INFERENCE CORP /CA/, 10-Q, 1999-12-13

INFERENCE CORP /CA/
10-Q, 1999-12-13
PREPACKAGED SOFTWARE

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<PAGE>

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

-------------

FORM 10-Q

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

For the quarterly period ended Commission File Number
October 31, 1999 0-26334
OR

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

INFERENCE CORPORATION
(Exact name of Registrant as specified in its charter)

Delaware 95-3436352
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)

100 Rowland Way
Novato, California 94945
(415) 893-7200
(Address, including zip code, and telephone number,
including area code, of Registrant's principal executive
offices)

-------------------

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

Yes x No
----- -----

As of December 3, 1999 there were 7,186,752 shares of the Registrant's Class A
Common Stock, par value $0.01 per share, and 535,332 shares of the Registrant's
Class B Common Stock, par value $0.01 per share, outstanding.

- --------------------------------------------------------------------------------

-1-
<PAGE>

INFERENCE CORPORATION

Index

<TABLE>
<CAPTION>
Page
----
<S> <C>
Part I FINANCIAL INFORMATION

ITEM 1. Condensed Consolidated Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets at
October 31, 1999 and January 31, 1999............................................... 3

Condensed Consolidated Statements of Operations for the Three and
Nine Months Ended October 31, 1999 and 1998......................................... 4

Condensed Consolidated Statements of Cash Flows for the
Nine Months Ended October 31, 1999 and 1998......................................... 5

Notes to Condensed Consolidated Financial Statements................................... 7

ITEM 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations................................................. 11

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk............................. 26

Part II OTHER INFORMATION

ITEM 1. Legal Proceedings...................................................................... 28

ITEM 2. Changes in Securities.................................................................. 28

ITEM 3. Defaults upon Senior Securities........................................................ 28

ITEM 4. Submission of Matters to a Vote of Security Holders.................................... 28

ITEM 5. Other Information...................................................................... 28

ITEM 6. Exhibits and Reports on Form 8-K....................................................... 28

Signature.............................................................................. 29

Index to Exhibits...................................................................... 30
</TABLE>

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-2-
<PAGE>
PART I
FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

INFERENCE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

<TABLE>
<CAPTION>
October 31, January 31,
1999 1999
------------ ------------
<S> <C> <C>
ASSETS

Current assets:
Cash and cash equivalents.......................... $ 18,813,000 $ 25,761,000
Accounts receivable, net........................... 4,945,000 7,063,000
Other current assets............................... 836,000 433,000
------------ ------------
Total current assets............................. 24,594,000 33,257,000

Property and equipment, net.......................... 1,810,000 1,607,000
Intangible assets, net............................... 945,000 --
Other assets......................................... 515,000 511,000
------------ ------------
$ 27,864,000 $ 35,375,000
============ ============

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
Accounts payable................................... $ 607,000 $ 819,000
Accrued salaries and related items................. 2,295,000 2,371,000
Other accrued liabilities.......................... 2,218,000 2,785,000
Deferred revenue................................... 4,553,000 4,642,000
------------ ------------
Total current liabilities........................ 9,673,000 10,617,000

Shareholders' equity:
Common stock....................................... 76,000 70,000
Additional paid-in capital......................... 48,478,000 46,328,000
Accumulated deficit................................ (29,998,000) (21,312,000)
Accumulated other comprehensive loss............... (365,000) (328,000)
------------ ------------
Total shareholders' equity....................... 18,191,000 24,758,000
------------ ------------
$ 27,864,000 $ 35,375,000
============ ============
</TABLE>

See accompanying notes.

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-3-
<PAGE>

INFERENCE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
October 31, October 31,
------------------------------ ----------------------------
1999 1998 1999 1998
----------- ---------- ----------- -----------
<S> <C> <C> <C> <C>
Revenues:
Products.......................................... $ 2,294,000 $4,912,000 $ 7,503,000 $12,105,000
Services.......................................... 3,220,000 3,412,000 9,911,000 10,080,000
----------- ---------- ----------- -----------
Total revenues.................................. 5,514,000 8,324,000 17,414,000 22,185,000

Operating costs and expenses:
Cost of product revenue........................... 339,000 233,000 744,000 611,000
Cost of service revenue........................... 1,533,000 1,615,000 4,915,000 5,177,000
Product development............................... 2,167,000 1,358,000 5,556,000 3,860,000
Sales and marketing............................... 4,546,000 3,807,000 12,008,000 11,278,000
General and administrative........................ 1,021,000 853,000 2,796,000 3,100,000
Amortization of intangible assets................. 61,000 -- 122,000 --
Acquisition related............................... -- -- 677,000 --
Restructuring..................................... -- 282,000 -- 1,856,000
----------- ---------- ----------- -----------
Total operating costs and expenses.............. 9,667,000 8,148,000 26,818,000 25,882,000
----------- ---------- ----------- -----------
Income (loss) from operations....................... (4,153,000) 176,000 (9,404,000) (3,697,000)
Interest income..................................... 244,000 324,000 780,000 980,000
Other income (expenses)............................. (39,000) 13,000 (62,000) (27,000)
----------- ---------- ----------- -----------
Income (loss) before income taxes................... (3,948,000) 513,000 (8,686,000) (2,744,000)
Provision for income taxes.......................... -- 100,000 -- 100,000
----------- ---------- ----------- -----------
Net income (loss)................................... $(3,948,000) $ 413,000 $(8,686,000) $(2,844,000)
=========== ========== =========== ===========

Other comprehensive income (loss):
Foreign currency translation adjustment........... 7,000 20,000 (37,000) (92,000)
----------- ---------- ----------- -----------
Comprehensive income (loss)..................... $(3,941,000) $ 433,000 $(8,723,000) $(2,936,000)
=========== ========== =========== ===========

Net income (loss) per share:
Basic............................................. $ (0.52) $ 0.06 $ (1.18) $ (0.39)
=========== ========== =========== ===========
Diluted........................................... $ (0.52) $ 0.06 $ (1.18) $ (0.39)
=========== ========== =========== ===========

Shares used in computing net income (loss) per
share:
Basic............................................. 7,598,000 6,992,000 7,370,000 7,224,000
=========== ========== =========== ===========
Diluted........................................... 7,598,000 7,083,000 7,370,000 7,224,000
=========== ========== =========== ===========
</TABLE>

See accompanying notes.

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-4-
<PAGE>

INFERENCE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

<TABLE>
<CAPTION>
Nine Months Ended
October 31,
---------------------------------
1999 1998
----------- -----------
<S> <C> <C>
Cash flows from operating activities:
Net loss.......................................................................... $(8,686,000) $(2,844,000)
Adjustments to reconcile net loss to net cash used in operating activities:
Acquired in-process research and development.................................... 450,000 --
Depreciation and amortization................................................... 1,074,000 762,000
Stock based compensation expense................................................ -- 209,000
Changes in operating assets and liabilities, net of effects from
acquisition of Verix Software:
Accounts receivable.......................................................... 2,123,000 673,000
Other current assets......................................................... (395,000) 535,000
Other assets................................................................. (4,000) 96,000
Accounts payable............................................................. (219,000) (49,000)
Accrued salaries and related items........................................... (95,000) 185,000
Other accrued liabilities.................................................... (906,000) 281,000
Deferred revenue............................................................. (89,000) (18,000)
----------- -----------
Net cash used in operating activities............................................... (6,747,000) (170,000)
----------- -----------

Cash flows from investing activities:
Net cash paid for acquisition of Verix Software.................................. (84,000) --
Purchases of property and equipment, net......................................... (1,130,000) (454,000)
----------- -----------
Net cash used in investing activities............................................... (1,214,000) (454,000)
----------- -----------

Cash flows from financing activities:
Net proceeds from issuance of common stock....................................... 1,050,000 253,000
Repurchase of common stock....................................................... -- (2,762,000)
----------- -----------
Net cash provided by (used in) financing activities................................. 1,050,000 (2,509,000)
----------- -----------

Effect of exchange rate differences on cash......................................... (37,000) (92,000)
----------- -----------

Net decrease in cash and cash equivalents........................................... (6,948,000) (3,225,000)
Cash and cash equivalents at beginning of period.................................... 25,761,000 28,010,000
----------- -----------

Cash and cash equivalents at end of period.......................................... $18,813,000 $24,785,000
=========== ===========
</TABLE>

See accompanying notes.

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-5-
<PAGE>

INFERENCE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued)

(Unaudited)

<TABLE>
<CAPTION>
Nine Months Ended
October 31,
----------------------------------
1999 1998
----------- -----------
<S> <C> <C>
Supplemental disclosure of cash flow information:
Income taxes paid during the period........................................... $ 40,000 $ 89,000
----------- -----------

Supplemental disclosure of investing transactions:
In connection with the acquisition of Verix Software (Note 5),
the following transactions occurred:
Fair value of assets acquired............................................. $ 1,571,000 $ --
Issuance of common stock.................................................. (1,106,000) --
Cash paid................................................................. (100,000) --
Accrued acquisition costs................................................. (281,000) --
----------- -----------
Liabilities assumed........................................................... $ 84,000 $ --
=========== ===========
</TABLE>

See accompanying notes.

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-6-
<PAGE>

INFERENCE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals and adjustments) considered necessary to present
fairly the financial information have been included. This financial information
should be read in conjunction with the consolidated financial statements and
notes thereto for the year ended January 31, 1999, included in the Annual Report
on Form 10-K. The results of operations for the three and nine months ended
October 31, 1999 are not necessarily indicative of the results to be expected
for the entire fiscal year.

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

Certain prior period amounts have been reclassified to conform to the
current period presentation.

2. Software Revenue Recognition

Inference recognizes revenue in accordance with the Statement of
Position 97-2, Software Revenue Recognition ("SOP 97-2"), as amended by
Statement of Position 98-4, Deferral of the Effective Date of a Provision of
SOP 97-2 ("SOP 98-4"). Inference derives revenue from the sale of software
licenses, post-contract support ("support") and other services. Support includes
telephone technical support, bug fixes, and rights to unspecified upgrades on a
when-and-if available basis. Services range from installation, training, and
consulting to meet specific customer needs. In software arrangements that
include rights to multiple software products, specified upgrades, support and/or
other services, Inference allocates the total arrangement fee among each
deliverable based on the relative fair value of each of the deliverables
determined based on vendor-specific objective evidence.

Revenue from license fees is recognized when persuasive evidence of an
agreement exists, delivery of the product has occurred, no significant Inference
obligations with regard to implementation remain, the fee is fixed and
determinable and collectibility is probable. If the fee due from the customer is
not fixed or determinable, revenue is recognized as payments become due from the
customer. If collectibility is not considered probable, revenue is recognized
when the fee is collected.

Revenue allocable to support is recognized on a straight-line basis over
the period support is provided.

Arrangements that include other software services are evaluated to
determine whether those services are essential to the functionality of other
elements of the arrangement. When services are considered essential, revenue
under the arrangement is recognized using contract accounting. When services are
not considered essential, the revenue allocable to the software services is
recognized as the services are performed.

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-7-
<PAGE>

INFERENCE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

(Unaudited)

3. Basic and Diluted Net Income (Loss) Per Share

Basic earnings per share are computed by dividing net income (loss) by the
weighted-average number of common shares outstanding during the period. Diluted
earnings per share are computed by dividing net income (loss) by the
weighted-average number of common and common share equivalents during the
period. Common share equivalents are calculated using the treasury stock method
and represent incremental shares issuable upon exercise of Inference's
outstanding options and warrants.

Options to purchase 2,293,000 shares and 2,144,000 shares of common stock
were outstanding at October 31, 1999 and 1998, respectively. These options were
not included in the computation of diluted net loss per share for the three
months ended October 31, 1999 and the nine months ended October 31, 1999 and
1998 as a result of their anti-dilutive effect. Such stock options could have a
dilutive effect in future periods. In addition, the diluted net loss per share
for the nine months ended October 31, 1998 does not include the common share
equivalent effect of 22,000 shares of common stock, which could have been issued
under outstanding warrants. Diluted net income per share during the three months
ended October 31, 1998 included common share equivalents of 91,000, which were
primarily related to shares issuable upon the exercise of stock options.

4. New Accounting Pronouncements

In June 1998, the Financial Accounting Standards Board issued Statement
No. 133, "Accounting for Derivative Instruments and Hedging Activity," which is
required to be adopted in years beginning after June 15, 1999. The Statement
will require Inference to recognize all derivatives on the balance sheet at fair
value. Inference does not anticipate that the adoption of this Statement will
have a significant effect on its results of operations or financial position.

Statement of Position 98-9, "Modification of SOP 97-2, Software Revenue
Recognition, With Respect to Certain Transactions" ("SOP 98-9") was issued in
December 1998 and addresses software revenue recognition as it applies to
certain multiple-element arrangements. SOP 98-9 also amends SOP 98-4 to extend
the deferral of application of certain passages of SOP 97-2 through fiscal years
beginning on or before March 15, 1999. All other provisions of SOP 98-9 are
effective for transactions entered into in fiscal years beginning after March
15, 1999. Inference does not anticipate that the adoption of this SOP will have
a significant effect on its results of operations or financial position.

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-8-
<PAGE>

INFERENCE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

(Unaudited)

5. Business Acquisition

On April 30, 1999, Inference acquired all of the outstanding capital stock
of Verix Software ("Verix"), a privately held developer of Web direct sales
applications for e-commerce companies, for approximately $1,487,000. The results
of Verix' operations have been combined with those of Inference since the date
of acquisition.

The acquisition was accounted for using the purchase method of accounting.
Consideration for this transaction consisted of the following:

<TABLE>
<S> <C>
Cash................................................. $ 100,000
Inference common stock............................... 1,106,000
Acquisition costs.................................... 281,000
------------
$ 1,487,000
============
</TABLE>

A summary of the preliminary purchase price allocation is as follows:

<TABLE>
<S> <C>
Tangible assets...................................... $ 54,000
In-process research and development.................. 450,000
Developed technology................................. 400,000
Goodwill............................................. 567,000
Workforce............................................ 100,000
Liabilities assumed.................................. (84,000)
------------
$ 1,487,000
============
</TABLE>

A total of $677,000 was expensed in the quarter ended April 30, 1999
relating to acquisition items. This was comprised of in-process research and
development of $450,000 and other acquisition related expenses of $227,000.

At the time of the acquisition, the value of in-process research and
development was comprised of on-going projects related to the design and
development of an Internet Relationship Commerce (IRC) software solution. The
acquired in-process research and development was valued at $450,000 by Inference
management with the assistance of an independent appraiser. The value of the
purchased in-process technology was determined by estimating the projected net
cash flows related to such projects. These cash flows were discounted back to
their net present value at appropriate risk adjusted rates. The resulting
projected net cash flows from such projects were based on management's estimates
of revenues and operating profits related to such projects. These estimates were
based on several assumptions, including those summarized below. This valuation
was predicated on the determination that the developmental projects at the time
of acquisition were not technologically feasible and had no future alternative
use. This assumption was based on the anticipated effort required to bring the
acquired technologies to technological feasibility as illustrated by the fact
that Verix had not completed coding, alpha testing, or beta documentation for
the technologies related to the projects and that the technologies of the
projects had no alternative use other than as a part of the software application
which was not yet complete. This value was attributable solely to the
development efforts completed as of the acquisition date. Consistent with
Inference's expectations at the time of acquisition, the products related to the
acquired in-process technology were made commercially available late in the
second quarter of fiscal 2000.

The total amount allocated to developed technology and goodwill is being
amortized on a straight-line basis over a period of five years from the date of
acquisition. The amount allocated to workforce is being amortized on a
straight-line basis over a period of two years.

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-9-
<PAGE>

INFERENCE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

(Unaudited)

5. Business Acquisition (Continued)

Unaudited proforma combined results of operations for the nine months ended
October 31, 1999 and 1998 have been prepared as if the acquisition occurred at
the beginning of each period.

<TABLE>
<CAPTION>
Nine Months Ended October 31,
-------------------------------
1999 1998
------------- -------------
<S> <C> <C>
Total revenues................................. $ 17,419,000 $ 22,185,000
============= =============

Net loss....................................... $ (8,859,000) $ (3,895,000)
============= =============

Basic and diluted net loss per share........... $ (1.19) $ (0.52)
============= =============
</TABLE>

6. Restructuring Costs

In the quarter ended October 31, 1998, Inference recorded a restructuring
charge of $282,000, all of which was paid prior to the end of that quarter,
related to severance costs associated with personnel changes in the Company's
executive management team.

In the quarter ended July 31, 1998, Inference downsized operations in its
subsidiary in France. As a result, Inference recorded a restructuring charge
related to lease abandonment and severance charges in the amount of $253,000,
all of which was paid as of July 31, 1999.

In the quarter ended April 30, 1998, Inference recorded a restructuring
charge, primarily related to severance costs in the amount of $1.3 million, as a
result of a 12% reduction in force and personnel changes in Inference's
executive management team. Employees were terminated from all areas of
Inference, including the marketing, development and administrative areas. These
charges were fully paid as of October 31, 1998.

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-10-
<PAGE>

ITEM 2. MANAGEMENT'S DISCUSSION AND ANAYLSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

In addition to historical information contained herein, this Form 10-Q
contains forward-looking statements that are subject to certain risks, trends
and uncertainties that could cause actual results to differ materially from
those expressed in or implied by such forward-looking statements. Factors that
could cause or contribute to differences in the final results include, but are
not limited to, timeliness of new k-Commerce product releases, including the
Windows NT version of k-Commerce Support Enterprise, fluctuations in quarterly
operating results, the size and timing of customer orders for product licenses,
changes in the competitive marketplace, market acceptance and customer demand
for k-Commerce product offerings, risks of entering markets in which Inference
has limited or no prior experience and the potential loss of key employees.
Third quarter financial results are not an indication of future results. Further
information on potential factors that may affect future results are discussed
further in the section of this Form 10-Q entitled "Additional Factors That May
Affect Future Results," and "Quantitative and Qualitative Disclosures about
Market Risk." Readers should also carefully review the business and risk factors
described in the documents Inference files from time to time with the Securities
and Exchange Commission, including, without limitation, the Annual Report on
Form 10-K, Current Reports on Form 8-K and Registration Statement on Form S-3.

The following discussion should be read in conjunction with the condensed
consolidated financial statements and notes thereto.

Results of Operations

The following table sets forth the percentages that certain statement of
operations items are to total revenues for the three and nine months ended
October 31, 1999 and 1998:

<TABLE>
<CAPTION>
Three months ended Nine months ended
October 31, October 31,
------------------ -----------------
1999 1998 1999 1998
-------- --------- -------- --------
<S> <C> <C> <C> <C>
Revenues:
Products................................... 42% 59% 43% 55%
Services................................... 58% 41% 57% 45%
-------- --------- -------- --------
Total.................................... 100% 100% 100% 100%
Operating costs and expenses:
Products................................... 6% 3% 4% 3%
Services................................... 28% 20% 28% 23%
Product development........................ 39% 16% 32% 17%
Sales and marketing........................ 82% 46% 69% 51%
General and administrative................. 19% 10% 16% 14%
Amortization of intangibles................ 1% -- 1% --
Acquisition related........................ -- -- 4% --
Restructuring.............................. -- 3% -- 8%
-------- --------- -------- --------
Total.................................... 175% 98% 154% 116%
-------- --------- -------- --------
Loss from operations......................... (75%) 2% (54%) (16%)
======== ========= ======== ========
</TABLE>

Three months ended October 31, 1999 and October 31, 1998

Revenues

Inference recognizes revenue in accordance with the Statement of
Position 97-2, Software Revenue Recognition ("SOP 97-2"), as amended by
Statement of Position 98-4, Deferral of the Effective Date of a Provision of
SOP 97-2 ("SOP 98-4"). We derive revenue from the sale of software licenses,
post-contract support ("support") and other services. Support includes telephone
technical support, bug fixes, and rights to unspecified upgrades on a
when-and-if available basis. Services range from installation, training, and
consulting to meet specific customer needs. In software arrangements that
include rights to multiple software products, specified upgrades, support and/or
other services, we allocate the total arrangement fee among each deliverable
based on the relative fair value of each of the deliverables determined based on
vendor-specific objective evidence.

- --------------------------------------------------------------------------------

-11-
<PAGE>

Revenue allocable to support is recognized on a straight-line basis over
the period support is provided.

Total revenues decreased to $5,514,000 in the three months ended
October 31, 1999 from $8,324,000 in the three months ended October 31, 1998.
This 34% decrease was primarily attributable to a decrease in product revenue.
We have recently released our k-Commerce Sales line of products and k-Commerce
Support Enterprise product, which are intended to enable our customers to
provide personalized one-to-one sales, service and support over the Web. To best
capitalize on the opportunities presented by our new offerings, we have
refocused and realigned our resources into two separate product divisions,
k-Commerce Support Sales and k-Commerce Support Enterprise.

Total revenues from the Americas operations decreased to $3,198,000 in the
three months ended October 31, 1999 from $4,497,000 in the three months ended
October 31, 1998, representing a 29% decrease. Total international revenues
decreased to $2,316,000 in the three months ended October 31, 1999 from
$3,827,000 in the three months ended October 31, 1998, representing a
39% decrease. Total international revenues for the three months ended October
31, 1999 and October 31, 1998 represented 42% and 46% of total revenues,
respectively. We currently have subsidiaries in the United Kingdom, France and
the Netherlands, offering licenses and consulting services, and have
relationships with 11 distributors worldwide, serving Europe, the Middle East
and Africa, and Asia and the Pacific Rim. International operations, however, are
subject to various risks, including unexpected changes in regulatory
requirements, tariffs and other trade barriers; costs and risks of localizing
products for foreign countries; longer accounts receivable payment cycles;
potentially adverse tax consequences; repatriation of earnings; exchange rate
fluctuations; and the burdens of complying with a wide variety of foreign laws.
There can be no assurance that such factors will not have an adverse effect on
the revenues from our future international operations and, consequently, our
results of operations and financial condition.

Product Revenue

Product revenue decreased to $2,294,000 in the three months ended
October 31, 1999 from $4,912,000 in the three months ended October 31, 1998,
representing a decrease of 53%. The decrease in product revenue was due to lower
unit sales volumes, combined with a lower average transaction size. The prices
of our products have remained relatively constant. Product revenue represented
42% and 59% of total revenues for the three months ended October 31, 1999 and
October 31, 1998. During the three months ended October 31, 1999, four customers
in the aggregate accounted for 44% of total product revenue, while during the
three months ended October 31, 1998, one customer accounted for 38% of total
product revenue.

Product revenue from the Americas operations decreased to $1,245,000 in the
three months ended October 31, 1999 from $2,617,000 in the three months ended
October 31, 1998, representing a 52% decrease. International product revenue
decreased to $1,049,000 in the three months ended October 31, 1999 from
$2,295,000 in the three months ended October 31, 1998, representing a
54% decrease.

Service Revenue

Service revenue consists of maintenance revenue and consulting revenue.
Total service revenue decreased to $3,220,000 in the three months ended
October 31, 1999 from $3,412,000 in the three months ended October 31, 1998,
representing a 6% decrease.

- --------------------------------------------------------------------------------

-12-
<PAGE>

Service revenue from the Americas operations increased to $1,953,000 in the
three months ended October 31, 1999 from $1,880,000 in the three months ended
October 31, 1998, representing a 4% increase. Service revenue from the Americas
operations included maintenance revenue of $1,206,000 and $926,000 in the three
months ended October 31, 1999 and 1998, respectively, and consulting revenue of
$747,000 and $954,000 in the three months ended October 31, 1999 and 1998,
respectively. The increase in maintenance revenue was primarily the result of
continued customer renewals during the nine months ended October 31, 1999 and
significant maintenance contracts booked with product deals in the fourth
quarter of fiscal 1999 and the first quarter of fiscal 2000. The decrease in
consulting revenue was primarily attributable to a decline in domestic product
revenue during the nine months ended October 31, 1999, compared to the nine
months ended October 31, 1998.

International service revenue decreased to $1,267,000 in the three months
ended October 31, 1999 from $1,532,000 in the three months ended October 31,
1998, representing a 17% decrease. International service revenue included
maintenance revenue of $666,000 and $598,000 in the three months ended
October 31, 1999 and 1998, respectively, and consulting revenue of $601,000 and
$934,000 in the three months ended October 31, 1999 and 1998, respectively. The
decrease in consulting revenue was primarily attributable to a decline in
international product revenue during the nine months ended October 31, 1999,
compared to the nine months ended October 31, 1998.

Cost of Product Revenue

Cost of product revenue, consisting primarily of the costs of product media
and duplication, manuals, packaging materials, personnel-related costs, shipping
expenses and royalties paid to partners and third-party vendors, increased to
$339,000 in the three months ended October 31, 1999 from $233,000 in the three
months ended October 31, 1998, representing a 45% increase. The increase was
primarily attributable to royalties of $165,000 due to our partner, eGain. The
gross margin on product revenue was 85% and 95% for the three months ended
October 31, 1999 and October 31, 1998, respectively. The decrease was primarily
related to an increase in royalty expense combined with a decline in product
revenue.

As part of our development of the k-Commerce product line, we intend to
incorporate certain third party technology into our products, allowing us to
focus on providing quality, performance and functionality in our knowledge-based
technology. To the extent that we are required to pay royalties to these third
parties, the gross margin on product revenues will decrease accordingly.

Cost of Service Revenue

Cost of service revenue, consisting principally of personnel-related costs
for consulting, training and technical support, decreased to $1,533,000 in the
three months ended October 31, 1999 from $1,615,000 in the three months ended
October 31, 1998, representing a 5% decrease. The gross margin on service
revenue was 52% and 53% for the three months ended October 31, 1999 and
October 31, 1998, respectively.

Product Development

Product development expenses consist primarily of employee-related costs,
including salaries and benefits, in addition to equipment and facility costs
incurred in the research, design, development and enhancement of our products.
Product development expenses increased to $2,167,000 in the three months ended
October 31, 1999 from $1,358,000 in the three months ended October 31, 1998,
representing a 60% increase. The increase was primarily due to the growth of the
product development organization to expand on our k-Commerce product suite.
Product development expenses as a percentage of total revenues were 39% and
16% for the three months ended October 31, 1999 and October 31, 1998,
respectively. We incurred substantial product development costs in the three
months ended October 31, 1999 to complete the development of our k-Commerce
Support Enterprise product, which was released on October 26, 1999.
Consequently, we expect that product development expenses associated with this
product will begin to decline in the next quarter. However, we believe that
continued investment in product development will be required for our recently
released k-Commerce Sales line of products to obtain acceptance and market
advantage. Therefore, we do not anticipate significant decreases in total
product development expenses.

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Sales and Marketing

Sales and marketing expenses consist primarily of salaries, benefits and
commissions of sales and marketing personnel, trade shows and promotional
expenses, and non-chargeable customer field service and sales support. Sales and
marketing expenses increased to $4,546,000 in the three months ended October 31,
1999 from $3,807,000 in the three months ended October 31, 1998, representing a
19% increase. The increase was primarily attributable to increased marketing
activity related to the launch and promotion of our k-Commerce Sales and
k-Commerce Support Enterprise products. The increase in marketing expenses was
partially offset by a decrease in commissions resulting from a decline in
product revenue. Sales and marketing expenses as a percentage of total revenues
were 82% and 46% for the three months ended October 31, 1999 and October 31,
1998, respectively.

General and Administrative

General and administrative expenses consist of the personnel costs for
finance and accounting, human resources, information systems and general
management of Inference. General and administrative expenses increased to
$1,021,000 in the three months ended October 31, 1999 from $853,000 in the three
months ended October 31, 1998, representing a 20% increase. The increase was
primarily due to an increase in headcount in the current quarter, compared to
the same quarter in the prior year. General and administrative expenses as a
percentage of total revenues were 19% and 10% for the three months ended
October 31, 1999 and October 31, 1998, respectively.

Amortization of Intangible Assets

We recorded amortization of intangible assets of $61,000 for the three
months ended October 31, 1999. This was based upon intangible assets of
$1,067,000 recorded in connection with the acquisition of Verix Software.

Restructuring

In the quarter ended October 31, 1998, we recorded a restructuring charge
of $282,000 related to severance costs associated with personnel changes in our
executive management team, all of which was paid prior to the end of that
quarter.

Interest Income and Other Expenses, Net

Interest income and other expenses, net, primarily interest income,
decreased to $205,000 in the three months ended October 31, 1999 from
$337,000 in the three months ended October 31, 1998, representing a
39% decrease. The decrease was primarily due to a decrease in interest income as
a result of a reduction in cash balances.

Nine months ended October 31, 1999 and October 31, 1998

Revenues

Total revenues decreased to $17,414,000 in the nine months ended
October 31, 1999 from $22,185,000 in the nine months ended October 31, 1998,
representing a 22% decrease, which was primarily attributable to a decrease in
product revenue.

Total revenues from the Americas operations decreased to $10,170,000 in the
nine months ended October 31, 1999 from $12,457,000 in the nine months ended
October 31, 1998, representing an 18% decrease. Total international revenues
decreased to $7,244,000 in the nine months ended October 31, 1999 from
$9,728,000 in the nine months ended October 31, 1998, representing a
26% decrease. Total international revenues for the nine months ended October 31,
1999 and October 31, 1998 represented 42% and 44% of total revenues,
respectively.

Product Revenue

Product revenue decreased to $7,503,000 in the nine months ended
October 31, 1999 from $12,105,000 in the nine months ended October 31, 1998,
representing a decrease of 38%. The decrease in product revenue was due to lower

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unit sales volumes, combined with a lower average transaction size. The prices
of our products have remained relatively constant. Product revenue represented
43% and 55% of total revenues for the nine months ended October 31, 1999 and
October 31, 1998. During the nine months ended October 31, 1998, three customers
in the aggregate accounted for 30% of total product revenue.

Product revenue from the Americas operations decreased to $3,969,000 in the
nine months ended October 31, 1999 from $6,905,000 in the nine months ended
October 31, 1998, representing a 43% decrease. International product revenue
decreased to $3,534,000 in the nine months ended October 31, 1999 from
$5,200,000 in the nine months ended October 31, 1998, representing a 32%
decrease.

Service Revenue

Service revenue consists of maintenance revenue and consulting revenue.
Total service revenue decreased to $9,911,000 in the nine months ended
October 31, 1999 from $10,080,000 in the nine months ended October 31, 1998,
representing a decrease of 2%.

Service revenue from the Americas operations increased to $6,201,000 in the
nine months ended October 31, 1999 from $5,552,000 in the nine months ended
October 31, 1998, representing a 12% increase. Service revenue from the Americas
operations included maintenance revenue of $3,490,000 and $2,720,000 in the nine
months ended October 31, 1999 and 1998, respectively, and consulting revenue of
$2,711,000 and $2,832,000 in the nine months ended October 31, 1999 and 1998,
respectively. The increase in maintenance revenue was primarily the result of
continued customer renewals during the nine months ended October 31, 1999 and
significant maintenance contracts booked with product deals in the fourth
quarter of fiscal 1999 and the first quarter of fiscal 2000. The decrease in
consulting revenue was primarily attributable to a decline in domestic product
revenue during the nine months ended October 31, 1999, compared to the nine
months ended October 31, 1998.

International service revenue decreased to $3,710,000 in the nine months
ended October 31, 1999 from $4,528,000 in the nine months ended October 31,
1998, representing an 18% decrease. International service revenue included
maintenance revenue of $2,072,000 and $1,598,000 in the nine months ended
October 31, 1999 and 1998, respectively, and consulting revenue of
$1,638,000 and $2,930,000 in the nine months ended October 31, 1999 and 1998,
respectively. The increase in maintenance revenue was primarily the result of
continued customer renewals during the nine months ended October 31, 1999. The
decrease in consulting revenue was primarily attributable to a decline in
international product revenue during the nine months ended October 31, 1999,
compared to the nine months ended October 31, 1998.

Cost of Product Revenue

Cost of product revenue increased to $744,000 in the nine months ended
October 31, 1999 from $611,000 in the nine months ended October 31, 1998,
representing a 22% increase. The increase was primarily attributable to
royalties of $165,000 due to our partner, eGain, during the three months ended
October 31, 1999. The gross margin on product revenue was 90% and 95% for the
nine months ended October 31, 1999 and October 31, 1998, respectively. The
decrease was primarily related to an increase in royalty expense combined with a
decline in product revenue.

Cost of Service Revenue

Cost of service revenue decreased to $4,915,000 in the nine months ended
October 31, 1999 from $5,177,000 in the nine months ended October 31, 1998,
representing a 5% decrease. The gross margin on service revenue was 50% and
49% for the nine months ended October 31, 1999 and October 31, 1998,
respectively.

Product Development

Product development expenses increased to $5,556,000 in the nine months
ended October 31, 1999 from $3,860,000 in the nine months ended October 31,
1998, representing a 44% increase. The increase was primarily due to the growth
of the product development organization to expand on our k-Commerce product
suite. Product development expenses as a percentage of total revenues were 32%
and 17% for the nine months ended October 31, 1999 and October 31,

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1998, respectively. We incurred substantial product development costs in the
nine months ended October 31, 1999 to complete the development of our k-Commerce
Support Enterprise product, which was released on October 26, 1999.
Consequently, we expect that product development expenses associated with this
product will begin to decline in the next quarter. However, we believe that
continued investment in product development will be required for our recently
released k-Commerce Sales line of products to obtain acceptance and market
advantage. Therefore, we do not anticipate significant decreases in total
product development expenses.

Sales and Marketing

Sales and marketing expenses increased to $12,008,000 in the nine months
ended October 31, 1999 from $11,278,000 in the nine months ended October 31,
1998, representing an increase of 6%. The increase was primarily attributable to
increased marketing activity related to the launch and promotion of our
k-Commerce Sales and k-Commerce Support Enterprise products. The increase in
marketing expenses was partially offset by a decrease in commissions resulting
from a decline in product revenue. Sales and marketing expenses as a percentage
of total revenues were 69% and 51% for the nine months ended October 31, 1999
and October 31, 1998, respectively.

General and Administrative

General and administrative expenses decreased to $2,796,000 in the nine
months ended October 31, 1999 from $3,100,000 in the nine months ended October
31, 1998, representing a 10% decrease. The decrease in general and
administrative expenses primarily resulted from significant legal fees incurred
during the six months ended July 31, 1998 associated with the ServiceSoft
litigation, which was settled in July 1998. The decrease in general and
administrative expenses was partially offset by an increase in this category in
the three months ended October 31, 1999 due to an increase in headcount. General
and administrative expenses as a percentage of total revenues were 16% and
14% for the nine months ended October 31, 1999 and October 31, 1998,
respectively.

Amortization of Intangible Assets

We recorded amortization of intangible assets of $122,000 for the nine
months ended October 31, 1999. This was based upon intangible assets of
$1,067,000 recorded in connection with the acquisition of Verix Software.

Acquisition Related

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<PAGE>

Restructuring

Interest Income and Other Expenses, Net

Interest income and other expenses, net, primarily interest income,
decreased to $718,000 in the nine months ended October 31, 1999 from $953,000 in
the nine months ended October 31, 1998, representing a 25% decrease. The
decrease was primarily due to a decrease in interest income resulting from a
reduction in cash.

Liquidity and Capital Resources

Cash and cash equivalents at October 31, 1999 were $18,813,000, a decrease
of $6,948,000 since January 31, 1999. Working capital at October 31, 1999 was
$14,921,000.

Net cash used in operating activities amounted to $6,747,000 during the
nine months ended October 31, 1999, as compared to net cash used in operating
activities of $170,000 during the nine months ended October 31, 1998.

Investing activities for the nine months ended October 31, 1999 included
$1,130,000 for net purchases of property and equipment and $84,000 related to
the acquisition of Verix Software. We had no significant capital commitments as
of October 31, 1999.

Cash provided by financing activities for the nine months ended October 31,
1999 included $1,050,000 for the issuance of 369,000 shares of our common stock.

Our international operations are principally transacted in British pounds.
Translation into our reporting currency, the U.S. dollar, has not historically
had a material impact on our financial position. Additionally, our net assets
denominated in currencies other than the functional currency has not exposed us
to material risk associated with fluctuations in currency rates. Given this and
the relatively stable nature of the exchange rates, historically, between the
British pound and the U.S. dollar, we have not considered it necessary to use
foreign currency contracts or other derivative instruments to manage changes in
currency rates. However, future changes in the exchange rates between the
foreign currencies and the U.S. dollar could have an adverse effect on our
financial position.

We believe that existing cash balances, taking into consideration the
anticipated effect of cash flows from operations, will be sufficient to meet our
working capital and capital expenditure requirements for at least the next
twelve months.

ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS

WE HAVE RECENTLY EXPERIENCED QUARTERLY LOSSES, WE EXPECT TO INCUR LOSSES IN THE
NEAR FUTURE AND WE MAY NOT EVER BECOME PROFITABLE

We have now experienced losses in four of the last six quarters. As of
October 31, 1999, we had an accumulated deficit of approximately $30 million. We
expect to continue to incur net losses in the near future and possibly longer.
We anticipate that our expenses will continue to be high in the foreseeable
future as we continue to grow our k-

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<PAGE>

Commerce Sales division, develop our technology, expand our distribution
channels and increase our sales and marketing activities. These efforts may
prove more expensive than we currently anticipate and we may not succeed in
increasing our revenue sufficiently to offset these higher expenses. If our
revenues fail to keep pace with our expenses, we will continue to incur losses.
If we do achieve profitability in any period, we cannot be certain that we will
sustain or increase such profitability on a quarterly or annual basis.

FAILURE TO ACHIEVE BROAD MARKET ACCEPTANCE OF THE K-COMMERCE SUITE OF PRODUCTS
MAY MATERIALLY ADVERSELY AFFECT OUR REVENUE

Broad market acceptance of our k-Commerce Sales line of products and
k-Commerce Support Enterprise product is critical to our future success. As a
result, a decline in demand for or failure to achieve broad market acceptance of
k-Commerce products as a result of competition, technological change or
otherwise would have a material adverse effect on our business, operating
results and financial condition. As part of the k-Commerce initiative, we have
entered into several partnering agreements for the purposes of extending the
offerings and capabilities of our products. There can be no assurance that these
relationships will translate into increased revenues or additional demand for
our products.

DELAYS IN PRODUCT DEVELOPMENT MAY MATERIALLY ADVERSELY AFFECT OUR REVENUE

Our primary product development effort is focused on further building and
enhancing the k-Commerce product line. There can be no assurance that the
further development of these new product lines will be completed successfully or
on a timely basis or that the product will include the features required to
achieve market acceptance. Our future operations will be substantially dependent
on the k-Commerce product line, and failure to achieve market acceptance of this
family of products would have a material adverse effect on Inference's business,
operating results and financial condition.

We have in the past experienced delays in software development, and there
can be no assurance that we will not experience further delays in connection
with our current product development or future development activities. Software
products as complex as those offered by us may contain undetected errors when
first introduced or as new versions are released. Despite the quality assurance
procedures we currently have in place, there can be no assurance that errors
will not be found in our new or enhanced products after commencement of
commercial shipments, or that modifications to such products will not be
required to satisfy customer requirements, resulting in loss of or delay in
market acceptance. Delays or difficulties associated with new product
introductions or product enhancements could have a material adverse effect on
our business, operating results and financial condition.

THERE ARE MANY FACTORS, INCLUDING SOME BEYOND OUR CONTROL, THAT MAY CAUSE
FLUCTUATIONS IN OUR QUARTERLY OPERATING RESULTS

We have experienced significant quarterly fluctuations in operating results
and we anticipate that such fluctuations will continue in the future depending
on a number of factors described below, including many that are beyond our
control. As a result, we believe that quarter-to-quarter comparisons of our
financial results are not necessarily meaningful, and you should not rely on
them as an indication of our future performance. These factors include:

. Changes in demand for our software, including changes in industry
growth rates for our products

. Varying size, timing and contractual terms of customer orders for
our products

. Fluctuation of consulting service revenue depending upon the status
of projects

. Varying budgeting cycles of our existing and potential
customers

. Any downturn in our customers' businesses, in the domestic economy
or in international economies where our customers do substantial
business

. Changes in our pricing policies resulting from competitive pressures
such as aggressive price discounting by our competitors

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<PAGE>

. Our ability to develop and introduce on a timely basis new products or
enhanced versions of our existing software

. Changes in the mix of revenues attributable to domestic and
international sales

. Seasonal buying patterns which tend to peak in the fourth quarter

. Changes in the mix of revenue attributable to higher-margin software
license revenue as opposed to substantially lower-margin service revenue

Certain of the above factors can have a particularly significant effect on
our quarterly results, and they include the following:

FLUCTUATIONS IN LARGE CONTRACT LICENSE REVENUE. The value of individual
licenses as a percentage of quarterly revenues can be substantial, and
particular licenses may generate a substantial portion of the operating profits
for the quarter in which they are signed. To the extent we rely on these large
orders to meet our quarterly operating objectives, failure to close such
contracts in compliance with SOP 97-2, as modified by SOP 98-4, and in a
specified time period, could adversely affect our operating results.

VARYING SALES CYCLE. Product revenue is also difficult to forecast because the
market for client/server and Web-based software products is rapidly evolving,
and our sales cycle, from initial trial to multiple copy purchases and the
provision of support services, varies substantially from customer to customer.
Because our staffing and other operating expenses are based on anticipated
revenues, a substantial portion of which is not typically generated until the
end of each quarter, delays in the receipt of orders can cause significant
variations in operating results from quarter to quarter. We also may choose to
reduce prices or to increase spending in response to competition or to pursue
new market opportunities, which may adversely affect our operating results.
Accordingly, we believe that period-to-period comparisons of our results of
operations may not be meaningful and should not be relied upon as an indication
of future performance.

POTENTIAL CHANGES IN MIX OF LICENSE AND SERVICE REVENUE. Historically, a
majority of our revenue has been attributable to the licensing of our software
products. Changes in the mix of software products and services sold by us,
including the mix between higher margin software products and lower margin
maintenance, consulting and training, could materially affect our operating
results for future quarters.

Due to all of the foregoing factors, it is likely that in some future quarters
our operating results will be below the expectations of investors. Regardless of
the general outlook for our business, the announcement of quarterly operating
results below investor expectations is likely to result in a decline in the
trading price of our Class A Common Stock.

POTENTIAL YEAR 2000 PROBLEMS WITH OUR SOFTWARE OR OUR INTERNAL OPERATING SYSTEMS
COULD ADVERSELY AFFECT OUR BUSINESS

Many computer systems were not designed to handle any dates beyond the year
1999, and therefore computer hardware and software will need to be modified
prior to the year 2000 in order to remain functional. We have completed a Year
2000 compliance review for all products released through October 31, 1999. We do
not anticipate that addressing the Year 2000 problem for our products will have
a material impact on operations or financial results. To date, costs incurred in
remediating identified Year 2000 issues have not been material.

All our products are capable of correctly identifying, manipulating, and
performing calculations on dates later than December 31, 1999, where operations
based on dates held in 2 digit format are affected due to re-sequencing from 99
to 00. We have instituted, within our product design specifications, the
requirement that internal date representations are held in full format and
manipulations are not performed on short formats. This assumes the software is
used in accordance with its associated documentation and provided that when the
software is linked up to other components, such components factor in the
calendar date on the same conditions as our products. However, despite design
review and ongoing testing, our products may contain undetected errors or
defects associated with Year 2000 date handling. Known or unknown errors or
defects in its products could result in (i) delay or loss of revenue; (ii)
diversion of

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<PAGE>

development resources; (iii) damage to reputation; and (iv) increased service
and warranty costs. The occurrence of any of these errors or defects could
adversely affect our business, operations and financial condition.

Year 2000 issues may also affect the computer systems used internally by us to
manage and operate our business. To date we have not incurred and do not believe
that we will incur significant operating expenses or be required to invest
heavily in computer systems improvements to be Year 2000 compliant. As of
October 31, 1999, we had completed our review of all internal hardware systems
and software applications, both domestically and internationally, to determine
that they are complaint with the Year 2000. However, we may experience
significant unanticipated problems and costs caused by undetected errors or
defects in internal systems. We believe that the worst-case scenario if such
problems occur would be our inability to ship products and record revenue, which
would materially adversely affect our business, operations and financial
condition.

We do not currently have any information concerning the Year 2000 compliance
status of our customers or prospective customers. If current or future customers
fail to achieve Year 2000 compliance or if they divert technology expenditures
(especially technology expenditures reserved for software and services) to
address Year 2000 compliance issues, our business, results of operations or
financial condition would be materially adversely affected.

We have funded our Year 2000 activities from available cash and we have not
separately accounted for these costs in the past. To date, these costs have not
been material. We may incur additional costs for administrative, customer
support, internal IT and product engineering activities to address ongoing Year
2000 issues. We have developed alternative procedures to address situations that
may result if unanticipated problems caused by undetected errors or defects in
either internal systems or our products arise. The cost of implementing such
procedures may be material. Finally, we are also subject to external forces that
might generally affect industry and commerce, such as utility or transportation
company Year 2000 compliance failures and related service interruptions.

OUR INDUSTRY CHANGES RAPIDLY DUE TO EVOLVING TECHNOLOGY STANDARDS AND OUR FUTURE
SUCCESS WILL DEPEND ON OUR ABILITY TO CONTINUE TO MEET THE SOPHISTICATED NEEDS
OF OUR CUSTOMERS

The market for our products changes rapidly and our future success will depend
on our ability to continue to timely meet changing market conditions and
customer demands. The market for our products is characterized by rapid
technological developments, evolving industry standards, swift changes in
customer requirements and frequent new product introductions and enhancements.
As a result, our success depends upon our ability to continue to enhance our
existing products, respond to customer requirements, develop and introduce, in a
timely manner, new products incorporating technological advances and to address
the increasingly sophisticated needs of our customers by supporting existing and
emerging hardware, software, database and networking platforms. We will have to
develop and introduce enhancements to our existing products and new products on
a timely basis to keep pace with technological developments, evolving industry
standards and changing customer requirements. We expect that we will have to
respond quickly to:

. Rapid technological change

. Changing customer needs

. Frequent new product introductions

. Evolving industry standards that may render existing products and
services obsolete

To the extent one or more of our competitors introduce products that more
fully address customer requirements, our business, operating results and
financial condition could be adversely affected. There can be no assurance that
we will be successful in developing and marketing new products or enhancements
to our existing products on a timely basis or that any new or enhanced products
will adequately address the changing needs of the marketplace. As a result, our
position in existing markets or potential markets could be eroded rapidly by
product advances. The life cycles of our products are difficult to estimate. Our
growth and future financial performance will depend in part upon our ability to:

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. Continue to enhance our existing products

. Develop and introduce new applications that keep pace with technological
advances on a timely and cost-effective basis

. Meet changing customer requirements

. Match or exceed the product deliveries of our competitors

If we are unable to develop and introduce new products or enhancements to
existing products in a timely manner in response to changing market conditions
or customer requirements, our business, operating results and financial
condition will be materially and adversely affected. From time to time, we or
our competitors may announce new products, capabilities or technologies that
have the potential to replace or shorten the life cycles of our existing
products. There can be no assurance that announcements of currently planned or
other new products will not cause customers to delay their purchasing decisions
in anticipation of such products, which could have a material adverse effect on
our business, operating results and financial condition.

We expect that our product development efforts will continue to require
substantial investments to be able to attract and retain qualified software
development engineers. We may not have sufficient resources to make the
necessary investments. Any of these events could have a material adverse effect
on our business, quarterly and annual operating results and financial condition.

WE MAY LOSE LARGE CUSTOMER PURCHASES WHICH MAY MATERIALLY ADVERSELY AFFECT OUR
REVENUE

We occasionally sell our products to large customers. Large customers are
expected to deploy our products in business critical operations, which involve
significant capital and management commitments by such customers. Potential
large customers generally commit significant resources to an evaluation of
available software and require us to expend substantial time, effort and money
educating them about the value of our solutions. Sales of our products to such
customers require an extensive sales effort throughout a customer's organization
because decisions to purchase such products generally involve the evaluation of
the software by a significant number of customer personnel in various functional
and geographic areas, each often having specific and conflicting requirements.
A variety of factors, including factors over which we have little or no control,
may cause potential large customers to favor a particular supplier or to delay
or forego a purchase. As a result of these or other factors, the sales cycle
for our products to these large customers is long, typically ranging between
three and nine months. As a result of the length of the sales cycle and the
significant selling expenses resulting from selling to large customers, our
ability to forecast the timing and amount of specific sales is limited. The
delay or failure to complete, in compliance with SOP 97-2, one or more large
transactions to which we have devoted significant resources could have a
material adverse effect on our business, operating results and financial
condition and could cause significant variations in our operating results from
quarter to quarter.

OUR EXECUTIVE OFFICERS AND CERTAIN KEY PERSONNEL ARE CRITICAL TO OUR BUSINESS
AND THE LOSS OF ONE OR MORE OF SUCH OFFICERS AND KEY PERSONNEL OR THE
UNSUCCESSFUL INTEGRATION OF REPLACEMENTS FOR SUCH PERSONNEL COULD MATERIALLY
ADVERSELY AFFECT OUR BUSINESS

We have recently experienced significant changes to our executive management
team. There can be no assurance that our existing management team will work
effectively together or be successful in fulfilling our desired objectives. The
occurrence of any of these factors could materially adversely affect our
business, results of operations and financial condition. Our success will
depend to a significant extent on the continued service of certain key sales,
technical and senior management personnel. If we continue to experience
significant changes to our executive management team and lose the services of
any our key employees, this could materially adversely affect our business,
results of operations and financial condition, particularly if one or more of
our senior executives or key employees decided to join a competitor, or
otherwise compete directly or indirectly with us. In addition, we do not
maintain key man life insurance on our employees and have no plans to do so.

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WE MAY NOT BE ABLE TO RECRUIT AND RETAIN THE PERSONNEL WE NEED TO SUSTAIN OR
GROW OUR BUSINESS

We consider our relationship with our employees to be good, and there has
never been an interruption in our business activities due to labor unrest.
However, our future performance is contingent upon the uninterrupted service of
key sales, technological and executive management staff and upon the maintenance
of conditions that can help attract and retain capable salespeople, technicians
and managers.

We may not be successful in attracting, training and retaining qualified
personnel, and the failure to do so, particularly in key functional areas such
as product development and sales, could materially adversely affect our
business, results of operations and financial condition. Competition for such
personnel in the computer software industry is intense, and in the past we have
experienced difficulty in recruiting qualified personnel, especially developers
and sales personnel. The demand for qualified personnel is particularly acute
in the San Francisco Bay Area, due to the large number of software companies and
the low unemployment in the region. Our future success will likely depend in
large part on our ability to attract and retain additional experienced sales,
technical, marketing and management personnel. We expect competition for
qualified personnel to remain intense, and we may not succeed in attracting or
retaining such personnel.

COMPETITION MAY AFFECT THE AMOUNT OF REVENUE WE CAN GENERATE FROM SALES OF OUR
PRODUCTS AND SERVICES WHICH COULD ADVERSELY AFFECT OUR BUSINESS

The market for customer support software is highly competitive, and there are
certain competitors with substantially greater sales, marketing, development and
financial resources than us. Among our major competitors in the problem
identification and resolution segment of the market are Primus Knowledge
Solutions, Inc., Clarify, Inc., Verity, Inc. and other small privately held
companies. Furthermore, many potential customers implement low-end text
retrieval solutions or develop internal applications that eliminate the need to
acquire software and services from third-party vendors such as us.

We believe that that the competitive factors affecting the market for our
products and services include vendor and product reputation; product quality,
performance and price; product functionality and features; product scalability;
product integration with other enterprise applications; the availability of
products on multiple platforms; product ease-of-use; and the quality of customer
support services, documentation and training. The relative importance of each
of these factors depends upon the specific customer involved. There can be no
assurance that we will be able to compete effectively with respect to any of
these factors.

Our present or future competitors may be able to develop products comparable
or superior to those offered by us or adapt more quickly than us to new
technologies and evolving customer requirements. In order to be successful in
future, we must respond to technological change, customer requirements and
competitors' current products and innovations. In particular, while we are
currently developing additional product enhancements that we believe address
customer requirements, there can be no assurance that we will successfully
complete the development or introduction of these additional product
enhancements on a timely basis or that these product enhancements will achieve
market acceptance. Accordingly, there can be no assurance that we will be able
to continue to compete effectively in its market, that competition will not
intensify or that future competition will not have a material adverse effect on
our business, operating results and financial condition.

OUR FUTURE REVENUE IS SUBSTANTIALLY DEPENDENT UPON SERVICE REVENUE; WHICH IS
DEPENDENT ON FUTURE SALES OF OUR SOFTWARE PRODUCTS

We depend on our installed customer base for service revenue. Service revenue
depends in part on ongoing renewals of support contracts by our customers, some
of which may not renew their support contracts. Therefore, our current
customers may not necessarily generate significant service revenue in future
periods. In addition, our customers may not necessarily purchase additional
products or professional services. Our service revenue is also dependent upon
the continued use of these services by our installed customer base. Service
revenue represented 43% of total revenues for fiscal 1999, 53% for fiscal 1998
and 43% for fiscal 1997. We anticipate that service revenue will continue to
represent a significant percentage of total revenues. Because service revenue
has lower gross margins than license revenue, a continued increase in the
percentage of total revenues represented by service revenue or an unexpected
decrease in

- --------------------------------------------------------------------------------

-22-
<PAGE>

license revenue could have a detrimental impact on overall gross margins and
operating results. If service revenue is lower than anticipated, our business,
financial condition and operating results could be materially and adversely
affected.

THE MARKET PRICE OF OUR CLASS A COMMON STOCK WILL LIKELY BE SUBJECT TO
SUBSTANTIAL PRICE AND VOLUME FLUCTUATIONS DUE TO A NUMBER OF FACTORS, CERTAIN OF
WHICH ARE BEYOND OUR CONTROL

Stock prices and trading volumes for many software companies fluctuate widely
for a number of reasons, including some reasons which may be unrelated to their
businesses or results of operations. This market volatility, as well as general
domestic or international economic, market and political conditions, could
materially adversely affect the market price of our common stock without regard
to our operating performance. In addition, our operating results may be below
the expectations of public market analysts and investors. If this were to
occur, the market price of our common stock would likely decrease significantly.
The market price of our common stock has fluctuated significantly in the past
and may continue to fluctuate significantly because of:

. Future announcements concerning us or our competitors

. Quarterly variations in operating results

. Announcements of technological innovations

. Changes in product pricing policies by us or our competitors

. Litigation relating to proprietary rights or otherwise

. Market uncertainty about our financial condition or business prospects
or the prospects for our market in general

. Revenues or results of operations that do not match analysts'
expectations

. The introduction of new products or product enhancements by us or our
competitors

. General business conditions in our industry

. Changes in the mix of revenues attributable to license and maintenance
sales

. Seasonal trends in technology purchases and other general economic
conditions

ANY ACQUISITIONS OR INVESTMENTS THAT WE MAY MAKE WILL BE SUBJECT TO A NUMBER OF
FACTORS WHICH COULD MATERIALLY ADVERSELY AFFECT OUR BUSINESS AND SUCH
INVESTMENTS OR ACQUISITIONS MAY DILUTE EXISTING STOCKHOLDERS

As part of our business strategy, we may in the future review acquisition
prospects that would complement our existing product offerings, augment our
market coverage or enhance our technological capabilities, or that may otherwise
offer growth opportunities. If we were to make such an acquisition or large
investments, the risks described below could materially adversely affect our
business and future operating results. However, we may not be able to complete
any such additional acquisitions in the future. Any future acquisition or
investment would present risks commonly encountered in acquisitions of
businesses. The following are examples of such risks:

. Difficulty in combining the technology, operations or work force of the
acquired business

. Disruption of our on-going businesses

. Difficulty in realizing the potential financial or strategic benefits of
the transaction

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<PAGE>

. Difficulty in maintaining uniform standards, controls, procedures and
policies across the existing and acquired businesses

. Difficulty in entering markets where we have no or limited prior
experience

. Possible impairment of relationships with employees and customers as a
result of any integration of new businesses and management personnel

. Possible dilution to existing stockholders if the consideration for such
transaction is paid in common stock

. Possible write-offs of software development costs or other assets,
acquisition of severance liabilities, or amortization of expenses
related to goodwill and other intangible assets and/or the acquisition
of debt, any of which could materially adversely affect our business,
financial condition, cash flows and results of operations.

There can be no assurance that we would be successful in overcoming these or
any other significant risks encountered and failure to do so could have a
material adverse effect upon our business, operating results and financial
condition.

ERRORS IN OUR PRODUCTS OR THE FAILURE OF OUR PRODUCTS TO CONFORM TO CUSTOMER
SPECIFICATIONS OR EXPECTATIONS COULD RESULT IN OUR CUSTOMERS ASSERTING CLAIMS
FOR DAMAGES AGAINST US OR IN DECREASED SALES OF OUR PRODUCTS

Because our software products are complex, they often contain errors or "bugs"
that can be detected at any point in a product's life cycle. While we
continually test our products for errors and work with customers through our
customer support services to identify and correct bugs in our software, we
expect that errors in our products will continue to be found in the future.
Although many of these errors may prove to be immaterial, certain of these
errors could be significant. Detection of any significant errors may result in,
among other things, loss of, or delay in, market acceptance and sales of our
products, diversion of development resources, injury to our reputation, or
increased service and warranty costs. These problems could materially adversely
affect our business and future quarterly and annual operating results.

A key determinative factor in our future success will continue to be the
ability of our products to operate and perform well with existing and future
leading, industry-standard application software products intended to be used in
connection with our products. Failure to meet in a timely manner existing or
future interoperability and performance requirements of certain independent
vendors could adversely affect the market for our products.

Commercial acceptance of our products and services could also be adversely
affected by critical or negative statements or reports by brokerage firms,
industry and financial analysts and industry periodicals concerning us, our
products, business or competitors or by the advertising or marketing efforts of
competitors, or other factors that could affect consumer perception.

PRODUCT LIABILITY CLAIMS ASSERTED AGAINST US IN THE FUTURE COULD ADVERSELY
AFFECT OUR BUSINESS

Our license agreements with our customers typically contain provisions
designed to limit our exposure to potential product liability claims. However,
it is possible that the limitation of liability provisions contained in our
license agreements may not be effective under the laws of certain jurisdictions.
Although we have not experienced any product liability claims to date, the sale
and support of our products may entail the risk of such claims, and there can be
no assurance that we will not be subject to such claims in the future. In
particular, issues relating to Year 2000 compliance have increased awareness of
the potential adverse effects of software defects and malfunctions. While we
carry insurance policies covering this type of liability, these policies may not
provide sufficient protection should a claim be asserted. A material product
liability claim could materially adversely affect our business.

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<PAGE>

WE RELY HEAVILY ON OUR INTELLECTUAL PROPERTY RIGHTS WHICH OFFER ONLY LIMITED
PROTECTION AGAINST POTENTIAL INFRINGERS; IF WE CANNOT PROTECT OUR INTELLECTUAL
PROPERTY RIGHTS, OUR BUSINESS COULD BE ADVERSELY AFFECTED

Our success depends in part upon our proprietary technology. Although case-
based reasoning technology ("CBR") is available in the public domain, we believe
implementation of the CBR technology is proprietary. We rely primarily on a
combination of copyright, trademark and trade secret laws, confidentiality
procedures and licensing arrangements to establish and protect our proprietary
rights. We have been awarded several patents for our CBR and related
technology. Our CBR technology is embedded in our current k-Commerce and CBR
family of products. Despite the precautions we have taken, it may be possible
for an unauthorized third party to copy or otherwise obtain and use our
products, technology or other information that we regard as proprietary or to
develop similar products or technology independently.

In addition, effective trademark, copyright and trade secret protection may be
unavailable or limited in certain foreign countries where we do not operate. We
may also be unable to protect our technology because:

. Unauthorized third parties may be able to copy aspects of our products
or obtain and use our proprietary information, including by our
licensing activities where we provide third parties with access to our
data model and other proprietary information underlying our licensed
applications

. Our competitors may independently develop similar or superior technology

. Policing unauthorized use of our software is difficult

. The laws of some foreign countries do not protect our proprietary rights
to the same extent as do the laws of the United States

. "Shrink-wrap" and/or "click-wrap" licenses may be wholly or partially
unenforceable under the laws of certain jurisdictions

We may have to employ litigation to enforce our intellectual property rights,
to protect our trade secrets or to determine the validity and scope of the
proprietary rights of others and any litigation could prove to be unsuccessful,
result in substantial costs and diversion of resources and could materially
adversely affect our business, future operating results and financial condition.
In addition, we generally provide our products to end-users under signed license
agreements. These agreements are negotiated with and signed by the licensee.
We occasionally publish articles regarding our technical developments in
industry publications that may prevent us from obtaining patent protection for
ideas contained in such publications, thus increasing the availability to third
parties of fundamental aspects of our technology. Our means of protecting our
proprietary rights may not be adequate and our inability to protect our
intellectual property rights may adversely affect our business and financial
condition.

THIRD PARTIES COULD ASSERT THAT OUR PRODUCTS INFRINGE THEIR INTELLECTUAL
PROPERTY RIGHTS, WHICH COULD ADVERSELY AFFECT OUR BUSINESS

We are not aware that any of our products infringe upon the proprietary rights
of third parties. There can be no assurance, however, that third parties will
not claim such infringement by us with respect to current or future products.
Any claims of this type could affect our relationships with existing customers
and may prevent future customers from licensing our products. Any of these type
of claims, with or without merit, could be time consuming, result in costly
litigation, cause product shipment delays or require us to enter into royalty or
licensing agreements. Royalty or license agreements may not be available on
acceptable terms or at all. If we were found to have infringed upon the
proprietary rights of third parties, we could be required to pay damages, cease
sales of the infringing products and redesign or discontinue such products, any
of which could have a material adverse effect on our business, operating results
and financial condition. We expect that we will increasingly be subject to
infringement claims as the number of products and competitors in the customer
support software industry grows and the functionality of such products overlaps
with other industry segments. As a result of these factors, infringement claims
could materially adversely affect our business.

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<PAGE>

OUR FUTURE SUCCESS IS DEPENDENT ON THE CONTINUED GROWTH AND COMMERCIAL
ACCEPTANCE OF THE WEB

Our future success depends in part upon the widespread adoption of the Web as
a primary medium for business applications and communications. If the Web does
not continue to increase in importance as a commercial medium, our business,
operating results and financial condition could be materially affected.
Critical issues concerning the commercial use of the Web, such as security,
reliability, cost, accessibility and quality of service, remain unresolved and
may negatively affect the growth of Web use or the attractiveness of business
communications over the Web.

WE MAY BECOME SUBJECT TO LITIGATION

We may become subject to legal proceedings and claims that arise in the
ordinary course of business. We currently believe that the ultimate amount of
liability, if any, with respect to any pending actions, either individually or
in the aggregate, will not materially affect our financial position, results of
operations or liquidity. However, the ultimate outcome of any litigation is
uncertain. If an unfavorable outcome were to occur, the impact could be
material. Furthermore, any litigation, regardless of the outcome, can have an
adverse impact on our results of operations as a result of defense costs,
diversion of management resources and other factors.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

OUR INTERNATIONAL OPERATIONS ARE EXPOSED TO INTERNATIONAL BUSINESS RISKS AS WELL
AS FLUCTUATIONS IN THE VALUE OF FOREIGN CURRENCY

Our international sales are made mostly from our foreign sales subsidiaries in
their respective countries and are typically denominated in the local currency
of each country. These subsidiaries also incur most of their expenses in the
local currency. Accordingly, all foreign subsidiaries use the local currency as
their functional currency.

Our exposure to foreign exchange rate fluctuations arises in part from
intercompany accounts in which costs incurred in the United States are charged
to our foreign sales subsidiaries. These intercompany accounts are typically
denominated in the functional currency of the foreign subsidiary in order to
centralize foreign exchange risk with the parent company in the United States.
We are also exposed to foreign exchange rate fluctuations as the financial
results of foreign subsidiaries are translated into U.S. dollars in
consolidation. As exchange rates vary, these results, when translated, may vary
from expectations and adversely impact overall expected results. The effect of
foreign exchange rate fluctuations in fiscal 1999 was not material.

In addition, these subsidiaries, which represented approximately 42% of our
total revenue in fiscal 1999, are subject to risks typical of an international
business, including, but not limited to the following, the occurrence of any of
which could materially adversely impact our business, operations and financial
condition:

. Difficulties in staffing and managing international operations

. Problems in collecting accounts receivable

. Longer payment cycles

. Fluctuations in currency exchange rates

. Seasonal reductions in business activity during the summer months in
Europe and certain other parts of the world

. Uncertainties relating to political, economic and tax circumstances

. Recessionary environments in foreign economies

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<PAGE>

. Increases in tariffs, duties, price controls or other restrictions on
foreign currencies or trade barriers imposed by foreign countries

COSTS ASSOCIATED WITH ENSURING THAT OUR PRODUCTS AND INTERNAL OPERATING SYSTEMS
ARE ABLE TO EFFECTIVELY WORK WITH THE EURO CONVERSION MAY ADVERSELY AFFECT OUR
BUSINESS

On January 1, 1999, a new currency, the Euro, became the legal currency for
eleven of the fifteen member countries of the European Economic Community.
Between January 1, 1999 and January 1, 2002, governments, companies and
individuals may conduct business in these countries in both the Euro and the
existing national currencies. On January 1, 2002, the Euro will become the sole
currency in these countries.

We are taking steps to evaluate internal system capabilities, review the
ability of financial institution vendors to support Euro transactions and
examine current marketing and pricing policies and strategies in light of the
Euro conversion. Although, we have not yet completed evaluating the impact of
the Euro conversion on our functional currency designations, the cost of this
effort is not expected to have a material adverse effect on our results of
operations and financial condition. There can be no assurance, however, that all
issues related to the Euro conversion have been identified and that any
additional issues would not have a material effect on our results of operations
or financial condition.

The conversion to the Euro also may have competitive implications on our
pricing and marketing strategies, the impact of which are not known at this
time. Additionally, we are at risk to the extent our principal European
suppliers and customers are unable to deal effectively with the impact of the
Euro conversion.

WE ARE EXPOSED TO MARKET RATE RISK FOR CHANGES IN INTEREST RATES

Our exposure to market rate risk for changes in interest rates relates
primarily to our investment portfolio. We currently do not use derivative
financial instruments. We invest, by policy, our excess cash balances in money
market accounts, debt instruments of the U.S. Government and its agencies, and
in high-quality corporate issuers, and limit the amount of credit exposure to
any one issuer. As of October 31, 1999, our investments consisted primarily of
funds contained in money market accounts. 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 due to
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 due to changes in interest
rates.

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-27-

<PAGE>

PART II

OTHER INFORMATION

ITEM 1. Legal Proceedings

None.

ITEM 2. Changes in Securities

None.

ITEM 3. Defaults upon Senior Securities

None.

ITEM 4. Submission of Matters to a Vote of Security Holders

None.

ITEM 5. Other Information

None.

ITEM 6. Exhibits and Reports on Form 8-K

(a) Exhibits required by Item 601 of Regulation S-K

Exhibit
Number Exhibit
------ -------

27 Financial Data Schedule.

(b) Reports on Form 8-K

1. On December 10, Inference filed a Form 8-K with the Securities and
Exchange Commission to announce management changes and financial
results for the quarter ended October 31, 1999.

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<PAGE>

SIGNATURE

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.

Inference Corporation

/s/ CHARLES W. JEPSON
-------------------------------
Charles W. Jepson
President And Chief Executive Officer
(Duly Authorized Officer, Principal Executive Officer and
Principal Financial Accounting Officer)

Dated: December 13, 1999

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-29-
<PAGE>

INDEX TO EXHIBITS

Exhibit
Number Exhibit
------ -------

27 Financial Data Schedule.

- --------------------------------------------------------------------------------

-30-

<PAGE>
<ARTICLE> 5

<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> JAN-31-2000
<PERIOD-START> FEB-01-1999
<PERIOD-END> OCT-31-1999
<CASH> 18,813,000
<SECURITIES> 0
<RECEIVABLES> 4,945,000
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 24,594,000
<PP&E> 6,737,000
<DEPRECIATION> 4,927,000
<TOTAL-ASSETS> 27,864,000
<CURRENT-LIABILITIES> 9,673,000
<BONDS> 0
0
0
<COMMON> 76,000
<OTHER-SE> 18,115,000
<TOTAL-LIABILITY-AND-EQUITY> 27,864,000
<SALES> 7,503,000
<TOTAL-REVENUES> 17,414,000
<CGS> 744,000
<TOTAL-COSTS> 5,659,000
<OTHER-EXPENSES> 6,355,000
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (8,686,000)
<INCOME-TAX> 0
<INCOME-CONTINUING> (8,686,000)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (8,686,000)
<EPS-BASIC> (1.18)
<EPS-DILUTED> (1.18)

</TABLE>