expenses. The decrease of the sales and marketing expenses was due primarily to reduction in spending on marketing programs, decrease of sales commissions and salaries and reduction in the allocation of fixed overhead costs as a result of the reduced headcount in these areas. For the three months period ended June 30, 2003, we amortized approximately $121,000 for deferred compensation related to stock options and $1,000 for compensation related to variable accounting. For the three months period ending June 30, 2002, we amortized approximately $147,000 for deferred compensation related to stock options. We plan to reduce our sales and marketing expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues.

     General and Administrative. General and administrative expenses consist mainly of personnel and related costs for general corporate functions, including finance, accounting, legal, human resources, bad debt expense and certain allocated expenses. The decrease of general and administrative expenses was due primarily to reduction of the allowance for doubtful accounts by approximately $240,000 as a result of lower bad debt exposure from lower levels of accounts receivable and our restructuring efforts, including headcount reductions. For the three months period ended June 30, 2003, we amortized approximately $82,000 for deferred compensation related to stock options and $34,000 for compensation related variable accounting. For the three months period ended June 30, 2002, we amortized approximately $83,000 for deferred compensation related to stock options and $69,000 for compensation related variable accounting. We anticipate that general and administrative expenses in the near future will include costs to comply with newly-proposed and enacted rules and regulations promulgated by the SEC and the NASDAQ stock market, including costs to use additional outside legal, accounting and advisory services.

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Interest and Other Income, Net

     Interest and other income, net, consists primarily of interest earned on cash balances, short-term and long-term investments, and stockholders’ notes receivable. Interest and other income, net, totaled approximately $499,000 and $917,000 for the three months periods ending June 30, 2003 and 2002, respectively. The decrease was due primarily to lower interest rates and the reduction of cash and investments balance due to these amounts being used for the operation of our business during the fiscal year of 2003.

Provision for Income Taxes

     The Company did not record any income tax provision for the three months ended June 30, 2003 and 2002, respectively.

     FASB Statement No. 109 provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes our historical operating performance and the reported cumulative net losses in all prior years, we have provided a full valuation allowance against our net deferred tax assets. We intend to evaluate the realizability of the deferred tax assets on a quarterly basis.

Recent Accounting Pronouncements

     In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF No. 00-21). EITF No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services or rights to use assets. The provisions of EITF No. 00-21 will apply to revenue arrangements entered into after April 1, 2004. The Company is currently evaluating the effect that the adoption of EITF No. 00-21 will have on its results of operations and financial condition.

     In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46), an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” FIN 46 requires certain variable interest entities (“VIEs”) to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new VIEs created or acquired after January 31, 2003. For VIEs created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. Selectica has not invested in any new VIEs created after January 31, 2003. Selectica is currently evaluating the effect that the adoption of FIN 46 will have on its results of operations and financial condition.

Liquidity and Capital Resources

                         
    June 30,   March 31,        
    2003   2003   Change
   
 
 
    (in thousands, except percentages)
Cash, cash equivalents and short-term investments
  $ 93,885     $ 109,217       (14 )%
Working capital
  $ 83,882     $ 95,122       (12 )%
                         
    Three Months Ended        
    June 30,        
   
       
    2003   2002   Change
   
 
 
    (in thousands, except percentages)
Net cash used in operating activities
  $ (4,839 )   $ (4,509 )     7 %
Net cash provided by (used in) investing activities
  $ (7,829 )   $ 7,291       (207 )%
Net cash provided by (used in) financing activities
  $ 166     $ (4,069 )     104 %

     Our primary sources of liquidity consisted of $93.9 million in cash, cash equivalents and short-term investments and $23.7 million in long-term investments for a total of $117.6 million as of June 30, 2003 compared to $109.2

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million in cash, cash equivalents and short-term investments and $13.1 million in long-term investments for a total of $122.3 million as of March 31, 2003. The decrease primarily related to approximately $4.8 million of cash used in operations, $84,000 for capital expenditure, $372,000 for stock repurchases in the open market, partially offset by approximately $538,000 of net proceeds from issuance of common stock during the three months ended June 30, 2003.

     We experienced a net decrease in working capital at June 30, 2003 as compared to March 31, 2003 primarily due to the cash used in operations, stock repurchases and purchases in excess of proceeds from long-term investments.

     We have funded our operations with proceeds from the private sale of common and preferred stock, and our initial public offering. The net cash used in operating activities for the three months period ended June 30, 2003 was consistent as compared to the same period a year ago. The net cash used in operating activities for the three months period ending June 30, 2003 was due primarily to net loss adjusted for non-cash expenses and a decrease in accounts receivable offset by a decrease of deferred revenues. The net cash used in operating activities for the three months period ending June 30, 2002 was due primarily to net loss adjusted for non-cash expenses and an increase of deferred revenues offset by an increase in accounts receivable. For the three months period ending June 30, 2002, a non-cash charge of goodwill amounting to approximately $10.0 million was recorded as a cumulative effect of an accounting change to adopt SFAS 142.

     The net cash used for investing activities was due primarily to approximately $7.7 million of net purchase of available-for-sale investments for the three months ended June 30, 2003 as compared to approximately $7.4 million of net proceeds generated from the maturities of the available-for-sale investments for the three months period ended June 30, 2002.

     The increase in cash provided by financing activities was due primarily to the increase of issuance of common stock and the lower amount of stock repurchases in the open market for the three months period ended June 30, 2003, as compared to the three month period ended June 30, 2002.

     During the period ending June 30, 2003, the Company repurchased 132,400 shares of its common stock at an average price of $2.91 in the open market at a cost of approximately $392,000 including brokerage fees. The aggregate of the purchases since the authorization by the Board of Directors was approximately 6.0 million shares at the cost of approximately $20.1 million including brokerage fees. This program was authorized by the Board of Directors in August 2001 to allow the Company to repurchase up to $30 million worth of stock in the open market subject to certain criteria as determined by the Board. This program expired in April 2003.

     In May 2003, the Board approved an additional stock buyback program to repurchase up to $30 million worth of stock in the open market subject to certain criteria as determined by the Board. To date, no shares have been repurchased.

     We had no significant commitments for capital expenditures as of June 30, 2003. We expect to fund our future capital expenditures, liquidity and strategic operating programs from a combination of available cash balances and internally generated funds. We have no outside debt, and do not have any plans to enter into borrowing arrangements.

     We engage in global business operations and are therefore exposed to foreign currency fluctuations. As of June 30, 2003, the effects of the foreign currency fluctuations were immaterial.

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RISKS RELATED TO OUR BUSINESS

     In addition to other information in this Form 10-Q, the following risk factors should be carefully considered in evaluating Selectica and its business because such factors currently may have a significant impact on Selectica’s business, operating results and financial condition. As a result of the risk factors set forth below and elsewhere in this Form 10-Q, and the risks discussed in Selectica’s other Securities and Exchange Commission filings including our Form 10-K for our fiscal year ended March 31, 2003, actual results could differ materially from those projected in any forward-looking statements.

We have a history of losses and expect to continue to incur net losses in the near-term.

     We have experienced operating losses in each quarterly and annual period since inception. We incurred net losses applicable to common stockholders of approximately $29.7 million, $26.4 million and $49.9 million for the fiscal years ended March 31, 2003, 2002 and 2001, respectively. We have incurred net losses of approximately $1.8 million for the three months ended June 30, 2003 and an accumulated deficit of approximately $151.0 million as of June 30, 2003. We plan to reduce our investment in research and development, sales and marketing, and general and administrative expenses in absolute dollars over the next year as necessary to balance expense levels with projected revenues. We will need to generate significant increases in our revenues to achieve and maintain profitability. If our revenue fails to grow or grows more slowly than we anticipate or our operating expenses exceed our expectations, our losses will significantly increase which would significantly harm our business and operating results.

The unpredictability of our quarterly revenues and results of operations makes it difficult to predict our financial performance and may cause volatility or a decline in the price of our common stock if we are unable to satisfy the expectations of investors or the market.

     In the past, our quarterly operating results have varied significantly, and we expect these fluctuations to continue. Future operating results may vary depending on a number of factors, many of which are outside of our control.

     Our quarterly revenues may fluctuate as a result of our ability to recognize revenue in a given quarter. We enter into arrangements for the sale of (1) licenses of software products and related maintenance contracts; (2) bundled license, maintenance, and services; and (3) services on a time and material basis. In instances where maintenance is bundled with a license of software products, such maintenance term is typically one year.

     For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fees are fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all of the criteria are met.

     Arrangements consisting of license and maintenance only. For those contracts that consist solely of license and maintenance we recognize license revenues based upon the residual method after all elements other than maintenance have been delivered as prescribed by Statement of Position 98-9 “Modification of SOP No. 97-2 with Respect to Certain Transactions.” We recognize maintenance revenues over the term of the maintenance contract as vendor-specific objective evidence of fair value for maintenance exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If vendor specific objective evidence does not exist to allocate the total fee to all undelivered elements of the arrangement, revenue is deferred until the earlier of the time at which (1) such evidence does exist for the undelivered elements, or (2) all elements are delivered. If unspecified future products are given over a specified term, we recognize license revenue ratably over the applicable period. We recognize license fees from resellers as revenue when the above criteria have been met and the reseller has sold the subject licenses through to the end-user.

     Arrangements consisting of license, maintenance and other services. Services can consist of maintenance, training and/or consulting services. Consulting services include a range of services including installation of off-the-shelf software, customization of the software for the customer’s specific application, data conversion and building of interfaces to allow the software to operate in customized environments.

     In all cases, we assess whether the service element of the arrangement is essential to the functionality of the other elements of the arrangement. In this determination we focus on whether the software is off-the-shelf software, whether the services include significant alterations to the features and functionality of the software, whether the services involve the building of complex interfaces, the timing of payments and the existence of milestones. Often the installation of the software requires the building of interfaces to the customer’s existing applications or customization of the software for specific applications. As a result, judgment is required in the determination of whether such services constitute “complex” interfaces. In making this determination we consider the following: (1) the relative fair value of the services compared to the software, (2) the amount of time and effort subsequent to delivery of the software until the interfaces or other modifications are completed, (3) the degree of technical difficulty in building of the interface and uniqueness of the application, (4) the degree of involvement of customer

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personnel, and (5) any contractual cancellation, acceptance, or termination provisions for failure to complete the interfaces. We also consider the likelihood of refunds, forfeitures and concessions when determining the significance of such services.

     In those instances where we determine that the service elements are essential to the other elements of the arrangement, we account for the entire arrangement under the percentage of completion contract method in accordance with the provisions of SOP 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts.” We follow the percentage of completion method since reasonably dependable estimates of progress toward completion of a contract can be made. We estimate the percentage of completion on contracts utilizing hours incurred to date as a percentage of the total estimated hours to complete the project. Recognized revenues and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are charged to income in the period in which the facts that give rise to the revision become known. To date, when we have been primarily responsible for the implementation of the software, services have been considered essential to the functionality of the software products and therefore license and services revenues have been recognized pursuant to SOP 81-1.

     For those contracts that include contract milestones or acceptance criteria we recognize revenue as such milestones are achieved or as such acceptance occurs.

     In some instances the acceptance criteria in the contract require acceptance after all services are complete and all other elements have been delivered. In these instances we recognize revenue based upon the completed contract method after such acceptance has occurred.

     For those arrangements for which we have concluded that the service element is not essential to the other elements of the arrangement we determine whether the services are available from other vendors, do not involve a significant degree of risk or unique acceptance criteria, and whether we have sufficient experience in providing the service to be able to separately account for the service. When the service qualifies for separate accounting we use vendor-specific objective evidence of fair value for the services and the maintenance to account for the arrangement using the residual method, regardless of any separate prices stated within the contract for each element.

     Vendor-specific objective evidence of fair value of services is based upon hourly rates. As previously noted, we enter into contracts for services alone and such contracts are based upon time and material basis. Such hourly rates are used to assess the vendor-specific objective evidence of fair value in multiple element arrangements.

     In accordance with Statement of Position 97-2, “Software Revenue Recognition,” vendor-specific objective evidence of fair value of maintenance is determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate). Each license agreement offers additional maintenance renewal periods at a stated price. Maintenance contracts are typically one year in duration.

     Because we rely on a limited number of customers, the timing of customer acceptance or milestone achievement, or the amount of services we provide to a single customer can significantly affect our operating results. For example, on these separate occasions our services and license revenues declined significantly in March 31, 2003, March 31, 2001 and June 30, 1999 due to the delays of milestone achievement of services and customer acceptance under a particular contract. See “Management’s Discussion and Analysis — Results of Operations.” Because expenses are relatively fixed in the near term, any shortfall from anticipated revenues could cause our quarterly operating results to fall below anticipated levels.

     We may also experience seasonality in revenues. For example, our quarterly results may fluctuate based upon our customers’ calendar year budgeting cycles. These seasonal variations may lead to fluctuations in our quarterly revenues and operating results.

     Based upon the foregoing, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and that such comparisons should not be relied upon as indications of future performance. In some future quarter, our operating results may be below the expectations of public market analysts and investors, which could cause volatility or a decline in the price of our common stock.

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If our bookings do not improve, our results of operations could be significantly harmed.

     In any given period our revenues are dependent on customer contracts booked during earlier periods. Because we typically recognize revenue in periods after contracts are entered into, a decline in the number of contracts booked during any particular period or the value of such contracts would cause a decrease in revenue in future periods. In recent months, the number and value of our bookings has continued to decrease significantly. If our bookings remain at current levels or if the value of such bookings decreases further, it will cause our revenues to decline in future periods which could significantly harm our business and operating results.

A continued decline in general economic conditions or a decrease in information technology spending could harm our results of operations.

     The change in economic conditions may lead to revised budgetary constraints regarding information technology spending for our customers. We have had potential customers select our Interactive Selling Solutions, but decide to delay or not to implement any configuration system. Many companies have decided to reduce their expenditures for information technology by either delaying non-mission critical projects or abandoning them until their levels of business justifies the expenses. A continuation of stagnation in information technology spending due to economic conditions or other factors could significantly harm our business and operating results.

Developments in the market for Interactive Selling Solutions may harm our operating results, which could cause a decline in the price of our common stock.

     The market for Interactive Selling Solutions, which has only recently begun to develop, is evolving rapidly. Because this market is relatively new, it is difficult to assess its competitive environment, growth rate and potential size. The growth of the market is dependent upon the willingness of businesses and consumers to purchase complex goods and services over the Internet and the acceptance of the Internet as a platform for business applications. In addition, companies that have already invested substantial resources in other methods of Internet selling may be reluctant or slow to adopt a new approach or application that may replace, limit or compete with their existing systems.

     The relative youth of the market poses a number of concerns. The acceptance and growth of the Internet as a business platform may not continue to develop at historical rates and a sufficiently broad base of companies may not adopt Internet platform-based business applications. The decrease in technology infrastructure spending may reduce the size of the market for Interactive Selling Solutions and other server based products. Our potential customers may decide to purchase more complete solutions offered by larger competitors instead of individual applications. If the market for Interactive Selling Solutions is slow to develop, or if our customers purchase more fully integrated products, it would significantly harm our business and operating results.

Our limited operating history and the fact that we operate in a new and evolving industry makes evaluating our business prospects and results of operations difficult.

     We were founded in June 1996 and have a limited operating history. We began marketing our products in early 1997 and released ACE 6.0 in March 2003. The revenue and income potential of our business and market are uncertain. As a result of our limited operating history, we have limited financial data that you can use to evaluate our business. Our revenue is dependent on our ability to enter into significant software license transactions with new and existing customers. Our success depends on gaining new customers and maintaining relationships with our existing customers. You must consider our prospects in light of the risks and difficulties we may encounter as an early stage company in the new and rapidly evolving market for Interactive Selling Solutions.

Failure to improve and maintain relationships with systems integrators and consulting firms, which assist us with the sale and installation of our products, would impede the acceptance of our products and the growth of our revenues.

     Our strategy has been to rely in part upon systems integrators and consulting firms to recommend our products to their customers and to install and deploy our products. To date, we have had limited success in utilizing these firms as a sales channel or as a provider of professional services. To increase our revenues and implementation

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capabilities, we must continue to develop and expand our relationships with these systems integrators and consulting firms. If these systems integrators and consulting firms are unwilling to install and deploy our products, we may not have the resources to provide adequate implementation services to our customers and our business and operating results could be significantly harmed.

We face intense competition, which could reduce our sales, prevent us from achieving or maintaining profitability and inhibit our future growth.

     The market for software and services that enable electronic commerce is intensely competitive and rapidly changing. We expect competition to persist and intensify, which could result in price reductions, reduced gross margins and loss of market share. Our principal competitors include, Oracle Corporation, SAP and Siebel Systems, all of which offer integrated solutions for electronic commerce incorporating some of the functionality of Interactive Selling Solutions.

     Our competitors may intensify their efforts in our market. In addition, other enterprise software companies may offer competitive products in the future. Competitors vary in size and in the scope and breadth of the products and services offered. Although we believe we have advantages over our competitors including the comprehensiveness of our solution, our use of Java technology and our multi-threaded architecture, some of our competitors and potential competitors have significant advantages over us, including:

    a longer operating history;
 
    preferred vendor status with our customers;
 
    more extensive name recognition and marketing power; and
 
    significantly greater financial, technical, marketing and other resources, giving them the ability to respond more quickly to new or changing opportunities, technologies, and customer requirements.

     Our competitors may also bundle their products in a manner that may discourage users from purchasing our products. Current and potential competitors may establish cooperative relationships with each other or with third parties, or adopt aggressive pricing policies to gain market share. Competitive pressures may require us to reduce the prices of our products and services. We may not be able to maintain or expand our sales if competition increases and we are unable to respond effectively.

Our lengthy sales cycle makes it difficult for us to forecast revenue and aggravates the variability of quarterly fluctuations, which could cause our stock price to decline.

     The sales cycle of our products has historically averaged between four and six months, and may sometimes be significantly longer. We are generally required to provide a significant level of education regarding the use and benefits of our products, and potential customers tend to engage in extensive internal reviews before making purchase decisions. In addition, the purchase of our products typically involves a significant commitment by our customers of capital and other resources, and is therefore subject to delays that are beyond our control, such as customers’ internal budgetary procedures and the testing and acceptance of new technologies that affect key operations. In addition, because we intend to target large companies, our sales cycle can be lengthier due to the decision process in large organizations. As a result of our products’ long sales cycles, we face difficulty predicting the quarter in which sales to expected customers may occur. If anticipated sales from a specific customer for a particular quarter are not realized in that quarter, our operating results for that quarter could fall below the expectations of financial analysts and investors, which could cause our stock price to decline.

If we do not keep pace with technological change, including maintaining interoperability of our product with the software and hardware platforms predominantly used by our customers, our product may be rendered obsolete and our business may fail.

     Our industry is characterized by rapid technological change, changes in customer requirements, frequent new product and service introductions and enhancements and emerging industry standards. In order to achieve broad

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customer acceptance, our products must be compatible with major software and hardware platforms used by our customers. Our products currently operate on the Microsoft Windows NT, Sun Solaris, IBM AIX, Linux, and Microsoft Windows 2000 Operating Systems. In addition, our products are required to interoperate with electronic commerce applications and databases. We must continually modify and enhance our products to keep pace with changes in these operating systems, applications and databases. Interactive Selling Solutions technology is complex and new products and product enhancements can require long development and testing periods. If our products were to be incompatible with a popular new operating system, electronic commerce application or database, our business would be significantly harmed. In addition, the development of entirely new technologies to replace existing software could lead to new competitive products that have better performance or lower prices than our products and could render our products obsolete and unmarketable.

We are the target of several securities class action complaints, and are involved in shareholder derivative litigation, all of which could result in substantial costs and divert management attention and resources.

Class Action

     Between June 5, 2001 and June 22, 2001, four securities class action complaints were filed against the Company, certain of our officers and directors, and Credit Suisse First Boston Corporation (“CSFB”), as the underwriters of our March 13, 2000 initial public offering (“IPO”), in the United States District Court for the Southern District of New York. On August 9, 2001, these actions were consolidated before a single judge along with cases brought against numerous other issuers, their officers and directors and their underwriters, that make similar allegations involving the allocation of shares in the IPOs of those issuers. The consolidation was for purposes of pretrial motions and discovery only. On April 19, 2002, plaintiffs filed a consolidated amended complaint asserting essentially the same claims as the original complaints.

     The amended complaint alleges that the Company, the officer and director defendants and CSFB violated federal securities laws by making material false and misleading statements in the prospectus incorporated in our registration statement on Form S-1 filed with the SEC in March 2000 in connection with our IPO. Specifically, the complaint alleges, among other things, that CSFB solicited and received excessive and undisclosed commissions from several investors in exchange for which CSFB allocated to those investors material portions of the restricted number of shares of common stock issued in our IPO. The complaint further alleges that CSFB entered into agreements with its customers in which it agreed to allocate the common stock sold in our IPO to certain customers in exchange for which such customers agreed to purchase additional shares of our common stock in the after-market at pre-determined prices. The complaint also alleges that the underwriters offered to provide positive market analyst coverage for the Company after the IPO, which had the effect of manipulating the market for Selectica’s stock.

     On July 15, 2002, the Company and the officer and director defendants, along with other issuers and their related officer and director defendants, filed a joint motion to dismiss based on common issues. Opposition and reply papers were filed and the Court heard oral argument. Prior to the ruling on the motion to dismiss, on October 8, 2002, the individual officers and directors entered into a stipulation of dismissal and tolling agreement with plaintiffs. As part of that agreement, plaintiffs dismissed the case without prejudice against the individual defendants. The Court ordered the dismissal of the officers and directors without prejudice on October 9, 2002. The court rendered its decision on the motion to dismiss on February 19, 2003, denying dismissal of the Company.

     On June 25, 2003, a Special Committee of the Board of Directors of the Company approved a Memorandum of Understanding (the “MOU”) reflecting a settlement in which the plaintiffs agreed to dismiss the case against the Company with prejudice in return for the assignment by the Company of claims that the Company might have against its underwriters. No payment to the plaintiffs by the Company is required under the MOU. There can be no assurance that the MOU will result in a formal settlement or that the Court will approve the settlement that the MOU sets forth.

Shareholder Derivative Action

     On April 16, 2002, a shareholder derivative action was filed in the Superior Court of California, Santa Clara County, against certain of our officers and directors, against CSFB, as the underwriters of our IPO, and against the Company as nominal defendant. The action was filed by a shareholder purporting to assert on behalf of the

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Company claims for breach of fiduciary duty, aiding and abetting and conspiracy, negligence, unjust enrichment, and breach of contract, relating to the pricing of shares in the Company’s IPO. On June 6, 2002, the shareholder plaintiff filed an amended complaint dropping the breach of contract claim against CSFB and adding claims against CSFB for breach of an agent’s duty to its principal and for violation of the California Unfair Competition Law, based on alleged violations of certain rules of the National Association of Securities Dealers.

     On November 25, 2002, following the removal of the case to federal court and the subsequent remand of the case back to the state court, the Company and the officer and director defendants filed answers to the amended complaint, preserving certain defenses including defenses based on plaintiff’s lack of standing to bring the suit. Also on November 25, 2002, CSFB filed a motion to dismiss the case, on the grounds that the plaintiff lacks standing. That motion was heard on March 4, 2003, and on March 18, 2003 the Court issued an Order sustaining the motion but granting plaintiff 30 days to file an amended complaint.

     On April 18, 2003, the plaintiff filed a second amended complaint. This complaint adds new allegations as to standing, and also alleges certain additional facts supporting the various causes of action against the defendants. Specifically, plaintiff’s new complaint alleges that CSFB offered and provided, and the individual defendants accepted, improper “gratuities” in the form of allocations of IPO stocks of other companies, in order to influence the selection of CSFB as the underwriter of the Company’s IPO.

     On June 17, 2003, CSFB responded to this second amended complaint by filing a demurrer (motion to dismiss) on the grounds that the plaintiff lacks standing to bring the action. Also on June 17, 2003, the Company and the individual defendants responded to the second amended complaint by joining CSFB’s demurrer, while reserving other objections. The demurrer is currently scheduled to be heard on August 12, 2003.

     The Company believes that the securities class action allegations against the Company and our officers and directors are without merit and, if settlement of the action is not finalized, the Company intends to contest the allegations vigorously. However, the litigation is in its preliminary stages, and the Company cannot predict its outcome. The litigation process is inherently uncertain. If the outcome of the litigation is adverse to the Company and if, in addition, the Company is required to pay significant monetary damages, the Company’s business would be significantly harmed. The shareholder derivative litigation is also in its preliminary stages. At a minimum, the class action litigation as well as the shareholder derivative litigation could result in substantial costs and divert our management’s attention and resources, which could seriously harm our business.

We have relied and expect to continue to rely on a limited number of customers for a significant portion of our revenues, and the loss of any of these customers could significantly harm our business and operating results.

     Our business and financial condition is dependent on a limited number of customers. Our five largest customers accounted for approximately 80% and 55% of our revenues for the three months ended June 30, 2003 and 2002, respectively, and our ten largest customers accounted for 89% and 74% of our revenues for the three months ended June 30, 2003 and 2002, respectively. Revenues from significant customers as a percentage of total revenues are as follows:

           
Three Months Ended June 30, 2003
       
 
Customer A
    36 %
 
Customer B
    15 %
 
Customer C
    13 %
 
Customer D
    10 %
Three Months Ended June 30, 2002
       
 
Customer D
    21 %
 
Customer E
    16 %

     We expect that we will continue to depend upon a relatively small number of customers for a substantial portion of our revenues for the foreseeable future. Contracts with our customers can generally be terminated on short notice by the customer. As a result, if we fail to successfully sell our products and services to one or more customers in any

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particular period, or a large customer purchases fewer of our products or services, defers or cancels orders, or terminates its relationship with us, our business and operating results would be harmed.

Our failure to meet customer expectations on deployment of our products could result in negative publicity and reduced sales, both of which would significantly harm our business and operating results.

     In the past, our customers have experienced difficulties or delays in completing implementation of our products. We may experience similar difficulties or delays in the future. Our Interactive Selling Solutions rely on defining a KnowledgeBase that must contain all of the information about the products and services being configured. We have found that extracting the information necessary to construct a KnowledgeBase can be more time consuming than we or our customers anticipate. If our customers do not devote the resources necessary to create the KnowledgeBase, the deployment of our products can be delayed. Deploying our products can also involve time-consuming integration with our customers’ legacy systems, such as existing databases and enterprise resource planning software. Failing to meet customer expectations on deployment of our products could result in a loss of customers and negative publicity regarding us and our products, which could adversely affect our ability to attract new customers. In addition, time-consuming deployments may also increase the amount of professional services we must allocate to each customer, thereby increasing our costs and adversely affecting our business and operating results.

If we are unable to maintain our direct sales force, sales of our products and services may not meet our expectations and our business and operating results will be significantly harmed.

     We depend on our direct sales force for all of our current sales and our future growth depends on the ability of our direct sales force to develop customer relationships and increase sales to a level that will allow us to reach and maintain profitability. If we are unable to retain qualified sales personnel, or if newly hired personnel fail to develop the necessary skills or to reach productivity when anticipated, we may not be able to increase sales of our products and services and our results of operation could be significantly harmed. We have recently had a high rate or turnover in our executive sales positions. If our sales management fails to successfully integrate into the company or improve the performance of the sales personnel, it could have a material adverse on our business.

If we are unable to manage our professional services organization, we will be unable to provide our customers with technical support for our products, which could significantly harm our business and operating results.

     We need to better manage our professional services organization to assist our customers with implementation and maintenance of our products. Because professional services have been expensive to provide, we must improve the management of our professional services organizations to improve our results of operations. Improving the efficiency of our consulting services is dependent upon attracting and retaining experienced project managers. In addition, because of market conditions, there is additional downward pressure on the pricing of services projects which makes it increasingly difficult to improve operating margins.

     Although services revenues, which are comprised primarily of revenues from consulting fees, maintenance contracts and training, are important to our business, representing 60% and 75% of total revenues for the three months period ended June 30, 2003 and 2002, respectively, services revenues have lower gross margins than license revenues. Gross margins for services revenues were 24% and 26% for the three months period ended June 30, 2003 and 2002, respectively, compared to gross margins for license revenues of 94% and 90% for the respective periods.

     We intend to charge for our professional services on a time and materials rather than a fixed-fee basis. However in current market conditions, many customers insist on services provided on a fixed-fee basis. To the extent that customers are unwilling to utilize third-party consultants or require us to provide professional services on a fixed fee basis, our cost of services revenues could increase and could cause us to recognize a loss on a specific contract, either of which would adversely affect our operating results. In addition, if we are unable to provide these resources, we may lose sales or incur customer dissatisfaction and our business and operating results could be significantly harmed.

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If new versions and releases of our products contain errors or defects, we could suffer losses and negative publicity, which would adversely affect our business and operating results.

     Complex software products such as ours often contain errors or defects, including errors relating to security, particularly when first introduced or when new versions or enhancements are released. In the past, we have discovered defects in our products and provided product updates to our customers to address such defects. Our products and other future products may contain defects or errors, which could result in lost revenues, a delay in market acceptance or negative publicity, each which would significantly harm our business and operating results.

The loss of any of our key personnel would harm our competitiveness because of the time and effort that we would have to expend to replace such personnel.

     We believe that our success will depend on the continued employment of our management team and key technical personnel, none of whom, except Dr. Sanjay Mittal, our President, Chairman and Chief Executive Officer, and Stephen Bennion, our Chief Financial Officer, has an employment agreement with us. If one or more members of our senior management team or key technical personnel were unable or unwilling to continue in their present positions, these individuals would be difficult to replace. Consequently, our ability to manage day-to-day operations, including our operations in Pune and Chennai, India, develop and deliver new technologies, attract and retain customers, attract and retain other employees and generate revenues would be significantly harmed.

A substantial portion of our operations are conducted by India-based personnel, and any change in the political and economic conditions of India or in immigration policies, that adversely affects our ability to conduct our operations in India could significantly harm our business.

     We conduct development, quality assurance and professional services operations in India. As of June 30, 2003, there were 220 persons employed in India. We are dependent on our India-based operations for these aspects of our business. As a result, we are directly influenced by the political and economic conditions affecting India. Operating expenses incurred by our operations in India are denominated in Indian currency and accordingly, we are exposed to adverse movements in currency exchange rates. This, as well as any other political or economic problems or changes in India, could have a negative impact on our India-based operations, resulting in significant harm to our business and operating results. Furthermore, the intellectual property laws of India may not adequately protect our proprietary rights. We believe that it is particularly difficult to find quality management personnel in India, and we may not be able to timely replace our current India-based management team if any of them were to leave our company.

     Our training program for some of our India-based employees includes an internship at our San Jose, California headquarters. Additionally, we provide services to some of our customers internationally with India-based employees. We presently rely on a number of visa programs to enable these India-based employees to travel and work internationally. Any change in the immigration policies of India or the countries to which these employees travel and work could cause disruption or force the termination of these programs, which would harm our business.

We may not be able to recruit or retain personnel, which could impact the development or sales of our products.

     Our success depends on our ability to attract and retain qualified management, engineering, sales and marketing and professional services personnel. We do not have employment agreements with most of our key personnel. If we are unable to retain our existing key personnel, or attract and train additional qualified personnel, our growth may be limited due to our lack of capacity to develop and market our products.

If we become subject to product liability litigation, it could be costly and time consuming to defend and could distract us from focusing on our business and operations.

     Since our products are company-wide, mission-critical computer applications with a potentially strong impact on our customers’ sales, errors, defects or other performance problems could result in financial or other damages to our customers. Although our license agreements generally contain provisions designed to limit our exposure to product liability claims, existing or future laws or unfavorable judicial decisions could negate such limitation of liability provisions. Product liability litigation, even if it were unsuccessful, would be time consuming and costly to defend.

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Our future success depends on our proprietary intellectual property, and if we are unable to protect our intellectual property from potential competitors our business may be significantly harmed.

     We rely on a combination of trademark, trade secret and copyright law and contractual restrictions to protect the proprietary aspects of our technology. These legal protections afford only limited protection for our technology. We currently hold six patents in U.S. In addition, we have two trademarks registered in U.S., one trademark registered and one pending in South Korea, two trademarks registered in Canada and one trademark registered in European Community and we have also applied to register another two trademarks in the United States. Our trademark applications might not result in the issuance of any trademarks. Our patents or any future issued trademarks might be invalidated or circumvented or otherwise fail to provide us any meaningful protection. We seek to protect the source code for our software, documentation and other written materials under trade secret and copyright laws. We license our software pursuant to license agreements, which impose certain restrictions on the licensee’s ability to utilize the software. We also seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. In addition, the laws of many countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of the proprietary rights of others. Our failure to adequately protect our intellectual property could have a material adverse effect on our business and operating results.

Any acquisitions that we may make could disrupt our business and harm our operating results.

     We may acquire or make investments in complementary companies, products or technologies. In the event of any such investments, acquisitions or joint ventures, we could:

    issue stock that would dilute our current stockholders’ percentage ownership;
 
    incur debt;
 
    assume liabilities;
 
    incur amortization expenses related to other intangible assets; or
 
    incur large and immediate write-offs.

     These investments, acquisitions or joint ventures also involve numerous risks, including:

    problems combining the purchased operations, technologies or products with ours;
 
    unanticipated costs;
 
    diversion of managements’ attention from our core business;
 
    adverse effects on existing business relationships with suppliers and customers;
 
    potential loss of key employees, particularly those of the acquired organizations; and
 
    reliance to our disadvantage on the judgment and decisions of third parties and lack of control over the operations of a joint venture partner.

     Any acquisition or joint venture may cause our financial results to suffer as a result of these risks.

If we are subject to intellectual property litigation, we may incur substantial costs, which would harm our operating results.

     Our success and ability to compete are dependent on our ability to operate without infringing upon the proprietary rights of others. Any intellectual property litigation could result in substantial costs and diversion of

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resources and could significantly harm our business and operating results. From time to time, we receive correspondence from patent holders recommending that we license their patents. After reviewing these patents, we have informed these patent holders that it would not be necessary to license these patents. However, we may be required to license such patents or incur legal fees to defend our position that such licenses are not necessary. We cannot assure you that if required to do so, we would be able to obtain a license to use either patent on commercially reasonable terms, or at all.

     Any threat of intellectual property litigation could force us to do one or more of the following:

    cease selling, incorporating or using products or services that incorporate the challenged intellectual property;
 
    obtain from the holder of the infringed intellectual property right a license to sell or use the relevant intellectual property, which license may not be available on reasonable terms;
 
    redesign those products or services that incorporate such intellectual property; or
 
    pay money damages to the holder of the infringed intellectual property right.

     In the event of a successful claim of infringement against us and our failure or inability to license the infringed intellectual property on reasonable terms or license a substitute intellectual property or redesign our product to avoid infringement, our business and operating results would be significantly harmed. If we are forced to abandon use of our trademark, we may be forced to change our name and incur substantial expenses to build a new brand, which would significantly harm our business.

Restrictions on export of encrypted technology could cause us to incur delays in international product sales, which would adversely impact the expansion and growth of our business.

     Our software utilizes encryption technology, the export of which is regulated by the United States government. If our export authority is revoked or modified, if our software is unlawfully exported or if the United States adopts new legislation restricting export of software and encryption technology, we may experience delay or reduction in shipment of our products internationally. Current or future export regulations could limit our ability to distribute our products outside of the United States. While we take precautions against unlawful exportation of our software, we cannot effectively control the unauthorized distribution of software across the Internet.

Our recent restructuring has placed a significant strain on our management systems and resources, and if we fail to manage these changes, our business will be harmed.

     We have recently experienced a drastic reduction in headcount which followed a period of rapid growth and expansion. These changes have placed significant demands on our managerial, administrative, operational, financial and other resources.

     Our rapid growth required us to manage a large number of relationships with customers, suppliers and employees, as well as a large number of complex contracts. Our recent restructuring has forced us to handle these demands with a smaller number of employees. If we are unable to initiate procedures and controls to support our future operations in an efficient and timely manner, or if we are unable to otherwise manage these changes effectively, our business would be harmed.

Our results of operations will be harmed by charges associated with stock-based compensation, accelerated vesting associated with stock options issued to employees, charges associated with other securities issued by us, and charges related to variable accounting.

     We have in the past and expect in the future to incur a significant amount of amortization of charges related to securities issuances in future periods, which will negatively affect our operating results. Since inception we have recorded approximately $10.5 million in net deferred compensation charges. During the three months period ended June 30, 2003 and 2002, we recorded approximately $431,000 and $579,000 of such charges which included the

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compensation expenses related to option acceleration and variable accounting, respectively. We expect to amortize approximately $1.2 million compensation for the fiscal year ending March 31, 2004 and we may incur additional charges in the future in connection with grants of stock-based compensation at less than fair value and for charges related to variable plan accounting.

     Due to the repurchase of our common stock from certain key employees during the year ended March 31, 2002, the remaining outstanding shares of our common stock which were purchased with full recourse promissory notes, were deemed to be compensatory as of January 4, 2002 and became subject to variable accounting. During the period ending June 30, 2003, the Company recorded a total compensation expense of approximately $38,000 related to variable accounting of which approximately $3,000 was included in cost of goods sold, approximately $1,000 was included in sales and marketing expense and approximately $34,000 was included in general and administrative expense. During the period ending June 30, 2002, the Company recorded a total compensation expense of approximately $110,000 related to variable accounting of which approximately $40,000 was included in cost of goods sold, approximately $1,000 was included in sales and marketing expense and approximately $69,000 was included in general and administrative expense.

Our operating results could be adversely affected by impairment of goodwill and other indefinite lived intangible assets

     We accounted for the acquisition of Wakely Software Inc. as a purchase for accounting purposes and allocated approximately $13.1 million to identify intangible assets and goodwill. These assets were being amortized over a period of three to seven years. We also expensed approximately $1.9 million of in-process research and development at the time of acquisition. See Note 10 of the Notes to Consolidated Financial Statements for the year ended March 31, 2003, Note 8 of the Notes to Consolidated Financial Statements for the year ended March 31, 2002, Note 9 of Notes to Consolidated Financial Statements for the year ended March 31, 2001 and Note 10 of the Notes to Consolidated Financial Statements for the year ended March 31, 2000.

     In August 2001, the Financial Accounting Standards Board (FASB) issued Statement on Financial Accounting Standards 144, “Accounting for the Impairment or Disposal of Long-lived Assets” (SFAS 144). SFAS 144, which supercedes SFAS 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of” (SFAS 121), establishes a single accounting model, based on the framework established in SFAS 121, for long-lived assets to be disposed of. The statement is effective for financial statements issued for fiscal years beginning after December 15, 2001. We adopted SFAS 144 beginning fiscal 2003 and the provisions of this statement did not have a significant impact on our financial condition or operating results.

     In June 2001, the FASB issued SFAS 142, “Goodwill and Other Intangible Assets” (SFAS 142), effective for fiscal years beginning after December 15, 2001. Under SFAS 142, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests. SFAS 142 also requires that goodwill be tested for impairment at the reporting unit level at adoption and at least annually thereafter, utilizing a two-step methodology. The initial step requires us to determine the fair value of each reporting unit and compare it to the carrying value, including goodwill, of such unit. If the fair value exceeds the carrying value, no impairment loss would be recognized. However, if the carrying value of the reporting unit exceeds its fair value, the goodwill of this unit may be impaired. The amount, if any, of the impairment would then be measured in the second step.

     In April 2002, we performed, under SFAS 142, the first of the required impairment tests of goodwill. That test indicated that the carrying values exceeded their estimated fair values, as determined utilizing various valuation techniques including discounted cash flow and comparative market analysis. Thereafter, given the indication of a potential impairment, we performed step two of the test. We compared the implied fair value of the affected reporting unit’s goodwill to its carrying value to measure the amount of impairment. The fair value of goodwill was determined by allocating the reporting unit’s fair value to all of its assets and liabilities in a manner similar to a purchase price allocation. Based on this analysis, we measured and recognized an impairment loss of approximately $10.0 million for the three months ended June 30, 2002. This loss was recorded as a cumulative effect of an accounting change in the period.

     Prior to April 1, 2002, Goodwill was amortized on a straight-line basis over the estimated useful life, generally five years. The carrying value of goodwill was reviewed if facts and circumstances suggested that they may be

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impaired. If this review indicates that carrying values of goodwill will not be recoverable based on projected undiscounted future cash flows, carrying values are reduced to estimated fair values by first reducing goodwill and second by reducing long-term assets and other intangibles. During fiscal year 2002 the applicable accounting policy for reviewing goodwill for impairment was an undiscounted cash flow basis, a method allowed by SFAS 121. When analyzed using undiscounted cash flows prescribed by SFAS 121, we did not have an impairment of any intangibles assets at March 31, 2002.

Because the trading price of our common stock is below the cash value of our common stock (cash, cash equivalents, and investments divided by total shares outstanding), we may receive solicitations to purchase the company for less than our cash value.

     Our common stock has recently traded on the Nasdaq National Market at a significant discount to the cash value of our common stock. As a result, we have from time to time received, and may in the future receive, solicitations from third parties offering to purchase the company for the market value of our common stock. We believe that these offers are being made to arbitrage the difference between the market price and the cash value of our common stock and are not in the best interests of our stockholders. Although we have not received any indication that any third party intends to make a hostile offer for our common stock, any significant differential between the market value and the cash value of our common stock may make such activities more likely. If we were to receive a hostile offer for our common stock, the company may be required to incur significant costs to respond which could have a negative effect on our business and financial results. If successful in causing a change in control, such an offer could result our stockholders receiving less than what we believe to be the fair value of our common stock. Although the company has certain anti-takeover protections in place to try to prevent this result, such as a classified board and a shareholder rights plan, such protections may not be sufficient to protect shareholder value.

Anti-takeover provisions could prevent or delay a change of control.

     Provisions of our amended and restated certificate of incorporation and amended and restated bylaws and Delaware law could make it more difficult for a third party to acquire us. These provisions include the “staggered” nature of our board of directors that results in directors being elected for terms of three years and the stockholder rights plan adopted by the Company on February 4, 2003. These provisions may have the effect of delaying, deferring, or preventing a change in our control, impeding a merger, consolidation, takeover, or other business combination, which in turn could preclude our stockholders from recognizing a premium over the prevailing market price of the common stock.

Unauthorized break-ins or other assaults on our computer systems could harm our business.

     Our servers are vulnerable to physical or electronic break-ins and similar disruptions, which could lead to loss of data or public release of proprietary information. In addition, unauthorized persons may improperly access our data. We have experienced an unauthorized break-in by a “hacker” who has stated that he could, in the future, damage our systems or take confidential information. These and other types of attacks could harm us. Actions of this sort may be very expensive to remedy and could adversely affect results of operations.

Demand for our products and services will decline significantly if our software cannot support and manage a substantial number of users.

     Our strategy requires that our products be highly scalable. To date, only a limited number of our customers have deployed our products on a large scale. If our customers cannot successfully implement large-scale deployments, or if they determine that we cannot accommodate large-scale deployments, our business and operating results would be significantly harmed.

Changes to accounting standards and financial reporting requirements, may affect our financial results.

     We are required to follow accounting standards and financial reporting set by governing bodies in the U.S. and other countries where we do business. From time to time, these governing bodies implement new and revised laws and regulations. These new and revised accounting standards, financial reporting and tax laws may require changes to accounting principles used in preparing our financial statements. These changes may have a material impact on

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our business and financial results. For example, a change in accounting rules can have a significant effect on our reported results and may even affect our reporting of transactions completed before the change became effective. As a result, changes to existing rules or reconsideration of current practices caused by such changes may adversely affect our reported financial results or the way we conduct our business.

Compliance with new regulations dealing with corporate governance and public disclosure may result in additional expenses and require significant management attention.

     Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Stock Market rules, are creating uncertainty for companies such as ours. For example, new laws and regulations may require us to change the composition of our board of directors, the composition, the responsibility and manner of operation of various board-level committees, and the type and volume of information filed by us with governing bodies. We are committed to complying with these requirements and maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest all reasonably necessary resources to comply with evolving standards. This investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities.

RISKS RELATED TO THE INDUSTRY

If use of the Internet does not continue to develop and reliably support the demands placed on it by electronic commerce, the market for our products and services may be adversely affected, and we may not achieve anticipated sales growth.

     Growth in sales of our products and services depends upon the continued and increased use of the Internet as a medium for commerce and communication. Growth in the use of the Internet is a recent phenomenon and may not continue. In addition, the Internet infrastructure may not be able to support the demands placed on it by increased usage and bandwidth requirements. There have also been well-publicized security breaches involving “denial of service” attacks on major web sites. Concerns over these and other security breaches may slow the adoption of electronic commerce by businesses, while privacy concerns over inadequate security of information distributed over the Internet may also slow the adoption of electronic commerce by individual consumers. Other risks associated with commercial use of the Internet could slow its growth, including:

    inadequate reliability of the network infrastructure;
 
    slow development of enabling technologies and complementary products; and
 
    limited accessibility and ability to deliver quality service.

     In addition, the recent growth in the use of the Internet has caused frequent periods of poor or slow performance, requiring components of the Internet infrastructure to be upgraded. Delays in the development or adoption of new equipment and standards or protocols required to handle increased levels of Internet activity, or increased government regulation, could cause the Internet to lose its viability as a commercial medium. If the Internet infrastructure does not develop sufficiently to address these concerns, it may not develop as a commercial marketplace, which is necessary for us to increase sales.

Increasing government regulation of the Internet could limit the market for our products and services, or impose greater tax burdens on us or liability for transmission of protected data.

     As electronic commerce and the Internet continue to evolve, federal, state and foreign governments may adopt laws and regulations covering issues such as user privacy, taxation of goods and services provided over the Internet, pricing, content and quality of products and services. If enacted, these laws and regulations could limit the market for electronic commerce, and therefore the market for our products and services. Although many of these regulations may not apply directly to our business, we expect that laws regulating the solicitation, collection or processing of personal or consumer information could indirectly affect our business.

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     Laws or regulations concerning telecommunications might also negatively impact us. Several telecommunications companies have petitioned the Federal Communications Commission to regulate Internet service providers and online service providers in a manner similar to long distance telephone carriers and to impose access fees on these companies. This type of legislation could increase the cost of conducting business over the Internet, which could limit the growth of electronic commerce generally and have a negative impact on our business and operating results.

ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The following discusses our exposure to market risk related to changes in foreign currency exchange rates and interest rates. This discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors including those set forth in the Risk Factors section of this quarterly report on Form 10-Q.

Foreign Currency Exchange Rate Risk

     We develop products in the United States and India and sell them worldwide. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Since our sales are currently priced in U.S. dollars and are translated to local currency amounts, a strengthening of the dollar could make our products less competitive in foreign markets.

     Our exposure to fluctuation in the relative value of other currencies has been limited because substantially all of our assets are denominated in U.S. dollars. The impact to our financial statements has therefore not been material. To date, we have not entered into any foreign exchange hedges or other derivative financial instruments. We will continue to evaluate our exposure to foreign currency exchange rate risk on a regular basis.

Interest Rate Risk

     We established policies and business practices regarding our investment portfolio to preserve principal while obtaining reasonable rates of return without significantly increasing risk. This is accomplished by investing in widely diversified short-term and long-term investments, consisting primarily of investment grade securities. Our interest income is sensitive to changes in the general level of U.S. interest rates.

     For the three months period ended June 30, 2003, a hypothetical 50 basis point increase in interest rates would have resulted in a reduction of approximately $117,000 (less than 0.13%) in the fair value of our cash equivalents and investments. This potential change is based upon a sensitivity analysis performed on our financial positions at June 30, 2003. For the three months period ended June 30, 2002, a hypothetical 50 basis point increase in interest rates would have resulted in a reduction of approximately $388,000 (less than 0.31%) in the fair value of our cash equivalents and investments. This potential change is based upon a sensitivity analysis performed on our financial positions at June 30, 2002.

     Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted because of a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations because of changes in interest rates or we may suffer losses in principal if forced to sell securities that have seen a decline in market value because of changes in interest rates. Our investments are made in accordance with an investment policy approved by the Board of Directors. In general, our investment policy requires that our securities purchases be rated A1/P1, AA/Aa3 or better. No securities may have a maturity that exceeds 18 months and the average duration of our investment portfolio may not exceed 9 months. At any time, no more than 15% of the investment portfolio may be insured by a single insurer and no more than 25% of investments may be invested in any one industry other than the US government bonds, commercial paper and money market funds.

     The following summarizes short-term and long-term investments at fair value, weighted average yields and expected maturity dates as of June 30, 2003:

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    2004   2005        2006             2007             2008        Thereafter   Total
   
 
 
 
 
 
 
    (in thousands)
Auction rate preferreds
  $ 36,200     $ 500     $         —     $         —     $         —     $         —     $ 36,700  
Weighted Average yield
    1.24 %     1.20 %                             1.24 %
Government agencies
    3,351       24,868                               28,219  
Weighted Average yield
    1.90 %     1.61 %                             1.64 %
Corporate notes & bonds
    3,177       5,246                               8,423  
Weighted Average yield
    1.57 %     1.50 %                             1.52 %
Asset-Backed securities
    1,774                                     1,774  
Weighted Average yield
    2.20 %                                   2.20 %
 
   
     
     
     
     
     
     
 
Total investments
  $ 44,502     $ 30,614     $     $     $     $     $ 75,116  
 
   
     
     
     
     
     
     
 

ITEM 4: CONTROLS AND PROCEDURES

     (a)  Evaluation of disclosure controls and procedures. Within the ninety-day period prior to the filing date of this report, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934). Based on the evaluation, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2003.

     (b)  Changes in internal controls. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

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PART II OTHER INFORMATION

ITEM 1: LEGAL PROCEEDINGS

Class Action

     Between June 5, 2001 and June 22, 2001, four securities class action complaints were filed against the Company, certain of our officers and directors, and Credit Suisse First Boston Corporation (“CSFB”), as the underwriters of our March 13, 2000 initial public offering (“IPO”), in the United States District Court for the Southern District of New York. On August 9, 2001, these actions were consolidated before a single judge along with cases brought against numerous other issuers, their officers and directors and their underwriters, that make similar allegations involving the allocation of shares in the IPOs of those issuers. The consolidation was for purposes of pretrial motions and discovery only. On April 19, 2002, plaintiffs filed a consolidated amended complaint asserting essentially the same claims as the original complaints.

     The amended complaint alleges that the Company, the officer and director defendants and CSFB violated federal securities laws by making material false and misleading statements in the prospectus incorporated in our registration statement on Form S-1 filed with the SEC in March 2000 in connection with our IPO. Specifically, the complaint alleges, among other things, that CSFB solicited and received excessive and undisclosed commissions from several investors in exchange for which CSFB allocated to those investors material portions of the restricted number of shares of common stock issued in our IPO. The complaint further alleges that CSFB entered into agreements with its customers in which it agreed to allocate the common stock sold in our IPO to certain customers in exchange for which such customers agreed to purchase additional shares of our common stock in the after-market at pre-determined prices. The complaint also alleges that the underwriters offered to provide positive market analyst coverage for the Company after the IPO, which had the effect of manipulating the market for Selectica’s stock.

     On July 15, 2002, the Company and the officer and director defendants, along with other issuers and their related officer and director defendants, filed a joint motion to dismiss based on common issues. Opposition and reply papers were filed and the Court heard oral argument. Prior to the ruling on the motion to dismiss, on October 8, 2002, the individual officers and directors entered into a stipulation of dismissal and tolling agreement with plaintiffs. As part of that agreement, plaintiffs dismissed the case without prejudice against the individual defendants. The Court ordered the dismissal of the officers and directors without prejudice on October 9, 2002. The court rendered its decision on the motion to dismiss on February 19, 2003, denying dismissal of the Company.

     On June 25, 2003, a Special Committee of the Board of Directors of the Company approved a Memorandum of Understanding (the “MOU”) reflecting a settlement in which the plaintiffs agreed to dismiss the case against the Company with prejudice in return for the assignment by the Company of claims that the Company might have against its underwriters. No payment to the plaintiffs by the Company is required under the MOU. There can be no assurance that the MOU will result in a formal settlement or that the Court will approve the settlement that the MOU sets forth.

Shareholder Derivative Action

     On April 16, 2002, a shareholder derivative action was filed in the Superior Court of California, Santa Clara County, against certain of our officers and directors, against CSFB, as the underwriters of our IPO, and against the Company as nominal defendant. The action was filed by a shareholder purporting to assert on behalf of the Company claims for breach of fiduciary duty, aiding and abetting and conspiracy, negligence, unjust enrichment, and breach of contract, relating to the pricing of shares in the Company’s IPO. On June 6, 2002, the shareholder plaintiff filed an amended complaint dropping the breach of contract claim against CSFB and adding claims against CSFB for breach of an agent’s duty to its principal and for violation of the California Unfair Competition Law, based on alleged violations of certain rules of the National Association of Securities Dealers.

     On November 25, 2002, following the removal of the case to federal court and the subsequent remand of the case back to the state court, the Company and the officer and director defendants filed answers to the amended complaint, preserving certain defenses including defenses based on plaintiff’s lack of standing to bring the suit. Also on

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November 25, 2002, CSFB filed a motion to dismiss the case, on the grounds that the plaintiff lacks standing. That motion was heard on March 4, 2003, and on March 18, 2003 the Court issued an Order sustaining the motion but granting plaintiff 30 days to file an amended complaint.

     On April 18, 2003, the plaintiff filed a second amended complaint. This complaint adds new allegations as to standing, and also alleges certain additional facts supporting the various causes of action against the defendants. Specifically, plaintiff’s new complaint alleges that CSFB offered and provided, and the individual defendants accepted, improper “gratuities” in the form of allocations of IPO stocks of other companies, in order to influence the selection of CSFB as the underwriter of the Company’s IPO.

     On June 17, 2003, CSFB responded to this second amended complaint by filing a demurrer (motion to dismiss) on the grounds that the plaintiff lacks standing to bring the action. Also on June 17, 2003, the Company and the individual defendants responded to the second amended complaint by joining CSFB’s demurrer, while reserving other objections. The demurrer is currently scheduled to be heard on August 12, 2003.

     The Company believes that the securities class action allegations against the Company and our officers and directors are without merit and, if settlement of the action is not finalized, the Company intends to contest the allegations vigorously. However, the litigation is in its preliminary stages, and the Company cannot predict its outcome. The litigation process is inherently uncertain. If the outcome of the litigation is adverse to the Company and if, in addition, the Company is required to pay significant monetary damages, the Company’s business would be significantly harmed. The shareholder derivative litigation is also in its preliminary stages. At a minimum, the class action litigation as well as the shareholder derivative litigation could result in substantial costs and divert our management’s attention and resources, which could seriously harm our business.

ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS

(a)  Modification of Constituent Instruments

Not applicable

(b)  Change in Rights

Not applicable

(c)  Issuances of Securities

Not applicable

(d)  Use of Proceeds

Not applicable

ITEM 3: DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

ITEM 5: OTHER INFORMATION

None

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ITEM 6: EXHIBITS AND REPORT ON FORM 8-K

A.     Exhibits

     Exhibit 31.1

      Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

     Exhibit 31.2

      Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

     Exhibit 32.1

      Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

     Exhibit 32.2

      Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

B.     Reports on Form 8-K

The following Current Report on Form 8-K has been filed by the Company during the quarter for which this report is filed:

     On April 21, 2003, the Company reported under Item 7 “Financial Statements and Exhibits” and Item 9 “Regulation FD Disclosure” information pursuant to Item 12 “Results of Operations and Financial Condition” a press release announcing its preliminary results for fiscal forth quarter 2003. The Company announced that revenue for the fourth fiscal quarter ending March 31, 2003 would not meet prior guidance of $10.0 to $10.5 million. The primary reason for the shortfall was that the Company did not meet a milestone on a large customer project by the end of the quarter as planned.

     On May 01, 2003, the Company reported under Item 7 “Financial Statements and Exhibits” and Item 9 “Regulation FD Disclosure” information pursuant to Item 12 “Results of Operations and Financial Condition” a press release announcing its financial results for the fourth quarter and full fiscal year ended March 31, 2003. In addition, Patrick D. McCarthy was named senior vice president of worldwide sales. On May 1, 2003, in connection with the issuance of the press release, the Company held a conference call to discuss the press release.

     On May 6, 2003, the Company reported under Item 5 “Other Events” and Item 7 “Financial Statements and Exhibits” a press release announcing that its Board of Directors had authorized a new stock repurchase program whereby the Company could repurchase up to $30,000,000 of its common stock. Purchases under the new plan might be made at prevailing prices beginning immediately and ending at such time as the authorized funds were spent or the Company discontinued the program. The Company announced that as of March 31, 2003, the Company invested approximately $20,000,000 to repurchase 5.9 million shares under the previous stock repurchase program announced April 24, 2001.

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SIGNATURES

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

         
Date: August 11, 2003   SELECTICA, INC.
         
    By:   /s/ STEPHEN R. BENNION
       
        Stephen R. Bennion
        Chief Financial Officer and Secretary

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EXHIBIT INDEX

     
Exhibit    
Number   Description

 
Exhibit 31.1    
    Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
     
Exhibit 31.2    
    Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
     
Exhibit 32.1    
    Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
     
Exhibit 32.2    
    Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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