UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

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

For the quarterly period ended September 30, 2002
or

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

For the transition period from                      to                      

Commission File Number: 000-31155

EVOLVE SOFTWARE, INC.

(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization)

94-3219745
(I.R.S.  Employer
Identification No.)

150 Spear Street, San Francisco, CA
(Address of principal executive offices)

94105
(Zip Code)

Registrant's telephone number, including area code: (415) 229-3700

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.001 par value

          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 such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   YES ý   NO o

          The aggregate market value of the voting common stock held by non-affiliates of the registrant as of November 6, 2002 was approximately $5,718,760 based upon the closing sale price reported for that date on the NASDAQ SmallCap Market.   Shares of common stock held by each officer and director and by each person who owns more than 5% or more of the outstanding common stock have been excluded because such persons may be deemed to be affiliates.   This determination of affiliate status is not necessarily conclusive for other purposes.

          The number of shares outstanding of the registrant's common stock as of November 6, 2002 was 46,509,175.

EVOLVE SOFTWARE, INC.

FORM 10-Q

TABLE OF CONTENTS

Page 

PART I – FINANCIAL INFORMATION 

Item 1.

Financial Statements (unaudited)

Condensed Consolidated Balance Sheets As of September 30, 2002 and June 30, 2002

2

Condensed Consolidated Statements of Operations For the Three Months Ended September 30, 2002 and 2001

3

Item 2.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk 

Item 4.

Controls and Procedures

26

PART II – OTHER INFORMATION

Item 1.

Legal Proceedings

26

Item 2.

Changes in Securities and Use of Proceeds

26

Item 3.

Defaults Upon Senior Securities

27

Item 4.

Submissions of Matters to a Vote of Security Holders

27

Item 5.

Other Information

27

Item 6.

Exhibits and Reports on Form 8-K

27

Signature

 28

Certifications

29

PART I – FINANCIAL INFORMATION

 Item 1.  Financial Statements

The accompanying notes are an integral part of these condensed consolidated financial statements.

The accompanying notes are an integral part of these condensed consolidated financial statements.

The accompanying notes are an integral part of these condensed consolidated financial statements.

EVOLVE SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1.  Summary of Significant Accounting Policies

The Company

Evolve Software, Inc.  (the "Company" or "Evolve") was incorporated under the laws of the state of Delaware in February 1995 for the purpose of designing, developing, marketing and supporting enterprise application software products.  The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Evolve Software Europe Ltd., Evolve Software (India) Pvt. Ltd. and Evolve Canada, Inc., which were incorporated in May 2000, December 2000 and April 2001, respectively.

Liquidity

The Company has sustained net losses and negative cash flows from operations since its inception.  The Company's ability to meet its obligations in the ordinary course of business is dependent on its ability to increase revenues, to raise additional financing through public or private equity financing or other sources of financing to fund operations, or to reduce net operating expenses.  There is no assurance that the Company will achieve increased revenues, will be able to reduce net operating expenses or will be able to raise adequate financing from other sources.  Management believes that its current funds and access to available capital will be sufficient to enable the Company to meet its planned expenditures through at least June 30, 2003.  If anticipated operating results are not achieved, management has the intent and it believes that it has the ability, to reduce expenditures by reductions in headcount and certain other expense so as not to require additional financial resources, if such resources are not available on terms acceptable to the Company.

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 in accordance 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.  All adjustments (including adjustments of a normal recurring nature) considered necessary for a fair presentation have been included.  Operating results for the three-month period ended September 30, 2002, are not necessarily indicative of the results that may be expected for the year ending June 30, 2003.  For further information, refer to the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of Evolve and its wholly-owned subsidiaries.  All significant intercompany balances and transactions have been eliminated.

Use of Estimates

The Company has prepared these financial statements in conformity with generally accepted accounting principles which require the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

Revenue Recognition

The Company derives revenues from fees for licenses, implementation services and maintenance, and hosted license agreements.  The Company recognizes revenues in accordance with the provisions of American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, "Software Revenue Recognition,” as amended and SOP 81-1, “Accounting for Performance of Construction-type and Certain Production-type Contracts.”  The Company also follows the provisions of the Securities and Exchange Commission's Staff Accounting Bulletin (“SAB”) No. 101, "Revenue Recognition in Financial Statements."

Under SOP 97-2 as amended, SOP 81-1 and SAB 101, the Company recognizes revenues when all of the following conditions are met:

• when persuasive evidence of a customer agreement exists;

• the delivery of the product or service subject to the agreement has occurred;

• the associated fees are fixed or determinable; and

• the Company believes that collection of these fees is reasonably assured.

Generally, the Company has vendor specific objective evidence of fair value for the maintenance element of software arrangements based on the renewal rates for maintenance in future years as specified in the contracts.  In those cases where first year maintenance revenue is included in the license fee, the Company defers the fair value of the first year maintenance revenue at the outset of the arrangement and recognizes it ratably over the period during which the maintenance is to be provided, which normally commences on the date the software is delivered.

The Company has established vendor specific objective evidence of fair value for certain services.  For contracts, which involve significant implementation or other services which are essential to the functionality of the software and which are reasonably estimable, the license and services revenue is recognized over the period of each implementation, primarily using the percentage-of-completion method.  Labor hours incurred are used as the measure of progress towards completion.  A provision for estimated losses on engagements is made in the period in which the loss becomes probable and can be reasonably estimated.  In cases where a sale of a license does not include implementation services, as in the sale of additional seats, revenue is recorded upon delivery with an appropriate deferral for maintenance services, if applicable, provided all of the other relevant conditions have been met.

The Company’s services revenue includes reimbursement for travel expenses incurred by its consultants and reimbursed by its customers.  These revenues are recognized in the period in which they are incurred.   The associated expenses are included as a cost of revenue.

The Company generates revenue from its hosted license business by hosting the software and making the solution available to the customer via the Internet, as well as by providing maintenance and other services to the customer.  In such situations, customers pay a monthly fee for the term of the contract in return for access to the Company's software, maintenance and other services such as implementation, training, consulting and hosting.  For certain hosted software arrangements for which the Company does not have vendor specific objective evidence of fair value for the elements of the contract, fees are recognized on a monthly basis as the hosting service is provided.  In other circumstances where the customer has the right to take delivery of the software and the Company has vendor specific objective evidence of fair value for the hosted element of the contract, fees are allocated between the elements based on the vendor specific objective evidence.  The Company no longer offers new hosted services and will have fulfilled its obligations to current hosted customers no later than the end of the current fiscal year.

License revenue includes product licenses to companies from which the Company has purchased products and services under separate arrangements executed within a short period of time ("reciprocal arrangements").  Products and services purchased in reciprocal arrangements include:  (1) software licensed for internal use; (2) software licensed for resale or incorporation into the Company's products; and (3) development or implementation services.  For reciprocal arrangements, the Company considers Accounting Principles Board (“APB”) No. 29, "Accounting for Nonmonetary Transactions," and Emerging Issues Task Force (“EITF”) Issue No. 86-29, "Nonmonetary Transactions: Magnitude of Boot and Exceptions to the Use of Fair Value, Interpretation of APB No. 29, Accounting for Nonmonetary Transactions."  In determining these fair values, the Company considers the recent history of cash sales of the same products or services in similar sized transactions.  Revenues recognized under reciprocal arrangements were $55,000 and $434,000 for the fiscal quarters ended September 30, 2002 and 2001, respectively.

Deferred revenues represents amounts billed to customers under license and service arrangements in excess of amounts recognized as revenue to date from those arrangements.  Deferred revenues also represents fees derived from maintenance and hosted license agreements that are being recognized ratably over the unexpired portion of the underlying period of the agreements.  As work progresses towards completion of these arrangements, a portion of the deferred revenues will be recognized.  Certain revenues will also be deferred, if other revenue recognition criteria have not been met.

Comprehensive Income (Loss)

The Company follows Statement of Financial Accounting Standards ("SFAS") No.  130, "Reporting Comprehensive Income." SFAS No. 130 establishes standards for reporting and display of comprehensive income (loss) and its components in financial statements.  The statement of comprehensive loss is as follows:

Segment Information

The Company operates in only one segment, namely services delivery software and, as such, uses only one measure of profitability for internal reporting purposes.  To date, substantially all of the Company’s revenues have been derived from within the United States.  Additionally, substantially all of the Company’s long-lived assets are located in the United States.

Recent Accounting Pronouncements

In July 2001, the FASB issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets."  SFAS No. 141 requires business combinations initiated after June 30, 2001, to be accounted for using the purchase method of accounting and broadens the criteria for recording intangible assets separately from goodwill.  Recorded goodwill and intangibles will be evaluated against these new criteria and may result in certain intangibles being subsumed into goodwill, or alternatively, amounts initially recorded as goodwill may be separately identified and recognized apart from goodwill.  SFAS No. 142 requires the use of a non-amortization approach to account for purchased goodwill and certain intangibles.  Under a non-amortization approach, goodwill and certain intangibles will not be amortized into results of operations, but instead would be reviewed for impairment and written-down and charged to results of operations only in the periods in which the recorded value of goodwill and certain intangibles is more than its fair value.  Evolve adopted SFAS No. 142 effective July 1, 2002, which will result, among other items, in the Company no longer amortizing its existing goodwill.  Evolve is currently reviewing the impact of the adoption of FAS No. 142.  The impairment, if any, resulting from these transition tests will be recorded in the period it is determined and will be recognized as the cumulative effect of a change in accounting principle.  The Company has not yet determined what effect these impairment tests will have on its results from operations and financial position.  In accordance with SFAS No. 142, the Company has ceased to amortize $478,000 of goodwill as of June 30, 2002.  The following table presents the net loss and net loss per share, basic and diluted, as if goodwill and acquired workforce had not been amortized during the periods presented.

Intangible assets consist of the following:

Goodwill and acquired workforce amortization was zero and $107,000 for the three months ended September 30, 2002 and 2001, respectively.  Other intangibles amortization expense was $244,000 and $294,000 for the three months ended September 30, 2002 and 2001, respectively.

Estimated future amortization expense is as follows:

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets to be held and used, to be disposed of other than by sale and to be disposed of by sale.  Although SFAS No. 144 retains certain of the requirements of SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of,” it supersedes SFAS No. 121 and APB Opinion No. 30, “Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions for the Disposal of a Segment of a Business.”  SFAS No. 144 also amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to eliminate the exception to consolidation for a subsidiary for which control is likely to be temporary.  The statement is effective for financial statements issued for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years, with early adoption encouraged.  Evolve adopted SFAS No. 144 on July 1, 2002.  There was no significant impact on Evolve’s financial statements upon adoption.

In November 2001, the FASB discussed Topic D-103, recharacterized as EITF Issue No. 01-14, “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred.”  This issue deals with classification in the income statement of incidental expenses, that in practice are commonly referred to as “out-of-pocket” expenses, incurred by entities that provide services as part of their central ongoing operations.  The Task Force reached a consensus that reimbursements received for out-of-pocket expenses incurred should be characterized as revenue in the income statement.  This issue is effective for fiscal years beginning after December 15, 2001.  During the year ended June 30, 2002, the Company adopted EITF 01-14.  As a result, the Company reclassed a total amount of $217,000 and $131,000 from operating expenses to revenue for the fiscal quarters ended September 30, 2002 and 2001, respectively.   Additionally, the company reclassed a total amount of  $217,000 and $131,000 from operating expenses to cost of revenues for the fiscal quarters ended September 30, 2002 and 2001, respectively.

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146).  This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).”  This Statement requires that a liability for costs associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred.  The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002.

Note 2.  Acquisitions

On June 29, 2001, Evolve acquired certain assets of Vivant! Corporation ("Vivant").  The total acquisition cost was approximately $3.1 million, primarily comprised of $910,000 in cash, 1,553,254 shares of the Company’s common stock valued at $1.6 million, a future stock commitment valued at a minimum of $525,000 and $137,000 for transaction related expenses.  With the assistance of an independent valuation, the Company recorded approximately $2.2 million in developed technology, $718,000 in goodwill and $187,000 in acquired workforce upon this acquisition, which was accounted for as a purchase.  The number of shares issued to Vivant at the closing of the acquisition was subject to adjustment by issuance of additional shares or redemption of existing shares based on the market value of Evolve’s common stock as of the time the registration of such shares became effective.  However, the purchase agreement limited the aggregate number of shares to be issued by Evolve to 7,661,097.  The Company subsequently issued 663,495 shares to Vivant in September 2001 and 3,899,756 shares in January 2002 pursuant to the terms of the acquisition.  On July 9, 2002, the Company issued 1,544,592 shares to settle all remaining obligations under the agreement.  Since the date of acquisition, the results of Vivant's operations have been included in the Company’s consolidated financial statements.

Note 3.  Stock-based and related compensation charges

The Company incurred stock-based compensation charges in connection with stock option grants and sales of restricted stock to employees at exercise or sales prices below the deemed fair market value of its common stock for accounting purposes.  The cumulative difference between the deemed fair value of the underlying stock at the date the options were granted and the exercise price of the granted options was $40.3 million as of August 9, 2000, the date of the Company’s Initial Public Offering.  This amount is being amortized, using the accelerated method of FASB Interpretation No. 28, "Accounting for Stock Appreciation Rights and Other Variable or Award Plans," over the four-year vesting period of the granted options.  At September 30, 2002, the effects of systematic amortization, employee terminations and modifications of stock-based awards had reduced the remaining unearned stock-based compensation balance to $523,000 which will be fully amortized, at a maximum, at the end of fiscal 2004.  The Company recorded stock based charges of $815,000 and $280,000 for the three months ended September 30, 2002, and 2001, respectively.

In connection with the termination of employment of certain executive officers in fiscal 2001, the Company incurred stock-based charges of $154,000 and $973,000 during the quarters ended September 30, 2002 and 2001, because of certain conditions of the executive’s severance agreements related to their restricted stock purchases.   At September 30, 2002, stock based compensation of $52,000, related to these agreements, was outstanding.  This amount will be fully amortized in the next fiscal quarter.

In October 2001, the Board of Directors voted to modify existing stockholder loans, which were issued to allow board members, officers and selected employees to exercise stock options and purchase restricted stock, from full-recourse to non-recourse and to extend their due dates, in the event of termination, from thirty days to fifteen months after the date of termination.  The loans are secured only by the underlying stock, which they were used to purchase.  As a result, the loans became subject to variable accounting and the outstanding stockholder loans and related interest were revalued to their net realizable value of $0.12 per share at September 30, 2002, resulting in a reduction of stockholders loans and related interest and an increase in expenses of $47,000 for the three months ended September 30, 2002.  Until they are due or repaid, if earlier, the loans will be revalued each quarter to their net realizable value as determined by the stock price at that time.

The financial impact on operating results of these arrangements is included within stock-based and related charges expense.

Note 4.  Issuance of  Debt

On September 30, 2002, the Company signed a Second Amendment to Amended and Restated Loan and Security Agreement, which supersedes all previous amendments and agreements.  The amendment relates to the outstanding term loan facility of $2.0 million, and the fully secured standby letter-of-credit of $2.5 million.  The term loan facility incurs annual interest of the prime rate plus 1.00%.  As of September 30, 2002, the rate was 5.75%. 

The term loan is scheduled to be fully repaid on July 1, 2003, and is fully collateralized by all of the Company’s assets, including intellectual property, except for leased equipment.  In connection with the loan amendment, the bank approved new financial covenants for the period commencing September 30, 2002.  Under this amendment all previous covenants are replaced in their entirety with the new covenants.  The Company is required to:  (1) maintain at all times a minimum bank liquidity ratio of 2.00 to 1.00; (2) maintain at all times minimum unrestricted cash of $2.0 million; and (3) maintain minimum revenue targets which increase quarterly.

At September 30, 2002, the Company was in compliance with all amended covenants.

Note 5.  Contingencies

From time to time, the Company is involved in litigation relating to claims arising from the ordinary course of business.  At September 30, 2002, the Company is defending against a claim filed by an early customer in the federal district court in Massachusetts.  This customer alleges a variety of claims including that the software and services purchased from the Company did not satisfy certain contractual obligations and that the Company engaged in practices that they allege were unfair.  The court granted the Company’s motion to dismiss several of the claims.  The Company believes that the plaintiff’s claims are without merit, and intends to defend vigorously against them. 

On August 1, 2002, the Company settled a claim from an early customer for a previously accrued amount, without admission of liability.  

In November 2001, a complaint seeking class action status was filed, against the Company, in the United States District Court for the Southern District of New York.  The complaint is purportedly brought on behalf of all persons who purchased the Company’s common stock from August 9, 2000, through December 6, 2000.  The complaint names as defendants some of the Company’s former officers and several investment banking firms that served as managing underwriters of the Company’s initial public offering.  Among other claims, the complaint alleges liability under the Securities Act of 1933 and the Securities Exchange Act of 1934, on the grounds that the registration statement for the Company’s initial public offering did not disclose that:  (1) the underwriters had allegedly agreed to allow certain of their customers to purchase shares in the offering in exchange for alleged excess commissions paid to the underwriters; and (2) the underwriters had allegedly arranged for certain of their customers to purchase additional shares in the aftermarket at pre-determined prices under alleged arrangements to manipulate the price of the stock in aftermarket trading.  The Company is aware that similar allegations have been made in numerous other lawsuits challenging initial public offerings conducted in 1998, 1999 and 2000.  No specific amount of damages is claimed in the complaint involving the initial public offering.  The Company intends to contest the claims vigorously.  The Company is unable, at this time, to determine whether the outcome of the litigation will have a material impact on its results of operations or financial condition in any future period. 

The Company believes that there are no other claims or actions pending or threatened against it, the ultimate disposition of which would have a material adverse effect on the Company or the reported financial results.

Note 6.  Restructuring Charges

Beginning in the quarter ended June 30, 2001, through the quarter ended September 30, 2002, the Company critically reviewed its operations and cost structure and took actions to reduce costs and strengthen its position in executing its strategy.  Since June 30, 2001, through the quarter ended September 30, 2002, these decisions resulted in the involuntary termination of 227 employees.  The terminations were from all functions of the Company’s operations and included twenty-two employees from the closure of the India research facility.  As a result of the headcount reduction for the quarter ended September 30, 2002, the Company recorded charges of $77,000 in severance and related benefit charges.  The Company reversed $317,000 of previously accrued restructuring charges accrued in fiscal year ended June 30, 2002, relating to its India facilities, as a result of subleasing its rental space sooner than expected and selling all of its fixed assets for more than was anticipated.

A rollforward of the restructuring-related liabilities follows:

Note 7.  Net Loss per Share

Basic and diluted net loss per share are computed using the weighted average number of common shares outstanding during each period.  Since the Company has had a net loss for all periods presented, net loss per share on a diluted basis is equivalent to basic net loss per share.  Common shares issuable upon exercise of stock options and warrants and upon conversion of convertible preferred stock are excluded because the effect would be anti-dilutive.  A reconciliation of the numerator and denominator used in the calculation of basic and diluted net loss per share follows:

At September 30, 2002 and 2001, options to purchase 17,999,737 and 4,762,007 shares of common stock were outstanding with a weighted-average exercise price of $0.44 and $3.51, respectively.  At September 30, 2002, the outstanding Series A Preferred Stock was convertible into 54 million shares of common stock.  Warrants to purchase 575,000 shares of Series A Preferred Stock at $10.00 per share and 9.4 million shares of common stock at $1.00 per share, if exercised, were convertible into 15.5 million and 9.4 million shares of common stock, respectively, as of September 30, 2002.  If the Series A Preferred Stock warrants are exercised, they will result in the issuance of an additional 3.9 million common stock warrants.  These common stock equivalents have been excluded from the computation of diluted net loss per share because their effect would have been anti-dilutive.  The weighted-average purchase prices of stock subject to repurchase were $2.32 and $2.29 as of September 30, 2002 and 2001, respectively.

Note 8.  Series B Preferred Stock Financing

In August 2002, the Company completed a private placement of shares of Series B Preferred Stock pursuant to a Series B Preferred Stock Purchase Agreement, primarily with existing investors.  The Company sold an aggregate of 750,000 shares of Series B Preferred Stock at $10.00 per share for total proceeds of $7.5 million. 

Voting Rights.  The Series B preferred stockholders have voting rights on an as-if converted to common stock basis based on the conversion ratio as of the closing date.  As long as shares of Series B Preferred Stock are outstanding, the Series B preferred stockholders will vote as a separate class to elect directors which, when added to the directors elected by Series A preferred stockholders, will be in proportion to the number of shares of common stock into which both classes of the preferred stock are convertible.

Conversion.  Shares of the Series B Preferred Stock may, at the option of the holder, be converted at any time into common stock by dividing the liquidation preference per share of Series B Preferred Stock by the conversion price of $0.19 per share.  The Company may automatically convert the Series B Preferred Stock into common stock after five years from the date of issuance, if the common stock price exceeds $5.00, subject to adjustment in the event of a stock split, stock dividend, reverse stock split ore similar event, for 30 consecutive trading days.

Dividends.  The Series B Preferred Stock will share in all dividends declared on the common stock and Series A Preferred Stock on an as converted basis.

Liquidation Preferences.  The stated liquidation preference of the Series B Preferred Stock is equal to the original sales price of $7.5 million plus accretion from the date of issuance of 8% per annum compounded quarterly.  In the event of a change of control, the Series B preferred stockholders are entitled to receive the greater of (a) the amount of the liquidation preference that would be accreted over five years or (b) the amount which the Series B preferred stockholders would be entitled to if the Series B Preferred Stock were converted to common stock.  In the event of liquidation, the Series B Preferred Stock is senior to the Series A Preferred Stock.

Note 9.  Subsequent Events

In October 2002, the Company initiated a workforce reduction intended to further reduce operating expenses and to accelerate its timetable for profitability.  Associated with this restructuring, the Company moved its corporate headquarters to San Francisco, California.  The Company’s worldwide headcount was approximately 100 employees after the reduction.  The Company expects to incur a restructuring charge of approximately $6 million for the quarter ending December 31, 2002, in connection with vacating its Emeryville facility and the workforce reduction.  Included in the restructuring costs are the remaining lease liability, brokerage fees, impairment and disposal of fixed assets, and severance related costs.

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

You should read the following discussion in conjunction with the interim unaudited condensed consolidated financial statements and related notes included in this report, and with Management's Discussion and Analysis of Financial Condition and Results of Operations and related financial information contained in our Annual Report on Form 10-K for the fiscal year ended June 30, 2002.

Except for historical information, this report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  These forward-looking statements involve risks and uncertainties, including, among other things, statements regarding our future financing needs, our future revenue growth prospects and our expense projections for future periods.  Our actual results may differ significantly from those projected in the forward-looking statements.  Factors that might cause or contribute to these differences include, but are not limited to, those discussed in the section below entitled "Factors That May Affect Future Results of Operations."  You should carefully review these risks as well as the discussion of risks and uncertainties contained in our Annual Report on Form 10-K under the caption "Business—Factors That May Affect Future Results."  You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q.  We undertake no obligation to publicly release any revisions to the forward-looking statements or reflect subsequent events or circumstances after the date of this document.

Overview

Evolve provides enterprise software that optimizes the way organizations deliver services to their customers and employees.  Our service delivery software products are designed for service-oriented organizations where successful project delivery is vital to their business.  We primarily market our solution to professional services organizations and to corporate information technology departments in medium-to-large enterprises.

We have licensed our solution to a wide range of customers who have deployed our software to effectively deliver complex projects and better manage their operations and workforces.  Our customers include a diverse set of small, medium and large organizations across a number of industry segments including high tech, financial services, professional services, automotive, communications, consumer goods, transportation, manufacturing, utilities, government and pharmaceuticals.  A number of our customers have global presence and leverage the Evolve solution to manage their operations on a worldwide basis.

Evolve was founded in February 1995.  From our inception through December 1998, our activities, funded by the venture capital we raised, consisted primarily of building our business infrastructure, recruiting personnel and developing software and service offerings.  Our Evolve solution was first made commercially available the quarter ended March 31, 1999.  We have incurred net losses and negative cash flows from operations since inception.  Our accumulated deficit at September 30, 2002, was $260.3 million.

In August 2000, we completed an initial public offering of 5,750,000 shares of common stock, resulting in proceeds of $46.5 million, net of offering costs.  From October 2001 through September 2002, we raised an additional  $25.5 million in financing from the issuance of Series A and Series B Preferred Stock to new and existing investors.

Results of Operations

Revenues

Total revenues were $4.8 million for the three months ended September 30, 2002, compared with revenues of $3.9 million for the comparable 2001 period, representing a 24% increase in total revenues.  For the quarter ended September 30, 2002, revenue from three customers accounted for 16%, 14% and 10% of total revenues.  For the quarter ended September 30, 2001, revenue from two customers accounted for 37% and 22% of total revenues.

The increase in revenues was attributable to our successful penetration into Corporate IT organizations in Global 2000 companies over the past year and continued selling to global services companies and services divisions within technology companies.  Efforts to sell into Corporate IT organizations began approximately twelve to fifteen months ago and we are now recognizing revenue from these deals that typically have extended sales cycles from two to twelve months or longer. 

For the three months ended September 30, 2002, license revenues were $2.1 million, services and maintenance revenues were $2.6 million and hosted revenues were $45,000 or 44%, 55% and 1%, respectively, of total revenues.  For the three months ended September 30, 2001, license revenues were $1.3 million, services and maintenance revenues were $2.1 million and hosted revenues were $475,000 or 34%, 54% and 12%, respectively, of total revenues.  We are no longer offering hosted services and anticipate that future hosted revenues will be minimal.

Cost of Revenues

Total cost of revenues, excluding stock-based compensation, was $2.3 million for the three months ended September 30, 2002, compared with cost of revenues of $2.0 million for the comparable 2001 period, representing a 17% increase.

Cost of license revenues consists principally of royalties due to third parties for integrated third-party technology.  Cost of license revenues was $208,000 for the three months ended September 30, 2002, compared with cost of license revenues of $460,000 for the comparable 2001 period, representing a 55% decrease in cost of license revenues.  The decrease in cost of license revenues was primarily attributable to reductions in our minimum royalty commitments with our third-party partners.  As a percentage of license revenues, cost of license revenues was 10% and 35% for the three months ended September 30, 2002, and 2001, respectively.

Cost of services and maintenance revenues, excluding stock-based compensation charges, consists principally of payroll, travel and overhead costs related to employees and consultants involved in providing services for implementation, training and technical support to our customers.  Cost of services and maintenance revenues, excluding stock-based compensation, was $2.1 million for the three months ended September 30, 2002, compared with $1.4 million for the comparable 2001 period, representing a 54% increase in cost of service and maintenance revenues.  The increase in total cost of services and maintenance revenues was primarily due to increased costs for third-party consultants involved in providing implementation services to customers.  As a percentage of services and maintenance revenues, cost of services and maintenance revenues, excluding stock-based compensation, was 81% and 66% for the three months ended September 30, 2002 and 2001, respectively.

Cost of hosted revenues consists principally of payroll related costs for employees involved in providing technical support and consulting services to our hosting customers, in addition to the cost of rental space for the servers that host the customers.  Cost of hosted revenues was zero for the three months ended September 30, 2002, compared with $151,000 for the comparable 2001 period.  The decrease was attributable to our decision to no longer offer hosting services, which resulted in fewer hosted customers.   As a percentage of hosted revenues, cost of hosted revenues was 0% and 32% for the three months ended September 30, 2002 and 2001, respectively.

The number of employees in our services organization decreased by 23% from September 30, 2001, to September 30, 2002. 

Operating Expenses

Sales and Marketing.  Sales and marketing expenses consist primarily of employee salaries, benefits, commissions and stock-based compensation, as well as the costs of advertising, public relations, website development, trade shows, seminars, promotional materials and other sales and marketing programs.  Sales and marketing expenses, excluding stock-based compensation, decreased by 33% to $3.1 million for the quarter ended September 30, 2002, from $4.6 million for the quarter ended September 30, 2001.  The decrease in sales and marketing expenses resulted primarily from significant workforce reductions, including the UK operation, beginning during the quarter ended June 30, 2001, and continuing through the quarter ended September 30, 2002, and a decrease in advertising and marketing initiatives.  The number of employees in our sales and marketing organization decreased by 27% from September 30, 2001, to September 30, 2002.  We expect that the level of sales and marketing expenses will remain stable in the next quarter.  However, management will continue to focus on managing expenses and will invest or reduce expenses as deemed appropriate.

Research and Development.  Research and development expenses consist primarily of personnel and related costs, including stock-based compensation, associated with our product development efforts, including fees paid to third-parties for engineering consulting services.  Research and development expenses, excluding stock-based compensation, decreased 30% to $2.4 million for the quarter ended September 30, 2002, from $3.5 million for the quarter ended September 30, 2001.  The decrease in research and development expenses related primarily to a decreased reliance on third-party consultants and our workforce reductions.  The number of employees in our research and development organization decreased by 35% from September 30, 2001, to September 30, 2002.  The reduction in headcount includes the closure of our India office and the discontinuance of our development efforts to support our ASP business.  We expect that research and development expenses will decline in the next quarter as a result of a workforce reduction in October 2002, and completion of certain engineering activities.  However, management will continue to focus on managing expenses and will invest or reduce expenses as deemed appropriate.

General and Administrative.  General and administrative expenses consist primarily of employee salaries and expenses, including stock-based compensation related to executive, finance and administrative personnel, bad debt expense, and professional service fees.  General and administrative expenses, excluding stock-based compensation, decreased 49% to $1.2 million for the three months ended September 30, 2002, from $2.3 million for the three months ended September 30, 2001.  The decrease in general and administrative expenses resulted primarily from our workforce reductions and a decrease in bad debt expense of $545,000.  The number of employees in our general and administrative organization decreased by 35% from September 30, 2001, to September 30, 2002.  We expect that general and administrative expenses will remain stable in the next quarter.  However, management will continue to focus on managing expenses and will invest or reduce expenses as deemed appropriate.

Stock-based and Related Compensation Charges.  We incurred stock-based compensation charges in connection with stock option grants and sales of restricted stock to our employees at exercise or sales prices below the deemed fair market value of our common stock for accounting purposes and as a result of amending certain stockholder loans and accelerated vesting rights granted to terminated executives.  Based on the remaining balance of $575,000 at September 30, 2002, our results from operations will include stock-based compensation expense, at a maximum, through end of fiscal 2004.  We recorded stock-based charges of $969,000 and $1.3 million for the three months ended September 30, 2002, and September 30, 2001, respectively.  Stock-based charges are amortized on an accelerated basis and the decrease in stock-based amortization resulted primarily from the resulting decline in the cost over time.  Additionally, amortization previously taken on an accelerated basis was reversed for employees who were terminated or who participated in the options exchange program.

In October 2001, the Board of Directors voted to modify existing stockholder loans, which were issued to allow board members, officers and selected employees to exercise stock options and purchase restricted stock, from full-recourse to non-recourse and to extend their due dates, in the event of termination, from thirty days to fifteen months after the date of termination.  The loans are secured only by the underlying stock, which they were used to purchase.  As a result, outstanding stockholder loans and related interest were revalued to their net realizable value of $0.12 per share at September 30, 2002, resulting in charges of $47,000 for the three months ended September 30, 2002.  Until they are due or repaid, if earlier, the loans will be revalued each quarter to their net realizable value as determined by the stock price at that time.

Amortization of stock-based compensation and the stockholder loan revaluation consisted of the following: