VERSATILITY INC, 10-Q/A, 1998-04-30

VERSATILITY INC
10-Q/A, 1998-04-30
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q/A
AMENDMENT NO.1 TO FORM 10-Q

(Mark One)

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

For the quarterly period ended July 31, 1997

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

For the Transition Period from ____________________ to ____________________

Commission File Number: 0-21793

VERSATILITY INC.
(Exact name of registrant as specified in its charter)

DELAWARE 52-1214354
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

11781 Lee Jackson Memorial Highway
Seventh Floor
Fairfax, Virginia 22033
(703) 591-2900

(Address and telephone number of principal executive offices)

Indicate by check mark whether 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 [ ]

As of August 31, 1997 there were 7,381,177 shares of common stock outstanding,
par value $.01 per share.

<PAGE>

VERSATILITY INC.

FORM 10-Q/A

TABLE OF CONTENTS

<TABLE>
<CAPTION>
Page No.
-------
<S><C>
PART I: FINANCIAL INFORMATION

Item 1: Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets as of April 30, 1997 and July 31, 1997 3

Condensed Consolidated Statements of Operations for the Three Months Ended July 31, 1996
and 1997 5

Condensed Consolidated Statements of Cash Flows for the Three Months Ended
July 31, 1996 and 1997 6

Condensed Consolidated Statements of Changes in Stockholders' Equity for the
Three Months Ended July 31, 1997 7

Notes to Condensed Consolidated Financial Statements 8

Item 2: Management's Discussion and Analysis of Financial Condition and
Results of Operations 11

PART II: OTHER INFORMATION

Item 1: Legal Proceedings 21

Item 2: Changes in Securities 22

Item 3: Defaults Upon Senior Securities 22

Item 4: Submission of Matters to a Vote of Security Holders 22

Item 5: Other Information 22

Item 6: Exhibits and Reports on Form 8-K 22

Signatures 23
</TABLE>

<PAGE>

THE UNDERSIGNED REGISTRANT HEREBY AMENDS THE FOLLOWING ITEMS, FINANCIAL
STATEMENTS, EXHIBITS OR OTHER PORTIONS OF ITS QUARTERLY REPORT ON FORM 10-Q AS
SET FORTH HEREIN. THIS QUARTERLY REPORT ON FORM 10Q/A IS FILED IN CONNECTION
WITH THE COMPANY'S RESTATEMENT OF FINANCIAL STATEMENTS FOR THE FISCAL YEAR ENDED
APRIL 30, 1997 AND FOR THE FISCAL QUARTERS ENDED JULY 31, 1997 AND OCTOBER 31,
1997. EXCEPT AS OTHERWISE NOTED, INFORMATION CONTAINED IN THIS REPORT IS AS OF
JULY 31, 1997.

Part I: Financial Information
Item 1: Financial Statements

VERSATILITY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

APRIL 30, 1997 JULY 31, 1997
-------------- -------------
(As Restated, (As Restated,
-------------- -------------
See Note 4) See Note 4)
-------------- -------------

ASSETS

Current assets:
Cash and cash equivalents............... $18,825,764 $14,742,713
Short-term investments.................. 6,039,255 5,987,436
Accounts receivable, net of allowance for
doubtful accounts of $909,501 and
$934,501.............................. 5,844,987 4,441,532
Prepaid expenses........................ 575,144 810,820
Inventory............................... 18,880 47,146
Note receivable-related party........... 519,305 519,305
Income taxes receivable................. -- 1,740,000
Related party receivables............... 153,381 164,354
----------- -----------
Total current assets...................... 31,976,716 28,453,306
----------- -----------
Other assets:
Deposits................................ 187,650 227,429
Prepaid expenses........................ 259,755 204,093
Investments............................. 1,433,464 1,437,021
Income taxes receivable................. 1,530,000 --
Assets held for sale.................... 508,210 1,392,620
Purchased software, net of accumulated
amortization of $42,098 and $53,059... 177,136 166,175
----------- -----------
Total other assets........................ 4,096,215 3,427,338
----------- -----------
Property and equipment
Computers............................... 1,168,246 1,315,980
Office furniture and equipment.......... 665,597 701,649
Leasehold improvements.................. 206,402 211,292
Capital leases.......................... 652,533 652,533
----------- -----------
2,692,778 2,881,454

Less: Accumulated depreciation and
amortization.......................... (1,675,749) (1,767,346)
----------- -----------
Net property and equipment.......... 1,017,029 1,114,108
----------- -----------
Total assets.............................. $37,089,960 $32,994,752
=========== ===========

See Notes to condensed consolidated financial statements

<PAGE>

VERSATILITY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)

APRIL 30, 1997 JULY 31, 1997
-------------- -------------
(As Restated, (As Restated,
-------------- -------------
See Note 4) See Note 4)
-------------- -------------

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable....................... $ 1,590,962 $ 1,946,735
Accrued liabilities.................... 2,337,034 2,102,566
Related party payables................. 28,030 19,440
Income taxes payable................... 104,777 14,777
Capital lease payable.................. 38,900 26,426
Line of credit.........................
- Operating 2,288,319 2,521,136
- Equipment 404,678 367,684
----------- -----------
Deferred revenue....................... 1,788,037 1,037,425
----------- -----------
Total current liabilities................ 8,580,737 8,036,189
----------- -----------
Other liabilities:
Capital lease payable, less current
maturities........................... 24,611 19,590
Deferred rent.......................... 316,360 331,565
----------- -----------
Total other liabilities................ 340,971 351,155
----------- -----------
Commitments and Contingencies

Stockholders' equity:
Preferred stock, $.01 par value,
2,000,000 shares authorized, no shares
issued or outstanding................ -- --
Common stock, par value $.01 -- 20,000,000
shares authorized, 7,297,365 shares issued
and outstanding at April 30, 1997;
7,381,177 shares issued and outstanding
at July 31, 1997.......................... 72,974 73,812
Additional paid-in capital................ 34,349,298 34,462,891
Foreign currency translation adjustments.. (83,880) (106,128)
Retained deficit.......................... (6,170,140) (9,823,167)
----------- -----------
Total stockholders' equity................ 28,168,252 24,607,408
----------- -----------
Total liabilities and stockholders' equity $37,089,960 $32,994,752
=========== ===========

See Notes to condensed consolidated financial statements.

<PAGE>

VERSATILITY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

<TABLE>
<CAPTION>
Three Months Ended
July 31,
1996(AS 1997(AS
------------- -------------
RESTATED, SEE RESTATED, SEE
------------- -------------
NOTE 4) NOTE 4)
------------- -------------
<S><C>
Revenue:
License revenue................................... $3,039,061 $ 2,044,573
Service and maintenance revenue................... 1,631,868 3,886,823
---------- ------------
Total revenue................................ 4,670,929 5,931,396
---------- ------------
Cost of revenue:
License revenue................................... 205,224 664,282
Service and maintenance revenue................... 1,239,661 3,275,587
---------- ------------
Total cost of revenue........................ 1,444,885 3,939,869
---------- ------------
Gross margin.......................................... 3,226,044 1,991,527
---------- ------------
Operating expenses:
Selling, general and administrative............... 3,028,807 4,332,895
Research and development.......................... 618,566 961,802
Litigation settlement and related costs........... -- 500,000
Depreciation and amortization..................... 49,816 98,560
----------- ------------
Total operating expenses..................... 3,697,189 5,893,257
----------- ------------
Loss from operations.................................. (471,145) (3,901,730)
Interest income (expense), net........................ (5,612) 248,703
----------- ------------
Loss before provision for income taxes............... (476,757) (3,653,027)
Benefit for income taxes.............................. (162,000) --
----------- ------------
Net loss.............................................. $ (314,757) $ (3,653,027)
============ ============
Net loss per share.................................... $ (0.06) $ (0.50)
=========== ============
Weighted average common and common
equivalent shares outstanding....................... 5,603,205 7,319,875
=========== ============
</TABLE>

See Notes to the condensed consolidated financial statements.

<PAGE>

VERSATILITY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

<TABLE>
<CAPTION>
THREE MONTHS ENDED
JULY 31,
1996(AS 1997(AS
------------- -------------
RESTATED, SEE RESTATED, SEE
------------- -------------
NOTE 4) NOTE 4)
------------- -------------
<S><C>
Cash flows from operating activities:
Net loss........................................... $ (314,757) $ (3,653,027)
Adjustments to reconcile net loss to net
cash provided by operating activities:
Depreciation................................... 44,066 87,599
Amortization................................... 5,750 10,961
Gain on equity investment...................... (28) --
Changes in assets and liabilities:
Accounts receivable........................ 878,822 1,403,455
Prepaid expenses........................... (9,260) (180,014)
Inventory.................................. (1,674) (28,266)
Related party receivables.................. 25,462 --
Deposits................................... 768 (39,779)
Accounts payable........................... (509,652) 355,773
Accrued liabilities........................ 155,226 (234,468)
Related party payables..................... 26,557 (8,590)
Income taxes payable....................... (432,924) (300,000)
Deferred rent.............................. 49,339 15,205
Deferred revenue........................... 606,816 (750,612)
----------- ------------
Net cash (used in) provided by
operating activities................. 524,511 (3,321,763)
----------- ------------
Cash flows from investing activities:
Purchase of investments............................ -- 48,262
Purchase of property and equipment and assets
held for sale.................................... (172,789) (1,069,088)
Related party note receivable...................... -- (10,973)
----------- ------------
Net cash used in investing activities.. (172,789) (1,031,799)
----------- ------------
Cash flows from financing activities:
Borrowings under line of credit.................... -- 232,817
Payments under line of credit...................... (545,008) (36,994)
Proceeds from sale of common stock, net............ -- 114,431
Principal payments under capital leases............ (10,600) (17,495)
----------- ------------
Net cash provided by (used in)
financing activities................. (555,608) 292,759
----------- ------------
Effect of exchange rate changes on cash................ 6,568 (22,248)
----------- ------------
Net decrease in cash and cash equivalents.............. (197,318) (4,083,051)
Cash and cash equivalents, beginning of period......... 2,280,273 18,825,764
----------- ------------
Cash and cash equivalents, end of period............... $2,082,955 $ 14,742,713
=========== ============
Supplemental disclosures of cash flow information:

Interest paid...................................... $ 51,630 $ 69,315
=========== ============
Income taxes paid.................................. $ 273,000 $ 290,000
=========== ============
</TABLE>

See Notes to condensed consolidated financial statements.

<PAGE>

VERSATILITY INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(UNAUDITED)

<TABLE>
<CAPTION>
NUMBER OF FOREIGN
SHARES OF ADDITIONAL CURRENCY
COMMON COMMON PAID-IN TRANSLATION RETAINED
STOCK STOCK CAPITAL ADJUSTMENTS DEFICIT TOTAL
---------- ------- ----------- ----------- ----------- -----------
<S><C>
Balance, April 30, 1997(As restated,
See Note 4)............................... 7,297,365 $72,974 $34,349,298 $ (83,880) $(6,170,140) $28,168,252
Issuance of common stock related to
exercise of stock options........... 83,812 838 113,593 114,431
Foreign currency translation
adjustments......................... (22,248) (22,248)
Net loss.............................. (3,653,027) (3,653,027)
--------- ------- ----------- ---------- ----------- -----------
Balance, July 31, 1997(As Restated, See
Note 4)................................... 7,381,177 $73,812 $34,462,891 $ (106,128) $(9,823,167) $24,607,408
========= ======= =========== ========== =========== ===========
</TABLE>

See notes to condensed consolidated financial statements.

<PAGE>

VERSATILITY INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been
prepared on the same basis as the audited consolidated financial statements and,
in the opinion of management, include all adjustments (consisting of only normal
recurring adjustments) necessary to present fairly the financial information set
forth therein, in accordance with generally accepted accounting principles. The
results of operations for the interim periods are not necessarily indicative of
the results to be expected for any future period. Certain information and
footnote disclosures normally contained in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted. These condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and notes thereto,
together with management's discussion and analysis of financial condition and
results of operations, contained in Versatility Inc.'s Annual Report on Form
10-K/A for the fiscal year ended April 30, 1997.

2. LITIGATION

One of the Company's former Value added Resellers (VARs) filed a claim for
arbitration against the Company in connection with the termination of the VAR's
reseller agreement with the Company, claiming not less than $1.0 million in
damages. The Company defended this action in arbitration proceedings. In April
1997, the arbitration panel awarded $267,000 in net damages to the plaintiff in
the proceeding. The arbitration panel's decision was appealed. In August 1997,
the Company settled the litigation with the former VAR for $250,000. The Company
has recorded a one-time charge in the quarter ending July 31, 1997 related to
this litigation for $500,000, which includes the settlement charge and other
costs and expenses associated with defending the litigation.

Recent Developments. Between March 6, 1998 and April 8, 1998 the Company and
certain of its current and former officers and directors, among others, were
sued in various putative securities class action filed in the United States
District Court for the Southern District of New York and the United States
District for the Eastern District of Virginia, as follows: Thomas Esposito, et
al. V. Versatility, Inc., et al. (S.D.N.Y.); Tammy Newsman v. Versatility, Inc.,
et al. (S.D.N.Y.); Sam Succar v. Versatility, Inc. et al. (S.D.N.Y.); Thomas K.
Doyle v. Versatility, Inc. et al. (E.D. Va); and Steven Bowen v. Versatility,
Inc. et al. (S.D.N.Y.) (together "the putative class actions"). In addition, the
Company's auditors and the lead underwriters in its December 1996 initial public
offering (IPO) were named as defendants in one or more of the putative class
actions. Collectively, the putative class actions assert claims under Sections
11, 12(2) and 15 of the Securities Act of 1933 and Section 10(b) and 20(a) of
the Securities Exchange Act of 1934 for alleged misrepresentations and omissions
in connection with the SEC public filings and other public statements made by
the Company. Among other allegations, each of the putative class actions alleges
that the Company misrepresented its financial results and its accounting
practices during the period December 12, 1996 through March 12, 1998, including
in the Company's IPO Prospectus. The complaints in certain of the putative class
actions also assert, among other allegations, that the Company and certain of
the other defendants made misrepresentations in the IPO Prospectus and
thereafter regarding the performance capabilities of the Company's CallCenter
product. The Company intends to vigorously defend this action. The ultimate
outcome including the amount of the possible loss cannot be determined at this
time. It is expected that the cost to defend this lawsuit will be substantial
and will have a material adverse effect on the Company's business and results
and operations. An unfavorable outcome in the litigation could have a material
adverse effect on the Company's financial condition and results of operations.

In addition to the above claim, the Company is a party to various legal
proceedings in the normal course of business, consisting of contract issues and
employee matters, which outcome cannot be ascertained at this time. Taken
together or individually, an adverse outcome on the results of these suits may
have a materially adverse impact on the Company. Because the outcome of these
matters cannot be ascertained at this time, the Company has not recorded any
significant accruals related to these matters.

<PAGE>

On March 12, 1998, the Company announced that it expected to restate its
financial results for the fiscal year ended April 30, 1997 and the fiscal
quarters ended July 30, 1997 and October 30, 1997, and that its Form 10-Q for
the quarter ended January 31, 1998 would not be filed on time, all as of result
of concerns over the accounting treatment of certain transactions. As a result
of this press release, the National Association of Securities Dealers ("NASD")
suspended trading of the Company's common stock on the NASDAQ National Market,
and instituted proceedings to remove the Company's common stock from listing on
the National Market. The NASD has indicated that trading may resume after
publication of the Company's restated financial statements; however, a hearing
on delisting is scheduled for April 30, 1998. In addition, the NASD is
continuing to investigate the circumstances surrounding the Company's
restatements. There can be no assurance that the Company's common stock will
continue to be listed on the National Market.

3. LINE OF CREDIT

Since the company was not in compliance with various covenants in the above
credit facility in subsequent quarters, on April 28, 1998, the Company entered
into an amendment to the credit facility which will be effective April 30, 1998,
in which the bank will waive all prior non-compliance, and which provides for
the following terms: the $2.0 million equipment line was cancelled and the
outstanding balance of $256,703 was transferred to the operating line of credit;
upon the effective date, the Company will permanently pay down the operating
line to $3.8 million and may not borrow any additional amounts under the line.
In addition, in exchange for the bank's forbearance in exercising its rights
under the previous arrangement, the Company has agreed to issue to the Bank
warrants to purchase 100,000 shares of the Company's common stock with and
exercise price of $2.50 per share. The credit facility continues to be
collateralized by all of the Company's assets. The agreement provides that the
Company must maintain certain financial covenants, including a minimum tangible
net worth and a minimum cash balance. The line of credit matures on November 5,
1998.

4. RESTATEMENT OF FINANCIAL STATEMENTS

Subsequent to the issuance of the Company's consolidated financial statements
for the year ended April 30, 1997, the Company's management determined that
certain revenue had been inappropriately recognized, the related receivables had
been improperly recorded, and certain costs had not been accrued or were
improperly recorded. As a result, the accompanying consolidated financial
statements as of July 31, 1997 and 1996 and for the quarters then ended have
been restated.

A summary of the significant effects of the restatements is as follows:

As of April 30, 1997: As Previously Reported As Restated
-------------------- ---------------------- -----------

Current Assets $42,940,494 $31,976,716
Current Liabilities 8,261,754 8,580,737
Retained Earnings (deficit) 3,639,393 (6,170,140)

<PAGE>

For the Quarter ended, As Previously Reported As Restated
July 31, 1996: ---------------------- -----------
- --------------

Total revenue $5,420,032 $4,670,929
Total operating expenses 3,705,168 3,697,189
Net income (loss) 202,346 (314,757)
Net income (loss) per
share 0.04 (0.06)
Weighted average common 5,603,205 5,603,205
and common equivalent
shares outstanding

As of July 31, 1997: As Previously Reported As Restated
- ------------------- ---------------------- -----------

Current Assets $40,600,859 $28,453,306
Current Liabilities 7,049,457 8,036,189
Retained Earnings 3,675,834 (9,823,167)
(deficit)

For the Quarter ended, As Previously Reported As Restated
July 31, 1997: ---------------------- -----------
- --------------

Total revenue $9,011,163 $5,931,396
Total operating expenses 6,407,509 5,893,257
Net income (loss) 46,441 (3,653,027)
Net income (loss) per 0.01 (0.50)
share
Weighted average common 7,993,606 7,319,875
and common equivalent
shares outstanding

<PAGE>

MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This document contains various forward-looking statements and information that
are based on management's beliefs as well as assumptions made by and information
currently available to management. Such statements are subject to various risks
and uncertainties which could cause actual results to vary materially from those
contained in such forward looking statements. Should one or more of these risks
or uncertainties materialize, or should underlying assumptions prove incorrect,
actual results may vary materially from those anticipated, estimated, expected
or projected. Certain of these risks and uncertainties as well as other risks
and uncertainties are described in Factors Which May Effect Future Operating
Results herein and in the Company's Registration Statement on Form S-1 filed
under the Securities Act of 1933, as amended, and declared effective on December
12, 1996 and the Annual Report on Form 10-K/A for the fiscal year ended April
30, 1997.

Overview

Versatility is a leading provider of client/server customer interaction software
that enables businesses to automate their telemarketing and teleselling
capabilities. Founded in 1981 as an information management consulting firm,
Versatility introduced its first commercial product in 1985, a telemarketing
application product based on the Digital Equipment Corporation ("DEC") VAX/VMS
System. The Company operated as a DEC value-added reseller, supplying turnkey
call center solutions to large and mid-sized companies in a variety of
industries, until the end of fiscal 1994. In November 1993, the Company began
developing applications based on the client/server architecture which culminated
with the release of the Versatility Series in May 1995. In fiscal 1996,
substantially all of the Company's revenue was derived from sales or services
related to the Versatility Series. In August 1996, the Company released
Versatility CallCenter, a CD-ROM-based call center software application that
supports call centers of 50 agents or less. The Versatility Call Center CD-ROM
product was discontinued in October 1997.

The Company's revenue is derived principally from two sources: (i) product
license fees for the use of the Company's software products and (ii) service
fees for implementation, maintenance, consulting and training related to the
Company's software products.

The Company's contracts with its customers often involve significant
customization and installation obligations. In these situations, license revenue
is recognized based on the percentage of completion method, which is based on
the achievement of certain performance milestones as defined in the contracts.
When the Company is under no obligation to install or customize the software,
license revenue is recognized upon shipment as long as cash collection is
probable. Service revenue for implementation, consulting services and training
is recognized as the services are performed. Revenue from maintenance services
is recognized ratably over the term of the service agreement. An allowance for
doubtful accounts receivable and sales has been recorded which is considered
adequate to absorb currently estimated bad debts and disputed amounts in these
accounts.

Although the particular customers may change from period to period, the Company
expects that large sales to a limited number of customers will continue to
account for a significant percentage of its total revenue in any particular
period. Given the customer concentration and the duration of the sales and
implementation cycle, the loss of a major customer or any reduction or delay in
sales to or implementation by these or other customers could have a material
adverse effect on the Company's operating results in any particular period.

Revenue from customers outside the United States accounted for 69.8% and 35.4%
of the Company's total revenue for the first three months of fiscal 1997 and
1998, respectively. While the Company's expenses incurred in foreign countries
are typically denominated in the local currencies, revenue generated by the
Company's international sales typically is paid in U.S. dollars or British
pounds. Although exposure to currency fluctuations to date has been
insignificant, there can be no assurance that fluctuations in currency exchange
rates in the future will not have a material adverse impact on the Company's
international operations. The Company currently does not engage in hedging
activities.

<PAGE>

Results of Operations

The following table sets forth certain financial data for the periods indicated
as a percentage of total revenue:

PERCENTAGE OF TOTAL
REVENUE
THREE MONTHS ENDED
JULY 31,
1996(1) 1997(1)
------- -------
Revenue:
License revenue......................... 65.1% 34.5%
Service and maintenance revenue......... 34.9 65.5
------- --------
Total revenue...................... 100.0 100.0
------- --------
Cost of revenue:
License revenue......................... 4.4 11.2
Service and maintenance revenue......... 26.5 55.2
------- --------
Total cost of revenue.............. 30.9 66.4
------- --------
Gross margin................................. 69.1 33.6
------- --------
Operating expenses:
Selling, general and administrative..... 64.8 73.1
Research and development................ 13.2 16.2
Litigation settlement and related costs. -- 8.4
Depreciation and amortization........... 1.1 1.7
------- --------
Total operating expenses........... 79.1 99.4
-------- --------
Loss from operations......................... (10.0) (65.8)
Interest income (expense), net............... (0.2) 4.2
-------- --------
Loss before benefit for income taxes......... (10.2) (61.6)
Provision for income taxes................... (3.5) --
-------- --------
Net loss..................................... (6.7)% (61.6)%
======= ========

(1) As Restated. See Note 5 of the Notes to the condensed consolidated
financial statements.

The following table sets forth, for each component of revenue, the cost of such
revenue expressed as a percentage of such revenue for the periods indicated:

Three Months Ended
July 31,
------------------
1996(1) 1997(1)
------- -------
Cost of license revenue...................... 6.8% 32.5%
Cost of service and maintenance revenue...... 76.0% 84.3%

(1) As Restated. See Note 5 of the Notes to the condensed consolidated
financial statements.

Revenue. Total revenue increased 27.0% from $4.7 million in the three months
ended July 31, 1996 to $5.9 million in the three months ended July 31, 1997. The
increase was primarily due to the significant increase in service revenue.
Revenue from license fees decreased 32.7% from $3.0 million in the three months
ended July 31, 1996, or 65.1% of total revenue, to $2.0 million in the three
months ended July 31, 1997, or 34.5% of total revenue. The decrease was
primarily due to indirect sales not materializing, while the Company
de-emphasized the direct sales channels. Service revenue increased 138.2% from
$1.6 million in the three months ended July 31, 1996 to $3.9 million in the
three months ended July 31, 1997 due to greater demand for the Company's
implementation and project management services. The mix of revenue changed from
roughly 65% licenses, 35% services in the prior year to approximately 34%
licenses, 66% services in the current year, on the strength of the services
revenue reported.

<PAGE>

Cost of Revenue. Cost of license revenue is comprised of the costs of media,
packaging, documentation and incidental hardware costs. Cost of service and
maintenance revenue consists of salaries, wages, benefits and other direct costs
related to installing, customizing and supporting customer implementations.
These costs also include telephone support and training.

Total cost of revenue increased from $1.4 million in the three months ended July
31, 1996, or 30.9% of total revenue, to $3.9 million in the three months ended
July 31, 1997, or 66.4% of total revenue. Cost of license revenue increased from
$205,000 in the three months ended July 31, 1996, or 4.4% of license revenue to
$664,000 in the three months ended July 31, 1997, or 11.2% of license revenue.
Cost of service and maintenance revenue increased from $1.2 million in the three
months ended July 31, 1996, or 76.0% of service and maintenance revenue, to $3.3
million in the three months ended July 31, 1997, or 84.3% of service and
maintenance revenue. The increase was the result of additions to the Company's
consulting, customization and implementation staff to support the Company's
projects. During the first quarter of fiscal 1998, the Company's cost of service
and maintenance revenue was higher as a percentage of such revenue due in part
to the engagement of contract programmers to complete certain custom
implementations of the Versatility Series. Total cost of revenue was adversely
affected in the current year compared to the same period in the prior year due
to the change in revenue mix between licenses and services, with services very
very labor intensive.

Selling, General and Administrative. Selling expenses consist of personnel
costs, including compensation and benefits and costs of travel, advertising,
public relations, seminars and trade shows. General and administrative expenses
represent the costs of executive, finance and support personnel and unallocated
corporate expenses such as rent, utilities, legal and auditing. Selling, general
and administrative expenses increased from $3.0 million for the three months
ended July 31, 1996, or 64.8% of total revenue, to $4.3 million for the three
months ended July 31, 1997, or 73.1% of total revenue. This increase was
attributable to additions to the Company's headcount, primarily sales and
marketing staff. At July 31, 1996, sales, marketing and administrative had 59
employees versus 122 employees at July 31, 1997.

Research and Development. Research and development expenses consist of personnel
costs and direct overhead costs incurred in developing software features and
functionality. Research and development expenses increased from $619,000 for the
three months ended July 31, 1996, or 13.2% of total revenue, to $962,000 for the
three months ended July 31, 1997, or 16.2% of total revenue. The increase was
due to the hiring of additional software engineers to support increased
development activities.

Litigation Settlement and Related Costs. One of the Company's former VARs filed
a claim for arbitration against the Company in connection with the termination
of the VAR's reseller agreement with the Company, claiming not less than $1.0
million in damages. The company defended this action in arbitration proceedings.
In April 1997, the arbitration panel awarded $267,000 in net damages to the
plaintiff in the proceedings. The arbitration panel's decision was appealed. In
August 1997, the Company settled the litigation with the former VAR for
$250,000. The Company has recorded a one-time charge in the quarter ending July
31, 1997 related to this litigation for $500,000, which includes the settlement
charge and other costs and expenses associated with defending the litigation.

Depreciation and Amortization. Depreciation and amortization expenses were
$50,000 in the three months ended July 31, 1996 and $99,000 in the three months
ended July 31, 1997. The increase due to additional depreciation expense on
equipment the Company purchased.

Interest Income (Expense), Net. Interest income (expense), net consists of
interest earned on cash and cash equivalents, offset by interest expense on debt
and equipment financing. Net interest income (expense) was $(6,000) and $249,000
for the three months ended July 31, 1996 and 1997, respectively. The difference
results from interest income attributable to the cash raised through the initial
public offering in the third quarter of fiscal 1997, partially offset by
interest expense related to borrowings on the line of credit.

Provision for Income Taxes. The Company accounts for income taxes under
Statement of Financial Accounting Standards No. 109 "Accounting for Income
Taxes"("SFAS 109"). The provision for income taxes is computed based on pretax
income, with deferred income taxes recorded for the differences between pretax
accounting and pretax taxable income. The Company's recorded a benefit for
income taxes of $162,000 for the three months ended July 31, 1996. The Company
did not record a benefit for the three months ended July 31, 1997 as the Company
had utilized in prior periods all its available tax benefits.

<PAGE>

Liquidity and Capital Resources

The Company has funded its operations to date through cash generated from
operations, through the private sale of preferred stock in January 1996 totaling
$3.5 million, from funds obtained from revolving credit facilities with
commercial banks and the Company's initial public offering in December 1996 that
raised $30.6 million in net proceeds. The Company's $2.5 million line of credit
had an outstanding balance of $2.5 million at July 31, 1997. Advances under the
working capital line bore interest at a variable annual rate equal to the prime
rate of the bank plus 0.5%. The line of credit expired on August 5, 1997

At July 31, 1997, the Company had $20.7 million in cash, cash equivalents and
short-term investments and $4.4 million in accounts receivable. For the three
months ended July 31, 1997, net cash used in operations totaled $3.3 million. In
addition, the Company used approximately $1.1 million for capital expenditures.
These uses of cash were partially offset by borrowings of $233,000 under the
Company's working capital line of credit and $114,000 related to employees
exercising stock options, resulting in a net cash decrease of $4.1 million.

Recent Developments

On October 29, 1997, the Company entered into a new credit facility
with its commercial bank which provided for a $5.0 million operating line of
credit and a new $2.0 million equipment line of credit. Since the company was
not in compliance with various covenants in the above credit facility in
subsequent quarters, on April 28, 1998, the Company entered into an amendment to
the credit facility which will be effective April 30, 1998, in which the bank
will waive all prior non-compliance, and which provides for the following terms:
the $2.0 million equipment line was cancelled and the outstanding balance of
$256,703 was transferred to the operating line of credit; upon the effective
date, the Company will permanently pay down the operating line to $3.8 million
and may not borrow any additional amounts under the line. In addition, in
exchange for the bank's forbearance in exercising its rights under the previous
arrangement, the Company has agreed to issue to the Bank warrants to purchase
100,000 shares of the Company's common stock with and exercise price of $2.50
per share. The credit facility continues to be collateralized by all of the
Company's assets. The agreement provides that the Company must maintain certain
financial covenants, including a minimum tangible net worth and a minimum cash
balance. The line of credit matures on November 5, 1998.

At April 27, 1998, the Company had $ 5.2 million in cash and cash equivalents
and $ 8.1 million in accounts receivable. Subsequent to the date of the
financial statements contained herein, the Company has incurred substantial
losses and anticipates a significant loss in the fourth quarter of fiscal 1998.
Additionally, the Company expects to incur significant amounts to defend the
lawsuits described below in "Litigation Risks". While significant cost cutting
measures have been initiated and completed in some circumstances, there can be
no assurance that the Company's cash on hand and cash flows from operations will
be sufficient to meet its ongoing obligations. The Company has retained
NationsBanc Montgomery Securities LLC to help it review its strategic
alternatives which include additional capital raising activities and evaluating
potential corporate partners. If the Company is unable to obtain additional
financing sufficient to meet its operating needs, the Company may be required to
significantly reduce the scope of its operations, which would have a material
adverse effect on the Company's business and results of operations and its
ability to compete. Such reduced operations and levels of cash may also cause
the Company to default under its credit facility.

Factors Which May Effect Future Operating Results

The following issues and uncertainties, among others, should be considered in
evaluating the Company's outlook.

Risks Relating to Cash Flow Levels. As of April 27, 1998, the Company had $ 5.2
million in cash and cash equivalents and $ 8.1 million in accounts receivable.
The Company believes that its cash on hand and cash flow from anticipated
operating activities may not be sufficient to meet its ongoing obligations
through the second quarter of fiscal 1999. Additionally, the Company expects to
incur significant amounts to defend the lawsuits described in "Litigation
Risks". The Company's independent auditors have stated in their report issued in
connection with the Company's Annual Report on Form 10-K/A that they have
substantial doubt about the Company's ability to continue as a going concern.
The Company has retained NationsBanc Montgomery Securities LLC to help it review
its strategic alternatives, which include additional capital raising activities
and evaluating potential corporate partners. If the Company is unable to obtain
additional financing sufficient to meet its operating needs, the Company may be
required to significantly reduce the scope of its operations, which would have a
material adverse effect on the Company's business, results of operations and its
ability to compete. Such reduced operations and levels of cash may

<PAGE>

also cause the Company to be in default under its credit facility. See Note 1 to
the Company's Consolidated Financial Statements for the year ended April 30,
1997.

Adverse Effects of Restatement of Financial Statements. On March 12, 1998, the
Company announced that it expected to restate its financial results for the
fiscal year ended April 30, 1997 and the fiscal quarters ended July 31, 1997 and
October 31, 1997, and that its Form 10-Q for the quarter ended January 31, 1998
would not be filed on time, all as a result of concerns over the accounting
treatment of certain transactions, which the Company was examining. The
uncertainties resulting from this announcement have had a material adverse
affect on the Company's business and financial condition. In addition to its
proceedings with the NASD (described in "Proceedings with the NASD" below)
filing of the lawsuits against the Company (described in "Litigation Risks"
below) such announcement has and will continue to have additional adverse
effects on the Company. First, due to the Company's financial uncertainty,
certain customers of the Company have stated that they will postpone purchases
of the Company's products and services until the Company's restated financial
results are released. There is no assurance that once such results are released,
such customers will purchase the Company's products and services. Second, there
can be no assurance that, once such financial results are released and trading
in the Company's Common Stock resumes, that the trading price per share of the
Company's Common Stock will not decline further due to reactions by analysts or
otherwise.

Litigation Risks. Between March 6, 1998 and April 8, 1998 the Company and
certain of its current and former officers and directors, among others, were
sued in various putative securities class action cases filed in the United
States District Court for the Southern District of New York and the United
States District Court for the Eastern District of Virginia, as follows: Thomas
Esposito, et al. V. Versatility, Inc. et al. (S.D.N.Y.); Tammy Newsman v.
Versatility, Inc., et al. (S.D.N.Y.); Sam Succar v. Versatility, Inc., et al.
(S.D.N.Y.); Thomas K. Doyle v. Versatility, Inc. et al. (E.D. Va); and Steven
Bowen v. Versatility, Inc. et al. (S.D.N.Y.) (together "the putative class
actions"). In addition, the Company's auditors and the lead underwriters in its
December 1996 initial public offering (IPO) were named as defendants in one or
more of the putative class actions. Collectively, the putative class actions
assert claims under Sections 11, 12(2), and 15 of Securities Act of 1933 and
Section 10(b) and 20(a) of the Securities Exchange Act of 1934 for alleged
misrepresentations and omissions in connection with the SEC public filings and
other public statements made by the Company. Among other allegations, each of
the putative class actions alleges that the Company misrepresented its financial
results and its accounting practices during the period December 12, 1996 through
March 12, 1998, including in the Company's IPO Prospectus. The complaints in
certain of the putative class actions also assert, among other allegations, that
the Company and certain of other defendants made misrepresentations in the IPO
Prospectus and thereafter regarding the performance capabilities of the
Company's CallCenter product.

Although the Company intends to vigorously defend against all claims brought it,
the ultimate outcome, including amount of possible loss, of litigation cannot be
determined at this time. It is expected that the cost to defend these lawsuits
will be substantial and will have a material adverse effect on the Company's
business and results of operations. An unfavorable outcome in the litigation
could have a material adverse effect on the Company's financial condition and
results of operations.

Proceedings with the NASD. On March 12, 1998, the Company announced that it
expected to restate its financial results for the fiscal year ended April 30,
1997 and the fiscal quarters ended July 30, 1997 and October 30, 1997, and that
its Form 10-Q for the quarter ended January 31, 1998 would not be filed on time,
all as of result of concerns over the accounting treatment of certain
transactions. As a result of this press release, the NASD suspended trading of
the Company's Common Stock on the Nasdaq National Market, and instituted
proceedings to remove the Company's Common Stock from listing on the Nasdaq
National Market. The NASD has indicated that trading may resume after
publication of the Company's restated financial statements; however, a hearing
on delisting is scheduled for April 30, 1998. There can be no assurance that the
Company's Common Stock will resume trading on the Nasdaq National Market or that
once trading resumes, the Common Stock will continue to be listed on the Nasdaq
National Market or any other listing or exchange.

Dependence on New Products; Risk Associated with Servicing the Customer
Interaction Software Market. The Company currently derives substantially all of
its revenue from sales of its Versatility Series software and related services.
The Versatility Series was introduced in May 1995, and the Company expects that
this product and related services will continue to account for all of the
Company's revenue for the foreseeable future. However, the Company has little
operating history with the Versatility Series products. The Company's financial
results for periods prior to fiscal 1996 reflect sales of the Company's previous
generation of products, which the Company no longer actively markets. The
lifecycle of the Company's current products is difficult to estimate as a result
of many factors, including the unknown future demand for customer interaction
software and the effects of competition in this market. Moreover, although the
Company intends to enhance these products and develop related products, the

<PAGE>

Company's strategy is to continue to focus on providing customer interaction
software applications as its sole line of business. As a result, any factor
adversely affecting the market for customer interaction software applications in
general, or the Versatility Series products in particular, could adversely
affect the Company's business, financial condition and results of operations.
The market for customer interaction software products is intensely competitive,
highly fragmented and subject to rapid change. The Company's outlook will depend
on continued growth in the market for customer interaction applications. There
can be no assurance that the market for customer interaction applications will
continue to grow. If this market fails to grow or grows more slowly than the
Company currently anticipates, the Company's business, financial condition and
results of operations would be materially adversely affected.

Dependence on Large License Fees and Customer Concentration. A relatively small
number of customers have accounted for a significant percentage of the Company's
revenue in any given period. Although the particular customers may change from
period to period, the Company expects that large sales to a limited number of
customers will continue to account for a significant percentage of its revenue
in any particular period for the foreseeable future. Therefore, the loss,
deferral or cancellation of an order could have a significant impact on the
Company's operating results in a particular quarter. The Company has no
long-term contracts with its customers and there can be no assurance that its
current customers will place additional orders, or that the Company will obtain
orders of similar magnitude from other customers. The loss of any major customer
or any reduction, delay in or cancellation of orders by any such customer, or
the failure of the Company to market successfully to new customers could have a
materially adverse effect on the Company's business, financial condition and
results of operations.

Quarterly Fluctuations in Revenue and Operating Results. The Company's revenue
and operating results could fluctuate significantly from quarter to quarter due
to a combination of factors, including variations in the demand for the
Company's products, the level of product and price competition, the length of
the Company's sales process, the size and timing of individual transactions, the
mix of products and services sold, the mix of sales through direct and indirect
channels, any delay in or cancellation of customer implementations, the
Company's success in expanding its customer support organization, direct sales
force and indirect distribution channels, the timing of new product
introductions and enhancements by the Company or its competitors, the ratio of
international to domestic sales, commercial strategies adopted by competitors,
changes in foreign currency exchange rates, customers' budgets constraints, and
the Company's ability to control costs. In addition, a limited number of
relatively large customer orders has accounted for and is likely to continue to
account for a substantial portion of the Company's total revenue in any
particular quarter. The timing of such orders can be difficult to predict given
the average size of the Company's orders and the length of its sales process.
The Company has in the past recognized a substantial portion of its revenue in
the last month of a quarter. Therefore, the loss, deferral or cancellation of an
order could have a significant adverse impact on the Company's revenue and
operating results in a particular quarter. Because the Company's operating
expense levels are relatively fixed and tied to anticipated levels of revenue,
any delay in the recognition of revenue from a limited number of license
transactions could cause significant variations in operating results from
quarter to quarter. Based upon all of the foregoing, the Company believes that
quarter-to-quarter comparisons of its results of operations are not necessarily
meaningful and such comparisons should not be relied upon as indications of
future performance. It is also likely that the Company's future quarterly
operating results in any given period will not meet the expectations of market
analysts or investors, which could have an adverse effect on the price of the
Company's Common Stock.

Length of Sales and Implementation Processes. Selling the Company's products
generally requires the Company to provide a significant level of education to
prospective customers regarding the use and benefits of the Company's products.
In addition, implementation of the Company's products involves a significant
commitment of resources by prospective customers and is commonly associated with
substantial integration efforts which may be performed by the Company, by the
customer, or by a third party systems integrator. For these and other reasons,
the length of time between the date of initial contact with the potential
customer and the implementation of the Company's products is often lengthy,
typically ranging from two to nine months or more, and is subject to delays over
which the Company has little or no control. The Company's implementation cycle
could be lengthened by increases in the size and complexity of its
implementations and by delays in its customers' adoption of client/server
computing environments. Delay in or cancellation of the sale or implementation
of applications could have a materially adverse effect on the Company's
business, financial condition and results of operations and cause the Company's
operating results to vary significantly from quarter to quarter.

Expansion of Sales Force and Channels of Distribution. Historically, the Company
has distributed its products primarily through its direct sales force. An
integral part of the Company's strategy was to expand its direct sales force
while developing additional marketing, sales and implementation relationships
with third party systems integrators and VARs. The Company's

<PAGE>

ability to achieve revenue growth in the future will depend on its ability to
attract, train and retain additional qualified direct sales personnel. In
addition, the Company was investing significant resources to develop its
relationships with third party systems integrators and VARs, especially in
international markets. The Company has only limited experience distributing its
products through indirect channels. If the Company is unable to develop its
relationships with third party systems integrators and VARs, or if the third
party systems integrators and VARs with which the Company develops relationships
are unable to effectively market, sell and implement the Company's software
applications, the Company's business, financial condition and results of
operations could be materially adversely affected.

Dependence on Indirect Distribution Channels; Potential for Channel Conflict.
The Company's strategy was to increase its use of third party systems
integrators and VARs to distribute its products. These independent sales
organizations, which generally install and support the product lines of a number
of companies, are not under the direct control of the Company, are not subject
to any minimum purchase requirements and can discontinue marketing the Company's
products at any time without cause. Many of the Company's third party systems
integrators and VARs sell or co-market potentially competitive products.
Accordingly, the Company must compete for the focus and sales efforts of its
third party systems integrators and VARs. Additionally, selling through indirect
channels may limit the Company's contacts with its customers. As a result, the
Company's ability to accurately forecast sales and revenue, evaluate customer
satisfaction and recognize emerging customer requirements may be hindered. In
addition, the Company's gross profit on sales to third party systems integrators
and VARs tends to be lower than on its direct sales, although the Company's
selling and marketing expenses and servicing costs also tend to be lower with
respect to these sales. There can be no assurance that the Company's current
third party systems integrators and VARs will continue to distribute or
recommend the Company's products or do so successfully. There can also be no
assurance that one or more of these companies will not begin to market products
in competition with the Company. The termination of one or more of these
relationships could adversely affect the Company's business, financial condition
and results of operations.

The Company's strategy of marketing its products directly to end-users and
indirectly through VARs and third party systems integrators may result in
distribution channel conflicts. The Company's direct sales efforts may compete
with those of its indirect channels and, to the extent different resellers
target the same customers, resellers may also come into conflict with each
other. Although the Company has attempted to manage its distribution channels in
a manner to avoid potential conflicts, there can be no assurance that channel
conflicts will not materially adversely affect its relationships with existing
third party systems integrators or VARs or adversely affect its ability to
attract new third party systems integrators and VARs.

Dependence on Practice Partners. The Company is currently enlisting the support
of a specific group of professional services organizations which will engage in
the practice of implementing and customizing the Company's software products.
Referred to as "Practice Partners," these organizations do not resell or
otherwise market the Company's products. Instead, the Company intends to support
the Practice Partners' efforts to learn to install, customize and support the
Company's products. The Company's future revenues may depend on the ability of
the Practice Partners to achieve this goal. Further, the costs required to
enlist, train and assist the Practice Partners could have a materially adverse
affect on the Company's business, financial condition and results of operations.

International Operations. Revenue from sales outside the United States in fiscal
1995, 1996 and 1997 and the first three months of fiscal 1998 accounted for
approximately 16.3%, 40.8%, 54.6%, and 35.4% respectively, of the Company's
total revenue. International operations are subject to inherent risks, including
the impact of possible recessionary environments in economies outside the United
States, changes in demand for the Company's products resulting from fluctuations
in exchange rates, unexpected changes in legal and regulatory requirements
including those relating to telemarketing activities, changes in tariffs,
seasonality of sales, costs of localizing products for foreign markets, longer
accounts receivable collection periods and greater difficulty in accounts
receivable collection, difficulties and costs of staffing and managing foreign
operations, reduced protection for intellectual property rights in some
countries, potentially adverse tax consequences and political and economic
instability. There can be no assurance that the Company will be able to sustain
or increase international revenue, or that the factors listed above will not
have a material adverse impact on the Company's international operations. While
the Company's expenses incurred in foreign countries are typically denominated
in the local currencies, revenue generated by the Company's international sales
typically is paid in U.S. dollars or British pounds. Although exposure to
currency fluctuations to date has been insignificant, there can be no assurance
that fluctuations in currency exchange rates in the future will not have a
material adverse impact on the Company's international operations. The Company
currently does not engage in hedging activities.

<PAGE>

A significant element of the Company's strategy was to continue the expansion of
its operations in international markets. This expansion has required and will
continue to require significant management attention and financial resources to
develop international sales channels. Because of the difficulty in penetrating
new markets, along with the Company's size and geographic location, there can be
no assurance that the Company will be able to maintain or increase international
revenue. To the extent that the Company is unable to do so, the Company's
financial condition and results of operations could be materially adversely
affected. A substantial portion of the Company's international sales are
expected to be made using indirect selling channels, such as third party systems
integrators and VARs. A reduction in sales by all or some of these distributors
or a termination of their relationships with the Company could have a material
adverse effect on the Company's business, financial condition and results of
operations.

Competition. The market for the Company's products is intensely competitive,
highly fragmented and subject to rapid change. Because the Company offers
multiple applications, which can be purchased separately or integrated as part
of the Versatility Series, the Company competes with a variety of companies
depending on the target market for their applications software products. The
Company's principal competitors in the customer interaction software market are
Brock International, Inc., Digital Systems International, Inc., Information
Management Associates, Inc., Scopus Technology, Inc. and The Vantive
Corporation. For installations where telephony functions are of prime
importance, competitors include Davox Corporation, Early Cloud and Company (a
division of IBM) and EIS International, Inc. The Company also competes with
third party professional service organizations that develop custom software and
with the information technology departments of potential customers, which
develop applications internally. Among the Company's potential competitors are
also a number of large hardware and software companies that may develop or
acquire products that compete with the Company's products. Increased competition
is likely to result in price reductions, reduced operating margins and loss of
market share, any of which could materially adversely affect the Company's
business, financial condition and results of operations. Many of the Company's
current and potential competitors have significantly greater financial,
technical, marketing and other resources than the Company. As a result, they may
be able to respond more quickly to new or emerging technologies and changes in
customer requirements, or to devote greater resources to the development,
promotion and sale of products than can the Company. There can be no assurance
that the Company will be able to compete successfully against current and future
competitors or that competitive pressures faced by the Company will not
materially adversely affect its business, financial condition and results of
operations.

Management of Growth. The Company expected significant growth in revenue, and
therefore staffed up operations and personnel. Continued growth will challenge
the Company's management systems and resources and require the Company to
improve and upgrade its management information systems. There can be no
assurance that the Company will be able to successfully upgrade its systems or
to attract, retain and successfully train the necessary personnel to accomplish
its strategies or that it will not experience constraints that will adversely
affect its ability to satisfy customer demand in a timely fashion or to
satisfactorily support its customers. Any of these events could injure the
Company's reputation or lead to loss of customers. If the Company is unable to
manage growth effectively, the Company's business, financial condition and
results of operations could be adversely affected.

Dependence on Growth of Client/Server Computing Environment. The client/server
software environment is relatively new. The Company markets its products solely
to customers that have committed or are committing their call center systems to
client/server environments, or are converting legacy systems, in part or in
whole, to a client/server environment. The Company's success will depend on
further development of and growth in the number of organizations adopting
client/server computing environments. There can be no assurance, however, that
the client/server market will maintain its current rate of growth. There also
can be no assurance that the client/server computing trends anticipated by the
Company will occur or that the Company will be able to respond effectively to
the evolving requirements of this market. If the client/server market fails to
grow, or grows at a rate slower than experienced in the past, the Company's
business, financial condition and results of operations could be materially
adversely affected.

Rapid Technological Change and Product Development Risks. The customer
interaction software market is subject to rapid technological change, changing
customer needs, frequent new product introductions and evolving industry
standards that may render existing products and services obsolete. As a result,
the Company's position in this market could be eroded rapidly by unforeseen
changes in application features and functions. The life cycles of the Company's
products are difficult to estimate. The Company's growth and future operating
results will depend in part upon its ability to enhance existing applications
and develop and introduce new applications that meet or exceed technological
advances in the marketplace, that meet changing customer requirements, that
respond to competitive products and that achieve market acceptance. The
Company's product development and

<PAGE>

testing efforts are expected to require substantial investments by the Company.
There can be no assurance that the Company will possess sufficient resources to
make these necessary investments. The Company has in the past experienced delays
both in developing new products and in customizing existing products, and there
can be no assurance that the Company will not experience difficulties that could
cause delays in the future. In addition, there can be no assurance that such
products will meet the requirements of the marketplace and achieve market
acceptance, or that the Company's current or future products will conform to
industry standards. If the Company is unable, for technological or other
reasons, to develop and introduce new and enhanced products in a timely manner,
the Company's business, financial condition and results of operations could be
materially adversely affected.

Software products as complex as those offered by the Company may contain errors
that may be detected at any point in the products' life cycles. The Company has,
in the past, discovered software errors in certain of its products and has
experienced delays in shipment of products during the period required to correct
these errors. In particular, the computing environment is characterized by a
wide variety of standard and non-standard configurations that make pre-release
testing for programming or compatibility errors very difficult and time
consuming. There can be no assurance that, despite extensive testing by the
Company and by current and potential customers, errors will not be found,
resulting in loss of, or delay in, market acceptance and sales, diversion of
development resources, injury to the Company's reputation, or increased service
and warranty costs, any of which could have a material adverse effect on the
Company's business, financial condition and results of operations.

Difficulty in Protecting Proprietary Technology; Risk of Infringement. The
Company relies on a combination of copyright, trade secret and trademark laws,
confidentiality procedures and contractual provisions to protect its proprietary
rights in its products and technology. The Company does not rely upon patent
protection and does not currently expect to seek patents on any aspects of its
technology. There can be no assurance that the confidentiality agreements and
other methods on which the Company relies to protect its trade secrets and
proprietary technology will be adequate. Further, the Company may be subject to
additional risks as it enters into transactions in countries where intellectual
property laws are not well developed or are poorly enforced. Legal protections
of the Company's rights may be ineffective in such countries. Litigation to
defend and enforce the Company's intellectual property rights could result in
substantial costs and diversion of resources and could have a materially adverse
effect on the Company's business, financial condition and results of operations,
regardless of the final outcome of such litigation. Despite the Company's
efforts to safeguard and maintain its proprietary rights both in the United
States and abroad, there can be no assurance that the Company will be successful
in doing so or that the steps taken by the Company in this regard will be
adequate to deter misappropriation or independent third-party development of the
Company's technology or to prevent an unauthorized third party from copying or
otherwise obtaining and using the Company's products or technology. There also
can be no assurance that others will not independently develop similar
technologies or duplicate any technology developed by the Company. Any such
events could have a material adverse effect on the Company's business, financial
condition and results of operations.

The Company has entered into agreements with a small number of its customers
requiring the Company to place its source code in escrow. These escrow
agreements typically provide that these customers have a limited, non-exclusive
right to use such code in the event that there is a bankruptcy proceeding by or
against the Company, if the Company ceases to do business or if the Company
fails to meet its support obligations. Entering into such agreements may
increase the likelihood of misappropriation by third parties.

As the number of customer interaction software applications in the industry
increases and the functionality of these products further overlaps, software
development companies like the Company may increasingly become subject to claims
of infringement or misappropriation of the intellectual property rights of
others. There can be no assurance that third parties will not assert
infringement or misappropriation claims against the Company in the future with
respect to current or future products. Any claims or litigation, with or without
merit, could be time-consuming, result in costly litigation, cause product
shipment delays or require the Company to enter into royalty or licensing
arrangements. Such royalty or licensing arrangements, if required, may not be
available on terms acceptable to the Company, if at all, which could have a
material adverse effect on the Company's business, financial condition and
results of operations. Adverse determinations in such claims or litigation could
also have a material adverse effect on the Company's business, financial
condition and results of operations.

Dependence on Key Personnel. The Company's success depends to a significant
extent upon the continued service of its executive officers and other key
management and technical personnel, and on its ability to continue to attract,
retain and motivate qualified personnel, such as experienced software developers
and sales personnel. Competition for such employees is very intense. The loss of
the services of one or more of the Company's executive officers, software
developers or other key personnel or the

<PAGE>

Company's inability to recruit replacements for such personnel could have a
material adverse effect on the Company's business, financial condition and
results of operations. The Company maintains $1.0 million of key-man life
insurance on Ronald R. Charnock, then the Company's President and Chief
Executive Officer at July 31, 1997. Since April 30, 1997 the Company has
replaced all of its senior management. The Company's current President and Chief
Operating Officer joined the Company in February 1988, together with the new
Senior Vice President of Operations. The Company's former President, Chairman
and Chief Executive Officer resigned from all positions with the Company, and
the former Chief Financial Officer and Vice President in charge of Sales have
also left the Company.

Regulatory Environment. Federal, state and foreign laws regulate certain uses of
outbound call processing systems. Although the compliance with these laws may
limit the potential use of the Company's products in some respects, the
Company's systems can be programmed to operate automatically in full compliance
with these laws through the use of appropriate calling lists and calling
campaign time parameters. There can be no assurance, however, that future
legislation further restricting telephone solicitation practices, if enacted,
would not adversely affect the Company.

Other Legal Proceedings. The Company is a party to various legal proceedings in
the normal course of business, consisting of contract issues and employee
matters, which outcome cannot be ascertained at this time (the more significant
ones are listed below). Taken together or individually, an adverse outcome on
the results of these suits may have a materially adverse impact on the Company.
The outcome of these matters cannot be ascertained at this time:

A former employee has sued the Company for approximately $1.2 million for
breach of contract amongst other claims;

A former customer is seeking damages in excess of $1 million for alleged
breach of contract and warranties, as well as alleged misrepresentations.
On April 16, 1998, the Company filed a response denying the allegations and
counterclaiming for damages in excess of $400,000 for breach of contract.
This matter is currently in the discovery stage. The Company intends to
vigorously defend this case;

A customer of a Versatility reseller has sued for damages for an amount not
less than $1,000,000. In December 1997, the District Court dismissed the
action. In February 1998, essentially the same claim was made in a
different District Court.

<PAGE>

Part II: Other Information

Item 1: Legal Proceedings:

One of the Company's former Value added Resellers (VARs) filed a claim for
arbitration against the Company in connection with the termination of the VAR's
reseller agreement with the Company, claiming not less than $1.0 million in
damages. The Company defended this action in arbitration proceedings. In April
1997, the arbitration panel awarded $267,000 in net damages to the plaintiff in
the proceedings. The arbitration panel's decision was appealed. In August 1997,
the Company settled the litigation with the former VAR for $250,000. The Company
has recorded a one-time charge in the quarter ending July 31, 1997 related to
this litigation for $500,000, which includes the settlement charge and other
costs and expenses associated with defending the litigation.

Recent Developments

Between March 6, 1998 and April 8, 1998 the Company and certain of its current
and former officers and directors, among others, were sued in various putative
securities class action filed in the United States District Court for the
Southern District of New York and the United States District for the Eastern
District of Virginia, as follows: Thomas Esposito, et al. V. Versatility, Inc.,
et al. (S.D.N.Y.); Tammy Newsman v. Versatility, Inc., et al. (S.D.N.Y.); Sam
Succar v. Versatility, Inc. et al. (S.D.N.Y.); Thomas K. Doyle v. Versatility,
Inc. et al. (E.D. Va); and Steven Bowen v. Versatility, Inc. et al. (S.D.N.Y.)
(together "the putative class actions"). In addition, the Company's auditors and
the lead underwriters in its December 1996 initial public offering (IPO) were
named as defendants in one or more of the putative class actions. Collectively,
the putative class actions assert claims under Sections 11, 12(2) and 15 of the
Securities Act of 1933 and Section 10(b) and 20(a) of the Securities Exchange
Act of 1934 for alleged misrepresentations and omissions in connection with the
SEC public filings and other public statements made by the Company. Among other
allegations, each of the putative class actions alleges that the Company
misrepresented its financial results and its accounting practices during the
period December 12, 1996 through March 12, 1998, including in the Company's IPO
Prospectus. The complaints in certain of the putative class actions also assert,
among other allegations, that the Company and certain of the other defendants
made misrepresentations in the IPO Prospectus and thereafter regarding the
performance capabilities of the Company's CallCenter product. Although the
Company intends to vigorously defend against all claims brought it, the ultimate
outcome, including amount of possible loss, of litigation cannot be determined
at this time. It is expected that the cost to defend these lawsuits will be
substantial and will have a material adverse effect on the Company's business
and results of operations. An unfavorable outcome in the litigation could have a
material adverse effect on the Company's financial condition and results of
operations.

In addition to the above claim, the Company is a party to
various legal proceedings in the normal course of business, consisting of
contract issues and employee matters, which outcome cannot be ascertained at
this time (the more significant ones are listed below). Taken together or
individually, an adverse outcome on the results of these suits may have a
materially adverse impact on the Company. Because the outcome of these matters
cannot be ascertained at this time, the Company has not recorded any significant
accruals related to these matters. The more significant of these matters are as
follows:

A former employee has sued the Company for approximately $1.2 million for
breach of contract amongst other claims;

A former customer is seeking damages in excess of $1 million for alleged
breach of contract and warranties, as well as alleged misrepresentations.
On April 16, 1998, the Company filed a response denying the allegations and
counter-claiming for damages in excess of $400,000 for breach of contract.
This matter is currently in the discovery stage. The Company intends to
vigorously defend this case;

<PAGE>

listing on the National Market. The NASD has indicated that trading may resume
after publication of the Company's restated financial statements; however, a
hearing on delisting is scheduled for April 30, 1998. In addition, the NASD is
continuing to investigate the circumstances surrounding the Company's
restatements. There can be no assurance that the Company's common stock will
continue to be listed on the National Market.

Item 2: Changes in Securities and Use of Proceeds

On December 12, 1996, the Company's S-1 (File No. 333-13771) became effective.
The Company has filed Form SR disclosing the sale of securities and the use of
proceeds through March 12, 1997. The net proceeds from the offering were
$30,625,564. No information has changed, except for the use of proceeds. The
Company used all of the proceeds from such offering during the period from the
effective date (December 12, 1996) through July 31, 1997, as follows:

Purchase and installation of machinery and equipment $ 1,551,118
Repayment of indebtedness 1,526,195
Working capital 22,150,221
Cash and short-term securities 5,398,030
-----------
Total $30,625,564
===========

None of these payments were made to directors, officers, general partners of the
Company or their associates, or to persons owning ten percent or more of any
class of equity securities of the Company, and to the affiliates of the Company.

Item 3: Defaults Upon Senior Securities:

Not Applicable.

Item 4: Submission of Matters to a Vote of Security Holders:

Not Applicable.

Item 5: Other Information:

Not Applicable.

Item 6: Exhibits and Reports on Form 8-K:

A. Exhibits

Exhibit No. Exhibits
- ----------- --------

10.9 Amendment to 1996 Employee Stock Purchase Plan
11.1 Statement Regarding Computation of Net Income Per Share
27.1 Financial Data Schedule

B. Reports on Form 8-K:

There were no reports on Form 8-K filed during the period.

<PAGE>

Signatures

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

VERSATILITY INC.

Dated: April 28, 1998 By: /s/ Kenneth T. Nelson
________________________________
Kenneth T. Nelson
Senior Vice President, Finance
and Chief Financial Officer
(Principal Financial and
Accounting Officer)

Exhibit 10.9

FIRST AMENDMENT TO

VERSATILITY INC.

1996 EMPLOYEE STOCK PURCHASE PLAN

This First Amendment (the "Amendment") to Versatility Inc. 1996
Employee Stock Purchase Plan (the "Plan") is dated and made effective as of May
22, 1997. The Plan was adopted by the Board of Directors of Versatility Inc.
(the "Company") on September 30, 1996, and was approved by the stockholders of
the Company (the "Stockholders") on September 30, 1996.

Article 15 of the Plan permits the Board of Directors, from time to
time, to adopt certain amendments to the Plan without approval of the
Stockholders. On May 22, 1997, the Board of Directors adopted a resolution to
amend the Plan to decrease the minimum length of employment requirement to be
eligible to participate in the Plan from one year to six months.

In accordance with the Board of Directors' action, the Plan is hereby
amended as set forth in this Amendment.

1. Article 3 is hereby amended by deleting the words "one year" in the
third line thereof after the word "completed and before the words
"of employment and substituting the words "six months" therefor.

2. Capitalized terms used but not defined in this Amendment shall have
the meanings ascribed to them in the Plan.

3. Except as expressly modified by this Amendment, the Plan shall
continue in full force and effect in accordance with its original
terms and conditions.

This Amendment was duly adopted by the Board of Directors on May 22, 1997.

Exhibit 11.1

Computation of Historical Net Income (loss) Per Common Share
(Unaudited)

THREE MONTHS ENDED
JULY 31,
1996(1) 1997(1)
------------ ----------

Net loss $ (314,757) $(3,653,027)
============ ===========

Weighted average number of shares
outstanding 4,000,000 7,319,875
Add:
Shares issuable upon conversion of
Series A Redeemable Convertible
Preferred Stock 992,061
Shares issuable from the assumed
exercise of options as determined by
the application of the treasury stock
method 611,144 0
------------ -----------
5,603,205 7,319,875
============ ===========
Net loss per common share $ (0.06) $ (0.50)
============ ===========

(1) As Restated. See Note 5 of the Notes to the condensed consolidated
financial statements.

The above computations include all common equivalent shares issued within the 12
months preceding the filing date as if they were outstanding for all periods
presented (using the treasury stock method) and the as if converted method with
regards to the Series A redeemable convertible preferred stock.

<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
ACCOMPANYING CONDENSED CONSOLIDATED FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>

<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> APR-30-1998
<PERIOD-START> MAY-01-1997
<PERIOD-END> JUL-31-1997
<CASH> 14,742,713
<SECURITIES> 5,987,436
<RECEIVABLES> 4,441,532
<ALLOWANCES> 934,501
<INVENTORY> 47,146
<CURRENT-ASSETS> 28,453,306
<PP&E> 2,881,454
<DEPRECIATION> (1,767,346)
<TOTAL-ASSETS> 32,994,752
<CURRENT-LIABILITIES> 7,703,789
<BONDS> 239,300
0
0
<COMMON> 73,812
<OTHER-SE> 24,533,596
<TOTAL-LIABILITY-AND-EQUITY> 32,994,752
<SALES> 2,044,573
<TOTAL-REVENUES> 5,931,396
<CGS> 664,282
<TOTAL-COSTS> 3,939,869
<OTHER-EXPENSES> 5,893,257
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (3,901,730)
<INCOME-TAX> 0
<INCOME-CONTINUING> (3,653,027)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (3,653,027)
<EPS-PRIMARY> (0.50)
<EPS-DILUTED> (0.50)

</TABLE>