10-K 1 va133728.htm FORM 10-K

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

Form 10-K

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

		For the fiscal year ended July 31, 2006

Or

	o	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: 000-28369

VA Software Corporation
(Exact name of Registrant as specified in its charter)

Delaware	77-0399299
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

46939 Bayside Parkway, Fremont, California, 94538
(Address, including zip code, of principal executive offices)

(510) 687-7000
(Registrant’s telephone number, including area code)

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

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes o

No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes o

No x

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 x

No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act). (Check one):

Large accelerated filer

Accelerated filer

Non-accelerated filer

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o

No x

As of September 29, 2006, there were 65,693,905 shares of the Registrant’s Common Stock outstanding. The aggregate market value of the Common Stock held by non-affiliates of the Registrant as of January 31, 2006 (based on the closing price for the Common Stock on the NASDAQ National Market for such date) was approximately $106,002,159. Shares of common stock held by each of our officers and directors and by each person or group who owns 5% or more of our outstanding common stock have been excluded in that such persons or groups may be deemed to be our affiliate. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2006 Annual Meeting of Stockholders (“Proxy Statement”) which will be held on December 6, 2006, and to be filed pursuant to Regulation 14A within 120 days after the Registrant’s fiscal year ended July 31, 2006, are incorporated by reference into Part III of this Form 10-K.

Table of Contents

			Page

PART I

Item 1	Business
		Overview		3
		Sales and Marketing		5
		Research and Development		5
		Competition		6
		Intellectual Property Rights		7
		Seasonality		7
		Employees		7
Item 1A	Risk Factors			8
Item 1B	Unresolved Staff Comments			17
Item 2	Properties			17
Item 3	Legal Proceedings			17
Item 4	Submission of Matters to a Vote of Security Holders			17

PART II

Item 5	Market for the Registrant’s Common Stock and Related Stockholder Matters			18
Item 6	Selected Consolidated Financial Data			19
Item 7	Management’s Discussion and Analysis of Financial Condition and Results of Operations.			19
Item 7A	Quantitative and Qualitative Disclosures About Market Risk			38
Item 8	Financial Statements and Supplementary Data			40
Item 9	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure			68
Item 9A	Controls and Procedures			69

PART III

Item 10	Directors and Executive Officers of the Registrant			72
Item 11	Executive Compensation			72
Item 12	Security Ownership of Certain Beneficial Owners and Management			72
Item 13	Certain Relationships and Related Transactions			73
Item 14	Principal Accounting Fees and Services.			73

PART IV

Item 15	Exhibits and Financial Statement Schedule			73
	Signatures			74

PART I

Item 1. Business

Special Note Regarding Forward-Looking Statements

This Form 10-K contains forward-looking statements that involve risks and uncertainties. Words such as “intend,” “expect,” “believe,” “in our view,” and variations of such words and similar expressions, are intended to identify such forward-looking statements, which include, but are not limited to, statements regarding our expectations and beliefs regarding future revenue growth; gross margins; financial performance and results of operations; technological trends in, and emergence of the market for collaborative software development applications; the future functionality, business potential, demand for, efficiencies created by and adoption of SourceForge Enterprise Edition; demand for online advertising; management’s strategy, plans and objectives for future operations; the impact of our restructuring and the amount of cash utilized by operations; our intent to continue to invest significant resources in development; competition, competitors and our ability to compete; liquidity and capital resources; the outcome of any litigation to which we are a party; our accounting policies; and sufficiency of our cash resources, cash generated from operations and investments to meet our operating and working capital requirements. Actual results may differ materially from those expressed or implied in such forward-looking statements due to various factors, including those set forth in this Business section under “Competition” and in the Risk Factors contained in the section of this Form 10-K entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” We undertake no obligation to update the forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-K.

Introduction

We were incorporated in California in January 1995 and reincorporated in Delaware in December 1999. From the date of our incorporation through October 2001, we sold Linux-based hardware systems and services under the name VA Linux Systems, Inc. On June 27, 2001, we announced our decision to exit our Linux-based hardware business. Today, we do business under the name VA Software Corporation (the “Company”) and we own and operate OSTG, Inc. (“OSTG”) a network of Internet web sites, including SourceForge.net and Slashdot.org, serving the information technology (“IT”) professional and software development communities, and OSTG’s wholly-owned subsidiary, ThinkGeek, Inc., (“ThinkGeek”) an online sales retailer. We also develop, market and support a software application known as SourceForge Enterprise Edition (“SFEE”).

We are subject to the informational requirements of the Securities Exchange Act of 1934 (the “Exchange Act”). Therefore, we file periodic reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). Such reports, proxy statements and other information may be obtained by visiting the Public Reference Room of the SEC at 100 F Street, NE, Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically.

You can access other information at our Investor Relations web site. The address is www.vasoftware.com/company/. The content of this web site is not intended to be incorporated by reference into this report or any other report we file with the SEC. We make available, free of charge, copies of our annual report on Form 10-K as soon as reasonably practicable after filing such material electronically or otherwise furnishing it to the SEC, and have made our annual reports on Form 10-K available on our web site since November 2002.

Business Overview

We currently view our business in three operating segments: Online Media, E-commerce and Software. In December 2005, we completed the sale of our Online Images business to Jupitermedia Corporation and we no longer have operations in that segment. For segment and geographic financial information, see Note 10 of the Notes to Consolidated Financial Statements of this Annual Report on Form 10-K.

Online Media

Our Online Media segment operates through OSTG, a network of Internet web sites, including SourceForge.net and Slashdot.org, serving the IT professional and software development communities. The OSTG network, including our ThinkGeek.com site, reaches over 30 million unique visitors a month (Source: Google Analytics and Omniture, September 2006). We believe that OSTG is a dynamic community-driven media network and a cornerstone of the open source software development community. OSTG attracts IT

decision-makers and buyers, from chief technology officers to project managers. IT professionals, technology enthusiasts and developers turn to OSTG sites to create content, debate and discuss current issues facing the technology marketplace, and to create IT news. OSTG is supported by sponsors and advertisers who want to reach the unique demographic of IT professionals and developers who visit our OSTG web sites. Our OSTG web sites include:

•	SourceForge.net, our flagship web site providing Open Source project hosting and hosted downloads of leading Open Source code and applications. SourceForge.net is the home for more than 130,000 Open Source projects and has more than 1,400,000 registered users.

•	Slashdot.org, our leading site focused on user-generated content, news and reviews for IT Professionals and technology enthusiasts. Slashdot.org is dedicated to providing the IT and business communities with an interactive platform to publish and comment on cutting-edge technology, hardware, software, games and online rights news.

•	Linux.com, our comprehensive web site for Linux and open source news and information. Linux.com caters to business and IT managers looking for migration strategies to Linux.

•	Freshmeat.net, one of the Internet’s most comprehensive indices of downloadable Linux, Unix and cross-platform software.

•	NewsForge.com, the online newspaper of record for Linux and open source software and business issues.

•	ITManagersJournal.com, a web site delivering strategic and technical information to help top-level IT professionals implement enterprise-level open source and proprietary architecture, applications, and infrastructure solutions.

Our Online Media segment represented 30%, 27% and 36% of net revenue during fiscal 2006, 2005 and 2004, respectively.

E-commerce

Our E-commerce segment provides online sales of a variety of retail products of interest to the software development and IT communities through ThinkGeek. We believe we offer a significantly broader range of unique products in a centralized location than are available in traditional stores. We do not have the shelf display space limitations that brick-and-mortar stores do. Our customers are able to buy electronics, office gadgets, apparel, caffeinated products and other specialty items with a single check-out. Consumers can either access the information directly through our web site, or get free help from our customer care representatives and experts by contacting them by e-mail at orders@thinkgeek.com or by telephone at 1-888-GEEKSTUFF.

Our E-commerce segment represented 47%, 49% and 46% of net revenue during fiscal 2006, 2005 and 2004, respectively.

Software

Our Software segment focuses on our SFEE software products and services.

SFEE is a proprietary, web-based software application designed for corporate commercial and public-sector IT professionals and software engineering organizations. SFEE combines software development and collaboration tools with the ability to track, measure and report on software project activity in real-time. SFEE improves the software development process by capturing and archiving software development code, documentation and communication in a central location. SFEE enables managers to gain insight and improved visibility into software development activity, thereby providing better resource and requirements management, defect tracking and the ability to resolve critical problems earlier in the development cycle. Organizations with distributed locations, offshore and/or outsourced software development teams can achieve improved productivity, communication, coordination, collaboration, project clarity and insight through SFEE’s standard set of development tools and secure, centralized code, documentation and communication repository.

Our Software segment represented 23%, 25% and 18% of net revenue during fiscal 2006, 2005 and 2004, respectively.

Sales and Marketing

Online Media

We sell our Internet advertisements via OSTG’s direct sales organization and also use our web sites to increase public awareness of our products. In addition, we have entered into co-marketing agreements with certain third-party online advertising and remnant sales networks with respect to marketing and/or selling advertising space on OSTG web sites.

E-commerce

Our E-commerce marketing and promotion strategy is designed to increase customer traffic to our online store, add new customers, build strong customer loyalty, maximize repeat purchases and develop incremental revenue opportunities. In addition, we have entered into co-marketing agreements with certain third parties with respect to marketing our E-commerce web site. We intend to continue to use the unique capabilities of the Internet as a means to encourage new and repeat customers to visit our web sites. Our advertising campaigns for our E-Commerce business generally run on our OSTG Online Media Business’s web sites where where we direct customers to our E-Commerce products through links to pages on our ThinkGeek.com E-Commerce web site. In addition, we currently offer a customer retention program, Geek Points, which is designed to add new customers and build customer loyalty. Through this program, customers are rewarded for shopping with us. When the customer signs up for Geek Points, they earn points on all of their purchases. Rewards for Geek Points participants include special promotions, discounts and access to products available only to those customers enrolled in the program.

Software

We primarily market and sell our SFEE software products (software, professional services, maintenance and support and training) directly to our end users through our SFEE field sales organization, on the Internet at www.vasoftware.com and on our various OSTG web sites. Our direct sales organization includes a telesales operation to augment our direct sales presence.

We maintain a complete marketing organization as well as customer service and support organizations for SFEE to provide support for installation, software usage, updates and system administration. Customer service and support are typically provided as part of the SFEE maintenance contract to ensure end user productivity. We also release periodic bug or security fix updates and version upgrades.

Research and Development

Online Media

We believe that the success of OSTG will depend partly on our ability to enhance our web sites and underlying technology to meet the needs of a rapidly-evolving marketplace and increasingly-sophisticated and demanding customers. We intend to continue to extend and strengthen the infrastructure and architecture underlying our online sites by enhancing existing features, adding additional features and allowing the community to link to external sources. These include, but are not limited to enhancing certain tools on SourceForge.net to improve the development experience for our registered users and enhancing our existing moderation system on Slashdot.org to provide a better layer of functionality to our comment system.

E-commerce

We have implemented a broad array of services and systems for customer service, product searching, order processing and order fulfillment functions, including, among other things:

•	Accepting and validating customer orders;

•	Organizing, placing and managing orders with vendors and fulfillment partners;

•	Receiving product and reserving inventory for specific customer orders; and

•	Managing shipment of products to customers based on various ordering criteria.

These services and systems use a combination of our own proprietary technologies and commercially-available, licensed technologies. We focus our internal development efforts on creating and enhancing the specialized, proprietary software that is unique to our business.

Our core online merchandise catalog, customer interaction, order collection, fulfillment and back-end systems are proprietary to ThinkGeek. The systems are designed to provide real-time connectivity to our distribution center systems. These include an inventory-tracking system, a real-time order tracking system, an executive information system and an inventory replenishment system. Our Internet servers use SSL technology to help conduct secure communications and transactions. We continue to invest in improving the E-commerce customer service, order processing, shipping and tracking systems.

Software

We believe that the success of SFEE will depend partly on our ability to enhance our product to meet the needs of a rapidly evolving marketplace and increasingly sophisticated and demanding customers. Therefore, we have devoted the majority of our research and development budget to the goal of improving SFEE. We intend to extend and strengthen our software by enhancing existing features, adding additional features and offering higher levels of integration with popular software development tools. Although we primarily develop SFEE technology internally, we may, based on timing and cost considerations, acquire technologies or products from third parties.

Competition

Online Media

The market for Internet media services provided by OSTG is highly competitive. Advertisers have many alternatives available to reach their target audience, including print (e.g., Ziff Davis Media’s eWeek and International Data Group’s Computerworld), general portal sites (e.g., aol.com, yahoo.com, google.com and msn.com) and other web sites focused on vertical markets (e.g., CNet Networks, Inc.’s cnet.com and techrepublic.com) and general business sites (BusinessWeek.com, Forbes.com and Fortune.com). Recently, Google, Inc. (“Google”) has begun offering open source code hosting capabilities that may be viewed as competitive to SourceForge.net’s offering and other companies and organizations also offer open source code hosting, open source code search, and open source software development-related services.. This competition may impact traffic to our SourceForge.net web site.

Many of our competitors in our Online Media business have substantial competitive advantages, including greater resources that can be devoted to the development, promotion and sale of their online services, more established sales forces and channels, greater software and web site development experience and greater name recognition.

E-commerce

The market for retail products similar to those offered by ThinkGeek is highly competitive. We compete with Internet portals and online service providers that feature shopping services, such as Amazon.com and Yahoo! and with other online or mail-order retailers. More recently some online retailers have developed sites which aim at the computer enthusiast and computer gaming markets. We believe that there are a number of competitive factors in our market, including company credibility, product selection and availability, convenience, price, privacy, web site features, functionality and performance, ease of purchasing, customer service and reliability and speed of order shipment.

Many of our competitors in our E-commerce business have substantial competitive advantages, including greater resources that can be devoted to the development, promotion and sale of their online products, more established sales forces and channels, greater software and web site development experience, and greater name recognition.

To be competitive, we must respond promptly and effectively to the challenges of technological change, evolving standards and our competitors’ innovations by continuing to enhance our services and products. Any pricing pressures or loss of potential customers resulting from our failure to compete effectively would reduce our revenue.

Software

We believe SFEE gives us an opportunity to operate in the collaborative software development market without an entrenched competitor. However, we face competition from software development tools and processes developed internally by customers, including ad hoc integrations of commercial software development tools and applications as well as open source software. There are also many entrenched competitors in closely-related markets who compete for customer budget allocations. Such competition could arise from, among others, Borland Software Corporation, Collabnet, Inc., International Business Machines Corporation, Microsoft Corporation and Serena Software, Inc., as well as numerous other public and privately-held software application development and tools suppliers. Additionally, recent and future business combinations among companies in the software industry will permit the resulting consolidated companies to offer more extensive suites of software products and broader arrays of software solutions, some of which may compete directly with SFEE. Changes resulting from current and future software industry consolidation may negatively impact our competitive position and operating results.

Many of these potential competitors are likely to have substantial competitive advantages, including greater resources that can be devoted to the development, promotion and sale of their products; more established sales forces and channels; greater software development experience; and greater name recognition.

Intellectual Property Rights

We protect our intellectual property through a combination of copyright, trademark, trade secret laws, employee and third-party nondisclosure agreements, and other methods of protection.

SFEE is licensed to our end-user customers as proprietary software code and documentation. We require our customers to enter into license agreements that impose restrictions on their ability to reproduce, distribute and utilize our software. In addition, we seek to avoid disclosure of our trade secrets through a number of means, including restricting access to our source code and object code and requiring those entities and persons with access to agree to confidentiality terms which restrict their use and disclosure.

SourceForge, SourceForge.net, Slashdot, ThinkGeek, Freshmeat, OSTG, VA Software, and the VA logo are some of our trademarks and/or registered trademarks that we use in the United States and in other countries.

Because the media and software industries are characterized by rapid technological change, we believe that factors such as the technological and creative skills of our personnel, new product developments, frequent product enhancements, name recognition and reliable product maintenance are more important to establishing and maintaining a technology leadership position than the various legal protections of our technology.

Seasonality

In the past several years, a substantial portion of our E-commerce revenue occurred in our second fiscal quarter, which in fiscal year 2007 will begin on November 1, 2006, and end on January 31, 2007. As is typical in the retail industry, we generally experience lower E-commerce revenue during the other quarters. Therefore, our E-commerce revenue in a particular quarter is not necessarily indicative of future E-commerce revenue for a subsequent quarter or our full fiscal year.

As noted above, our E-commerce business is highly seasonal, reflecting the general pattern associated with the retail industry of peak sales and earnings during the holiday shopping season. We have also noticed lower traffic on our Media Business web sites during the summer months. We have not noticed any significant seasonality in our Software revenue.

Employees

We believe our success will depend in part on our continued ability to attract and retain highly-qualified personnel in a competitive market for experienced and talented software engineers and sales and marketing personnel. Our employees are not represented by any collective bargaining organization; we have never experienced a work stoppage; and we believe that our relations with our employees are good. As of July 31, 2006, our employee base totaled 121, including 35 in operations, 32 in sales and marketing, 35 in research and development and 19 in finance and administration.

Item 1A. Risk Factors

CURRENT AND PROSPECTIVE INVESTORS IN VA SOFTWARE SECURITIES SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW BEFORE MAKING AN INVESTMENT DECISION. IN ADDITION, THESE RISKS ARE NOT THE ONLY ONES FACING OUR COMPANY. ADDITIONAL RISKS OF WHICH WE ARE NOT PRESENTLY AWARE OR THAT WE CURRENTLY BELIEVE ARE IMMATERIAL MAY ALSO IMPAIR OUR BUSINESS OPERATIONS. OUR BUSINESS COULD BE HARMED BY ANY OF THESE RISKS. THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE DUE TO ANY OF THESE RISKS, AND INVESTORS MAY LOSE ALL OR PART OF THEIR INVESTMENT.

Risks Related To Our Online Media Business

If our online business fails to continue to deliver original and compelling content and services, we will be unable to attract and retain users, which will adversely affect our financial results.

The successful development and production of content and services is subject to numerous uncertainties, including our ability to:

	•	anticipate and successfully respond to rapidly changing consumer tastes and preferences;

	•	fund new program development; and

	•	attract and retain qualified editors, writers and technical personnel.

We cannot assure that our online content and services will be attractive to a sufficient number of users to generate revenue consistent with our estimates or sufficient to sustain operations. In addition, we cannot assure that any new content or services will be developed in a timely or cost-effective manner. If we are unable to develop content and services that allow us to attract, retain and expand a loyal user base that is attractive to advertisers, we will be unable to generate sufficient revenue to grow our online business.

If our online business fails to deliver innovative marketing programs, we will be unable to attract and retain advertisers, which will adversely affect our financial results.

The successful development and production of marketing programs is subject to numerous uncertainties, including our ability to:

	•	enable advertisers to showcase products, services and/or brands to their intended audience;

	•	anticipate and successfully respond to emerging trends in online advertising; and

	•	attract and retain qualified marketing and technical personnel.

We cannot assure that our online marketing programs will enable us to attract and retain advertisers and generate revenue consistent with our estimates or sufficient to sustain operations. In addition, we cannot assure that any new marketing programs will be developed in a timely or cost-effective manner. If we are unable to deliver innovative marketing programs that allow us to expand our advertiser base, we will be unable to generate sufficient revenue to grow our online business.

Decreases or delays in advertising spending due to general economic conditions could harm our ability to generate advertising revenue, which would adversely affect our financial results.

Expenditures by advertisers tend to be cyclical, reflecting overall economic conditions as well as budgeting and buying patterns. Because we derive a large part of our revenue from advertising fees, decreases in or delays of advertising spending could reduce our revenue or negatively impact our ability to grow our revenue. Even if economic conditions continue to improve, marketing budgets and advertising spending may not increase from current levels.

The market in which SourceForge.net participates is becoming more competitive, and if we do not compete effectively, our online business could be harmed.

SouceForge.net hosts more than 130,000 open source software projects, and we derive revenue from SourceForge.net primarily through advertisements and sponsorship campaigns run on the site. Recently, Google has begun offering open source code hosting and search capabilities that may be viewed as competitive to SourceForge.net’s offering. Because Google enjoys substantial competitive advantages in the online space generally, including powerful brand identity, established marketing relationships, larger visitor base, and greater financial, technical, and other resources, we may be unable to compete effectively with Google’s offering. Further, other companies and organizations offer open source code hosting, open source code search, and open source software development-related services. Our competitors may be able to respond more quickly and effectively than we can to new or changing open source software opportunities, technologies, standards, or user requirements. Because of competitors’ advantages, even if our services are more effective than those of our competitors, users might accept the services of our competitors in lieu of ours. If we fail to compete effectively, our online business could be negatively impacted.

Unplanned system interruptions and capacity constraints and failure to effect efficient transmission of user communications and data over the Internet could harm our business and reputation.

The success of our online media business largely depends on the efficient and uninterrupted operation of the computer and communications hardware and network systems that power our web sites. We do not currently have a formal disaster recovery plan and our computer and communications systems are located in a single data center in Santa Clara County, California. Although we are considering moving our data center in connection with formulation of a formal disaster recovery plan, given the current location of our single data center and our lack of a formal disaster recovery plan, our systems and operations are vulnerable to damage or interruption from earthquake, fire, power loss, telecommunications failure and similar events.

During and prior to fiscal year 2006, we experienced service interruptions with our online sites, including service outages associated with our SourceForge.net and Slashdot.org sites. Service interruptions during fiscal year 2006 were caused by a variety of factors, including capacity constraints, single points of hardware failure, software design flaws and bugs, and third party denial of service attacks. Although we continue to work to improve the performance and uptime of our web sites, and have taken steps to mitigate these risks, we expect that service interruptions will continue to occur from time to time. If our web sites experience frequent or lengthy service interruptions, our business and reputation will be seriously harmed.

Risks Related To Our E-Commerce Business

We cannot predict our E-commerce customers’ preferences with certainty and such preferences may change rapidly. If we fail to accurately assess and predict our E-commerce customers’ preferences, it will adversely impact our financial results.

Our E-commerce offerings on our ThinkGeek.com web site are designed to appeal to IT professionals, software developers and others in technical fields. Misjudging either the market for our products or our customers’ purchasing habits will cause our sales to decline, our inventories to increase and/or require us to sell our products at lower prices, all of which would have a negative effect on our business.

We are exposed to significant inventory risks as a result of seasonality, new product launches, rapid changes in product cycles and changes in consumer tastes with respect to our products offered at our ThinkGeek E-commerce web site. Failure to properly assess our inventory needs will adversely affect our financial results.

In order to be successful, we must accurately predict our customers’ tastes and avoid overstocking or under-stocking products. Demand for products can change significantly between the time inventory is ordered and the date of sale. In addition, when we begin selling a new product, it is particularly difficult to forecast product demand accurately. The acquisition of certain types of inventory, or inventory from certain sources, may require significant lead-time and prepayment, and such inventory may not be returnable. We carry a broad selection and significant inventory levels of certain products and we may be unable to sell products in sufficient quantities or during the relevant selling seasons.

If we do not maintain sufficient E-commerce inventory levels, or if we are unable to deliver our E-commerce products to our customers in sufficient quantities, our E-commerce business operating results will be adversely affected.

We must be able to deliver our merchandise in sufficient quantities to meet the demands of our customers and deliver this merchandise to customers in a timely manner. We must be able to maintain sufficient inventory levels, particularly during the peak holiday selling seasons. If we fail to achieve these goals, we may be unable to meet customer demand, and our financial results will be adversely affected.

Our ThinkGeek E-commerce web site is dependent upon a single third party fulfillment and warehouse provider. The satisfaction of our E-commerce customers is highly dependent upon fulfillment of orders in a professional and timely manner, so any decrease in the quality of service offered by our fulfillment and warehouse provider will adversely affect our reputation and the growth of our E-commerce business.

Our ThinkGeek E-commerce web site’s ability to receive inbound inventory and ship completed orders efficiently to our customers is substantially dependent on a third-party contract fulfillment and warehouse provider. We currently utilize the services of Dotcom Distribution, Inc. (“Dotcom Distribution”), located in Edison, New Jersey. If Dotcom Distribution fails to meet our future distribution and fulfillment needs, our relationship with and reputation among our E-commerce customers will suffer and this will adversely affect our E-commerce growth. Additionally, if Dotcom Distribution cannot meet our distribution and fulfillment needs, particularly during the peak holiday selling seasons, or our contract with Dotcom Distribution terminates, we may fail to secure a suitable replacement or second-source distribution and fulfillment provider on comparable terms, which would adversely affect our E-commerce financial results.

Risks Related To Our Software Business

Because the market for our SFEE application software is still emerging, we do not know whether existing and potential customers will license SFEE in sufficient quantities for us to sustain profitability.

Our future growth and financial performance will depend on market acceptance of SFEE and our ability to license our software in sufficient quantities and under acceptable terms. The number of customers using SFEE is still relatively small. We expect that we will continue to need intensive marketing and sales efforts to educate prospective clients about the uses and benefits of SFEE. Various factors could inhibit the growth of the market for and market acceptance of SFEE. In particular, potential customers may be unwilling to make the significant capital investment needed to license SFEE. Many of our customers have licensed only limited quantities of SFEE, and these or new customers may decide not to deploy our software more broadly. We cannot be certain that a viable market for SFEE will be sustainable. If a viable market for SFEE fails to be sustainable, this would have a significant, adverse effect upon our software business and operating results.

We are devoting the majority of our research and development spending to our SFEE application, so if this software does not achieve market acceptance we may experience operating losses.

Although in fiscal year 2006, which ended on July 31, 2006, approximately 23% of our revenue was derived from our Software business, we devoted 51%, or $3.2 million, of our research and development spending to research and development associated with our SFEE software application. We expect to continue to allocate a substantial portion of our research and development resources to software for the foreseeable future. There can be no assurance, however, that we will be sufficiently successful in marketing, licensing, upgrading and supporting Software to offset our substantial research and development expenditures. A failure to grow software revenue sufficiently to offset the significant research and development costs will materially and adversely affect our business and operating results.

If we fail to attract and retain larger corporate and enterprise-level customers, our revenue will not grow and may decline.

We have focused our sales and marketing efforts upon larger corporate and enterprise-level customers. This strategy may fail to generate sufficient revenue to offset the substantial demands that this strategy will place on our business, in particular the longer sales cycles, higher levels of service and support and volume pricing and terms that larger corporate and enterprise accounts often demand. In addition, these larger customers generally have significant financial and personnel resources. As a result, rather than license software, our target customers may develop collaborative software development applications internally, including ad hoc development of applications based on open source code. A failure to successfully obtain revenue from larger corporate or enterprise-level customers will materially and adversely affect our operating results.

If we fail to anticipate or respond adequately to technology developments, industry standards or practices, and customer requirements, or if we experience any significant delays in product development, introduction, or integration, SFEE software may become obsolete or unmarketable, our ability to compete may be impaired, and our software revenue may not grow or may decline.

Rapid technological advances, changes in customer requirements, and frequent new product introductions and enhancements characterize the software industry generally. We must respond rapidly to developments related to hardware platforms, operating systems, and software development tools. These developments will require us to make substantial product development investments. We believe the success of our Software business will become increasingly dependent on our ability to:

	•	support multiple platforms, including Linux, commercial UNIX and Microsoft Windows;

	•	use the latest technologies to continue to support web-based collaborative software development; and

	•	continually support the rapidly changing standards, tools and technologies used in software development.

Our SFEE application software has a long and unpredictable sales cycle, which makes it difficult to forecast our future results and may cause our operating results to vary significantly.

The period between initial contact with a prospective customer and the licensing of SFEE varies and has often exceeded three and occasionally exceeded twelve months. Additionally, our sales cycle is complex because customers consider a number of factors before committing to license our software. Factors that our customers and potential customers have informed us that they consider when evaluating our software include product benefits, cost and time of implementation, and the ability to operate with existing and future computer systems and applications. We have found that customer evaluation, purchasing and budgeting processes vary significantly from company to company. We spend significant time and resources informing prospective customers about our software products, which may not result in completed transactions and associated revenue. Even if SFEE has been chosen by a customer, completion of the transaction is subject to a number of contingencies, which make our quarterly revenue difficult to forecast. These contingencies include but are not limited to the following:

	•	Our ability to sell SFEE software licenses may be impacted by changes in the strategic importance of software projects due to our customers’ budgetary constraints or changes in customer personnel;

	•	A customer’s internal approval and expenditure authorization process can be difficult and time consuming. Delays in approvals, even after we are selected as a vendor, could impact the timing and amount of revenue recognized in a quarterly period; and

	•	The number, timing and significance of enhancements to our software products and future introductions of new software by our competitors and us may affect customer-purchasing decisions.

If we do not continue to receive repeat business from existing software customers, our revenue will not grow and may decline.

We generate a significant amount of our SFEE license revenue from existing customers. Generally, our customers initially purchase a limited number of licenses as they evaluate, implement and adopt SFEE software. Even if customers successfully use SFEE, such customers may not purchase additional licenses to expand the use of our product. Purchases of additional licenses by these customers will depend on their success in deploying our software, their satisfaction with our product and support services and their use of competitive alternatives. A customer’s decision to widely deploy SFEE and purchase additional licenses may also be affected by factors that are outside of our control or which are not related to our product or services. In addition, as we deploy new versions of our software, or introduce new products, our current customers may not require the functionality of our new versions or products and may decide not to license these products.

Increased utilization and costs of our technical support services may adversely affect our financial results.

Over the short term, we may be unable to respond to fluctuations in customer demand for support services. We may also be unable to modify the format of our support services to compete with changes in support services provided by competitors. Further, customer demand for these services could cause increases in the costs of providing such services and adversely affect our operating results.

Contractual issues may arise during the negotiation process that may delay the anticipated closure of a transaction and our ability to recognize revenue as anticipated. The occurrence of such issues might cause our Software revenue and operating results to fall below our publicly-stated expectations, the expectations of securities analysts or the expectations of investors. Failure to meet public expectations is likely to materially and adversely affect the trading price of our common stock.

Because we focus on selling enterprise solutions, the process of contractual negotiation is critical and may be lengthy. Additionally, several factors may require us to defer recognition of license revenue for a significant period of time after entering into a license agreement, including instances where we are required to deliver either unspecified additional products or specified upgrades for which we do not have vendor-specific objective evidence of fair value. While we have a standard software license agreement that provides for revenue recognition provided that delivery has taken place, collectibility from the customer is reasonably assured and assuming no significant future obligations or customer acceptance rights exist, customer negotiations and revisions to these terms could impact our ability to recognize revenue at the time of delivery.

Many enterprise customers negotiate software licenses near the end of each quarter. In part, this is because enterprise customers are able, or believe that they are able, to negotiate lower prices and more favorable terms at that time. Our reliance on a large portion of Software revenue occurring at the end of the quarter and the increase in the dollar value of transactions that occur at the end of a quarter can result in increased uncertainty relating to quarterly revenue. Due to end-of-period variances, forecasts may not be achieved, either because expected sales do not occur or because they occur at lower prices or on terms that are less favorable to us.

In addition, slowdowns in our quarterly license contracting activities may impact our service offerings and may result in lower revenue from our customer training, professional services and customer support organizations. Our ability to maintain or increase service revenue is highly dependent on our ability to increase the number of license agreements we enter into with customers.

Risks Related To Our Financial Results

Certain factors specific to our businesses over which we have limited or no control may nonetheless adversely impact our total revenue and financial results.

The primary factors over which we have limited or no control that may adversely impact our total revenue and financial results include the following:

	•	specific economic conditions relating to IT spending;

	•	the discretionary nature of our software and online media customers’ purchase and budget cycles;

	•	the size and timing of software and online media customer orders;

	•	long software and online media sales cycles;

	•	our ability to retain skilled engineering and sales personnel;

	•	economic conditions relating to online advertising and sponsorship, and E-commerce;

	•	our ability to demonstrate and maintain attractive online user demographics;

	•	the addition or loss of specific online advertisers or sponsors, and the size and timing of advertising or sponsorship purchases by individual customers; and

	•	our ability to keep our web sites operational at a reasonable cost.

If our revenue and operating results fall below our expectations, the expectations of securities analysts or the expectations of investors, the trading price of our common stock will likely be materially and adversely affected. You should not rely on the results of our business in any past periods as an indication of our future financial performance.

Future changes in financial accounting standards, including pronouncements and interpretations of accounting pronouncements on software revenue recognition, share-based payments and financial instruments, may cause adverse unexpected revenue fluctuations and affect our reported results of operations.

From time to time, the American Institute of Certified Public Accountants (“AICPA”) and the SEC may issue accounting pronouncements, guidelines and interpretations regarding accounting pronouncements. A change in an accounting policy can have a significant effect on our reported results and may even affect our reporting of transactions completed before a change is announced. Accounting policies affecting our business, including rules relating to revenue recognition, share-based payments and financial instruments have recently been revised or are under review. In particular, new accounting pronouncements and varying interpretations of existing pronouncements on software revenue recognition, share-based payments and financial instruments have occurred with frequency, may occur in the future and could impact our revenue and results of operations. There have also been recent accounting pronouncements on the reporting of changes in accounting policies and the consideration of the effects on prior year misstatements. Required changes in our application of accounting pronouncements could cause changes in our reported results of operation and our financial condition.

If we fail to adequately monitor and minimize our use of existing cash, we may need additional capital to fund continued operations beyond the next 12 months.

Although we generated cash from operations during fiscal 2006, which ended July 31, 2006, we have historically experienced cash shortfalls, and unless we monitor and minimize the level of use of our existing cash, cash equivalents and marketable securities, we may require additional capital to fund continued operations beyond the next 12 months. While we believe we will not require additional capital to fund continued operations for the next 12 months, we may require additional funding within this time frame, and this additional funding, if needed, may not be available on terms acceptable to us, or at all. A slowdown in technology or advertising spending, as well as other factors that may arise, could affect our future capital requirements and the adequacy of our available funds. As a result, we may be required to raise additional funds through private or public financing facilities, strategic relationships or other arrangements. Any additional equity financing would likely be dilutive to our stockholders. Debt financing, if available, may involve restrictive covenants on our operations and financial condition. Our inability to raise capital when needed could seriously harm our business.

We have a history of losses and may incur net losses in the foreseeable future. Failure to remain profitable may materially and adversely affect the market price of our common stock and our ability to raise capital and continue operations.

Although we generated income from continuing operations of $1.3 million during the year ended July 31, 2006, we have incurred losses in each fiscal year since our inception and have an accumulated deficit of $741.1 million as of July 31, 2006. We may incur net losses in the future. Failure to remain profitable may materially and adversely affect the market price of our common stock and our ability to raise capital and continue operations beyond the next 12 months.

Risks Related To Competition

If we do not effectively compete with new and existing competitors, our revenue will not grow and may decline, which will adversely impact our financial results.

We believe that the emerging collaborative software development market continues to be fragmented, subject to rapid change and highly sensitive to new product introductions and marketing efforts by industry participants. Competition in related markets is intense. If our products gain market acceptance, we expect the competition to rapidly intensify as new competitors enter the marketplace. Our potential competitors include companies entrenched in closely related markets who may choose to enter and focus on collaborative software development. We expect competition to intensify in the future if the market for collaborative software development applications continues to expand. Our potential competitors include providers of software and related services as well as providers of hosted application services. Many of our potential competitors have significantly more resources, more experience, longer operating histories and greater financial, technical, sales and marketing resources than we do. In addition, open source code can be obtained through commercial vendors or downloaded and used on an ad hoc basis to address some collaborative software development challenges. We cannot guarantee that we will be able to compete successfully against current and future competitors or that competitive pressure and/or the availability of open source code will not result in price reductions, reduced operating margins and loss of market share, any one of which could seriously harm our business. Because individual product sales often lead to a broader customer relationship, our products must be able to successfully compete with and complement numerous competitors’ current and potential offerings. Moreover, we may be forced to compete with our strategic partners, and potential strategic partners, and this may adversely impact our relationship with an individual partner or a number of partners. Consolidation is underway among companies in the software industry as firms seek to offer more extensive suites of software products and broader arrays of software solutions. Changes resulting from this consolidation may negatively impact our competitive position and operating results.

Online competition is intense. Our failure to compete successfully could adversely affect our revenue and financial results.

The market for Internet content and services is intensely competitive and rapidly evolving. It is not difficult to enter this market and current and new competitors can launch new Internet sites at relatively low cost. We derive revenue from online advertising and sponsorships, for which we compete with various media including newspapers, radio, magazines and various Internet sites. We also derive revenue from E-commerce, for which we compete with other E-commerce companies as well as traditional, “brick and mortar” retailers. We may fail to compete successfully with current or future competitors. Moreover, increased competition could result in price reductions, reduced margins or loss of market share, any of which could have a material adverse effect on our future revenue and financial results. If we do not compete successfully for new users and advertisers, our financial results may be materially and adversely affected.

Risks Related To Intellectual Property

We are vulnerable to claims that our products infringe third-party intellectual property rights. Any resulting claims against us could be costly to defend or subject us to significant damages.

We expect that our software products will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. In addition, we may receive patent infringement claims as companies increasingly seek to patent their software. Our developers may fail to perform patent searches and may therefore unwittingly infringe on third-party patent rights. We cannot prevent current or future patent holders or other owners of intellectual property from suing us and others seeking monetary damages or an injunction against shipment of our software offerings. A patent holder may deny us a license or force us to pay royalties. In either event, our operating results could be seriously harmed. In addition, employees hired from competitors might utilize proprietary and trade secret information from their former employers without our knowledge, even though our employment agreements and policies clearly prohibit such practices.

Any litigation regarding our intellectual property, with or without merit, could be costly and time consuming to defend, divert the attention of our management and key personnel from our business operations and cause product shipment delays. Claims of intellectual property infringement may require us to enter into royalty and licensing agreements that may not be available on terms acceptable to us, or at all. In addition, parties making claims against us may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the United States and abroad and could result in an award of substantial damages against us. Defense of any lawsuit or failure to obtain any required license could delay shipment of our products and increase our costs. If a successful claim is made against us and we fail to develop or license a substitute technology, our business, results of operations, financial condition or cash flows could be immediately and materially adversely affected.

If we fail to adequately protect our intellectual property rights, competitors may use our technology and trademarks, which could weaken our competitive position, reduce our revenue, and increase our costs.

We rely on a combination of copyright, trademark and trade-secret laws, employee and third-party nondisclosure agreements, and other arrangements to protect our proprietary rights. Despite these precautions, it may be possible for unauthorized third parties to copy our products or obtain and use information that we regard as proprietary to create products that compete against ours. Some license provisions protecting against unauthorized use, copying, transfer, and disclosure of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries.

In addition, the laws of some countries do not protect proprietary rights to the same extent as do the laws of the United States. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase.

Our collection of trademarks is important to our business. The protective steps we take or have taken may be inadequate to deter misappropriation of our trademark rights. We have filed applications for registration of and registered some of our trademarks in the United States and internationally. Effective trademark protection may not be available in every country in which we offer or intend to offer our products and services. Failure to protect our trademark rights adequately could damage our brand identity and impair our ability to compete effectively. Furthermore, defending or enforcing our trademark rights could result in the expenditure of significant financial and managerial resources.

The scope of United States patent protection in the software industry is not well defined and will evolve as the United States Patent and Trademark Office grants additional patents. Because patent applications in the United States are not publicly disclosed until the patent is issued, applications may have been filed that would relate to our products.

Our software business success depends significantly upon our proprietary technology. Despite our efforts to protect our proprietary technology, it may be possible for unauthorized third parties to copy certain portions of our products or to reverse engineer or otherwise obtain and use our proprietary information. We do not have any software patents, and existing copyright laws afford only limited protection. In addition, we cannot be certain that others will not develop substantially equivalent or superseding proprietary technology, or that equivalent products will not be marketed in competition with our products, thereby substantially reducing the value of our proprietary rights. We cannot assure that we will develop proprietary products or technologies that are patentable, that any patent, if issued, would provide us with any competitive advantages or would not be challenged by third parties, or that the patents of others will not adversely affect our ability to do business. Litigation may be necessary to protect our proprietary technology. This litigation may be time-consuming and expensive.

Other Risks Related To Our Overall Business

We may be subject to claims as a result of information published on, posted on or accessible from our Internet sites, which could be costly to defend and subject us to significant damage claims.

We may be subject to claims of defamation, negligence, copyright or trademark infringement (including contributory infringement) or other claims relating to the information contained on our Internet sites, whether written by third parties or us. These types of claims have been brought against online services in the past and can be costly to defend regardless of the merit of the lawsuit. Although federal legislation protects online services from some claims when third parties write the material, this protection is limited. Furthermore, the law in this area remains in flux and varies from state to state. We receive notification from time to time of potential claims, but have not been named as a party to litigation involving such claims. While no formal complaints have been filed against us to date, our business could be seriously harmed if one were asserted.

We may be subject to product liability claims if people or property are harmed by the products we sell on our E-commerce web sites, which could be costly to defend and subject us to significant damage claims.

Some of the products we offer for sale on our E-commerce web sites, such as consumer electronics, toys, computers and peripherals, toiletries, beverages and clothing, may expose us to product liability claims relating to personal injury, death or property damage caused by such products, and may require us to take actions such as product recalls. Although we maintain liability insurance, we cannot be certain that our coverage will be adequate for liabilities actually incurred or that insurance will continue to be available to us on economically reasonable terms, or at all. In addition, some of our vendor agreements with our suppliers do not indemnify us from product liability.

We make significant investments in new products and services that may fail to become profitable endeavors.

We have made and will continue to make significant investments in research, development and marketing for new products and services. For example, in July 2006, we announced our plans to build a SourceForge.net Marketplace platform, including related support systems and infrastructure. Investments in new technology are inherently speculative. Commercial success for new products and services depends on many factors including innovativeness, developer support, and effective marketing. Significant revenue from new product and service investments may not be achieved for a number of years, if at all. Moreover, new products and services may not be profitable, and even if they are profitable, operating margins for new products and services may not meet our internal expectations or the expectations of investors and securities analysts. If our new products and services fail to achieve financial results that meet public expectations, our business could be seriously harmed and our stock price will likely decline.

If we are unable to implement appropriate systems, procedures and controls, we may not be able to successfully offer our services and grow our business.

Our ability to successfully offer our services and grow our business requires an effective planning and management process. We updated our operations and financial systems, procedures and controls following our strategic decision to exit the hardware business. Our systems will continue to require additional modifications and improvements to respond to current and future changes in our business. If we cannot grow our businesses, and manage that growth effectively, or if we fail to implement in a timely manner appropriate internal systems, procedures, controls and necessary modifications and improvements to these systems, our businesses will suffer.

If we lose key personnel or fail to integrate replacement personnel successfully, our ability to manage our business could be impaired.

Our future success depends upon the continued service of our key management, technical, sales, and other critical personnel. Our officers and other key personnel are employees-at-will, and we cannot assure that we will be able to retain them. Key personnel have left our company in the past and there likely will be additional departures of key personnel from time to time in the future. The loss of any key employee could result in significant disruptions to our operations, including adversely affecting the timeliness of product releases, the successful implementation and completion of company initiatives, and the results of our operations. Competition for these individuals is intense, and we may not be able to attract, assimilate or retain highly qualified personnel. Competition for qualified personnel in our industry and the San Francisco Bay Area, as well as other geographic markets in which we recruit, is intense and characterized by increasing salaries, which may increase our operating expenses or hinder our ability to recruit qualified candidates. In addition, the integration of replacement personnel could be time consuming, may cause additional disruptions to our operations, and may be unsuccessful.

Our stock price has been volatile historically and may continue to be volatile.

The trading price of our common stock has been and may continue to be subject to wide fluctuations. During our fiscal year ended July 31, 2006, the closing sale prices of our common stock on the NASDAQ Global Market ranged from $1.32 to $5.83 per share and the closing sale price on July 31, 2006, the last trading day of our fiscal year, was $3.97 per share. Our stock price may fluctuate in response to a number of events and factors, such as quarterly variations in operating results, announcements of technological innovations or new products and media properties by us or our competitors, changes in financial estimates and recommendations by securities analysts, the operating and stock price performance of other companies that investors may deem comparable to us, and news reports relating to trends in our markets or general economic conditions.

In addition, the stock market in general, and the market prices for Internet-related companies in particular, have experienced volatility that often has been unrelated to the operating performance of such companies. These broad market and industry fluctuations may adversely affect the price of our stock, regardless of our operating performance. Additionally, volatility or a lack of positive performance in our stock price may adversely affect our ability to retain key employees, all of whom have been granted stock options.

Sales of our common stock by significant stockholders may cause the price of our common stock to decrease.

Several of our stockholders own significant portions of our common stock. If these stockholders were to sell significant amounts of their holdings of our common stock, then the market price of our common stock could be negatively impacted. The effect of such sales, or of significant portions of our stock being offered or made available for sale, could result in strong downward pressure on our stock price. Investors should be aware that they could experience significant short-term volatility in our stock if such stockholders decide to sell a substantial amount of their holdings of our common stock at once or within a short period of time.

Our networks may be vulnerable to unauthorized persons accessing our systems, which could disrupt our operations and result in the theft of our proprietary information.

A party who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions or malfunctions in our Internet operations. We may be required to expend significant capital and resources to protect against the threat of security breaches or to alleviate problems caused by breaches in security.

Increasing regulation of the Internet or imposition of sales and other taxes on products sold or distributed over the Internet could harm our business.

The electronic commerce market on the Internet is relatively new and rapidly evolving. While this is an evolving area of the law in the United States and overseas, currently there are relatively few laws or regulations that directly apply to commerce on the Internet. Changes in laws or regulations governing the Internet and electronic commerce, including, without limitation, those governing an individual’s privacy rights, pricing, content, encryption, security, acceptable payment methods and quality of products or services could have a material adverse effect on our business, operating results and financial condition. Taxation of Internet commerce, or other charges imposed by government agencies or by private organizations, may also be imposed. Any of these regulations could have an adverse effect on our future sales and revenue growth.

Business disruptions could affect our future operating results.

Our operating results and financial condition could be materially and adversely affected in the event of a major earthquake, fire or other catastrophic event. Our corporate headquarters, the majority of our research and development activities and certain other critical business operations are located in California, near major earthquake faults. A catastrophic event that results in the destruction of any of our critical business or information technology systems could severely affect our ability to conduct normal business operations and as a result our future operating results could be adversely affected.

System disruptions could adversely affect our future operating results.

Our ability to attract and maintain relationships with users, advertisers, merchants and strategic partners will depend on the satisfactory performance, reliability and availability of our Internet channels and network infrastructure. Our Internet advertising revenue relate directly to the number of advertisements delivered to our users. System interruptions or delays that result in the unavailability of Internet channels or slower response times for users would reduce the number of advertisements and sales leads delivered to such users and reduce the attractiveness of our Internet channels to users, strategic partners and advertisers or reduce the number of impressions delivered and thereby reduce revenue. In the past twelve months, some of our sites have experienced a small number of brief service interruptions. We will continue to suffer future interruptions from time to time whether due to natural disasters, telecommunications failures, other system failures, rolling blackouts, viruses, hacking or other events. System interruptions or slower response times could have a material adverse effect on our revenue and financial condition.

Item 1B. Unresolved Staff Comments

Not applicable.

Item 2. Properties

Our principal locations are as follows:

Location	Purpose	Approximate Size (in square feet)	Expiration of Lease

United States of America
Fremont, California	100% sublet through lease expiration date	102,544	2010
Fremont, California	Corporate headquarters; OSTG and Software sales and marketing, finance and administration, research and development	36,767	2010
Fairfax, Virginia	ThinkGeek operations	5,139	2009

Item 3. Legal Proceedings

Information with respect to this Item may be found in Note 5 of the Notes to Consolidated Financial Statements of this Annual Report on Form 10-K, which information is incorporated into this Item 3 by reference.

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

Not applicable.

PART II

Item 5. Market for the Registrant’s Common Stock and Related Stockholder Matters

Our common stock is traded on the NASDAQ Global Market under the symbol LNUX. As of September 29, 2006, there were 809 holders of record of our common stock. We have not declared any cash dividends since our inception and do not expect to pay any dividends in the foreseeable future. The high and low closing sales prices, as reported by NASDAQ, of our common stock are as follows:

	High		Low

Fiscal Year Ended July 31, 2006:
Fourth Quarter	$	5.55	$	3.58
Third Quarter	$	5.83	$	1.88
Second Quarter	$	1.89	$	1.36
First Quarter	$	1.80	$	1.32
Fiscal Year Ended July 31, 2005:
Fourth Quarter	$	2.00	$	1.34
Third Quarter	$	2.08	$	1.32
Second Quarter	$	2.99	$	1.84
First Quarter	$	2.13	$	1.58

The foregoing reflects interdealer prices without retail markup, markdown, or commissions and may not necessarily reflect actual transactions.

Item 6. Selected Consolidated Financial Data

You should read the selected consolidated financial data set forth below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and the related notes included elsewhere in this Form 10-K.

The statement of operations data for the fiscal years ended July 31, 2006, July 31, 2005 and July 31, 2004 and the balance sheet data as of July 31, 2006 and July 31, 2005 are derived from the audited financial statements and related notes appearing elsewhere in this Form 10-K. The statement of operations data for the fiscal years ended July 31, 2003 and July 27, 2002 and the balance sheet data as of July 31, 2004, July 31, 2003 and July 27, 2002 are derived from audited financial statements not appearing in this Form 10-K. The revenue, cost of revenue and operating expenses data excludes the results of our Online Images business, which was sold in December 2005. The historical results are not necessarily indicative of results that may be expected for any future period.

Summary Financial Information
(In thousands, except per share data)

	For the years ended

	July 31, 2006		July 31, 2005			July 31, 2004			July 31, 2003			July 27, 2002

Selected Consolidated Statements of Operations Data:
Net revenue from continuing operations	$	43,632	$	30,603		$	27,339		$	22,648		$	19,147
Cost of revenue from continuing operations		20,671		15,939			15,042			12,442			9,468

Gross margin from continuing operations		22,961		14,664			12,297			10,206			9,679
Income (loss) from continuing operations		1,315		(5,649	)		(8,262	)		(15,511	)		(93,809	)
Income from discontinued operations, net of income taxes		9,647		955			622			629			561

Net income (loss)	$	10,962	$	(4,694	)	$	(7,640	)	$	(14,882	)	$	(93,248	)

Income (loss) per share from continuing operations:
Basic	$	0.02	$	(0.09	)	$	(0.14	)	$	(0.26	)	$	(1.73	)

Diluted	$	0.02	$	(0.09	)	$	(0.14	)	$	(0.26	)	$	(1.73	)

Income per share from discontinued operations:
Basic	$	0.16	$	0.01		$	0.01		$	0.01		$	0.01

Diluted	$	0.15	$	0.01		$	0.01		$	0.01		$	0.01

Net income (loss) per share:
Basic	$	0.18	$	(0.08	)	$	(0.13	)	$	(0.25	)	$	(1.72	)

Diluted	$	0.17	$	(0.08	)	$	(0.13	)	$	(0.25	)	$	(1.72	)

Shares used in per share calculation:
Basic		62,328		61,454			59,684			54,110			53,064

Diluted		64,704		61,454			59,684			54,110			53,064

Selected Balance Sheet data at year-end:
Cash, cash equivalents and investments	$	53,043	$	38,420		$	44,042		$	38,847		$	53,046
Working capital	$	51,265	$	34,369		$	25,866		$	28,825		$	33,486
Total assets	$	63,212	$	47,381		$	53,679		$	48,495		$	66,968
Liabilities, net of current portion	$	5,693	$	7,378		$	9,192		$	11,953		$	15,575
Total stockholders’ equity	$	49,378	$	31,665		$	35,770		$	27,202		$	39,388

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with “Selected Consolidated Financial Data” and our financial statements and the related notes included elsewhere in this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of certain factors including the risks discussed in “Item 1A. Risk Factors” and elsewhere in this Form 10-K. See Part I — Item 1 — “Special Note Regarding Forward-Looking Statements.”

Overview

We were incorporated in California in January 1995 and reincorporated in Delaware in December 1999. From the date of our incorporation through October 2001, we sold Linux-based hardware systems and services under the name VA Linux Systems, Inc. On June 27, 2001, we announced our decision to exit our Linux-based hardware business. Today, we do business under the name VA Software Corporation and we own and operate OSTG, Inc. (“OSTG”), a network of Internet web sites offering advertising and retail products and also develop, market and support a software application known as SourceForge Enterprise Edition (“SFEE”).

We currently view our business in three operating segments: Online Media; E-commerce; and Software. Our Online Media segment operates through OSTG, represents a network of Internet web sites, including SourceForge.net and Slashdot.org, serving the IT professional and software development communities. Our E-commerce segment provides online sales of a variety of retail products of interest to the software development and IT communities through ThinkGeek, Inc. (“ThinkGeek”), a wholly-owned subsidiary of OSTG. Our Software segment focuses on our SFEE software products and services.

In December 2005, we completed the sale of our Online Images business to Jupitermedia Corporation and we no longer have operations in that segment.

Our goals for fiscal 2006 were to continue to broaden our advertising base for OSTG while increasing traffic and to add new Software customers, all with a focus towards driving the Company towards profitability.

Within the Online Media segment, we reached record levels of unique visitors and advertisers. OSTG reaches over 30 million unique visitors a month (Source: Google Analytics and Omniture, September 2006). We also extended our reach to advertisers by providing new programs such as our Slashdot Vendor Integration, SourceForge.net Powerbar, category sponsorships and rich download programs, allowing the advertiser to reach our visitors.

Within the E-commerce segment, we continued to increase our customer base, increasing the number of orders by 34% from the prior year.

Within the Software segment, we continued to increase the number of customers to whom we have sold our SFEE products, totaling 164 at July 31, 2006.

Net revenue increased in fiscal 2006 as compared to fiscal 2005 due to revenue increases in all three business segments. Within the Online Media segment, revenue increased due to our focus on developing campaigns for targeted customers as well as increased revenue from greater levels of contextually-relevant advertising. E-commerce revenue increased due to an increase in orders from our customer base in this segment. Software revenue increased due to increased sales to existing customers as well as an increase in the number of customers to whom we have licensed SFEE.

Net revenue increased in fiscal 2005 as compared to fiscal 2004 primarily due to increased revenue from our Software and E-commerce businesses, offset by a decrease in our Online Media business and other revenue derived from our previous hardware business. Software revenue increased due to an increase in the number of customers to whom we have licensed SFEE. E-commerce revenue increased due to an increase in our customer base related to this segment.

Our sales continue to be primarily attributable to customers located in the United States of America.

Our net income (loss) from continuing operations was $1.3 million, ($5.6) million and ($8.3) million during fiscal years 2006, 2005 and 2004, respectively, or basic and diluted income (loss) of $0.02, ($0.09) and ($0.14), respectively, per share.

Critical Accounting Policies

Accounting policies, methods and estimates are an integral part of the consolidated financial statements prepared by management and are based upon management’s current judgments. Those judgments are normally based on knowledge and experience with regard to past and current events and assumptions about future events. Certain accounting policies, methods and estimates are particularly sensitive because of their significance to the financial statements and because of the possibility that future events affecting them may differ markedly from management’s current judgments. While there are a number of accounting policies, methods and estimates affecting our financial statements, areas that are particularly significant include revenue recognition policies, the assessment of impairment of long-lived assets, restructuring reserves for excess facilities for non-cancelable leases, income taxes, and contingencies and litigation.

Revenue Recognition

Online Media Revenue

Online Media revenue is derived from the sale of advertising space on our various web sites. We recognize Online Media revenue over the period in which the advertisements are displayed, provided that persuasive evidence of an arrangement exists, no significant obligations remain, the fee is fixed or determinable, and collection of the receivable is reasonably assured. Our obligations typically include guarantees of a minimum number of “impressions” (times that an advertisement is viewed by users of our online services). To the extent that minimum guaranteed impressions are not met in the specified time frame, we do not recognize the corresponding revenue until the guaranteed impressions are achieved. Since fiscal 2004, we have not had any significant barter transactions. Prior to the fiscal year ended July 31, 2004, we recorded barter revenue transactions at their estimated fair value based on our historical experience of selling similar advertising for cash in accordance with Emerging Issues Task Force (“EITF”) Issue 99-17, “Accounting for Advertising Barter Transactions.” We broadcast banner advertising in exchange for similar banner advertising on third-party web sites. Our barter arrangements are documented with our standard customer insertion order (and accompanying terms and conditions) or, in certain limited instances, via an alternative written contract negotiated between the parties. The standard terms and conditions include, but are not limited to, the web sites for each company that will display the impressions, the time frame that the impressions will be displayed, and the number, type and size of impressions to be delivered.

E-commerce Revenue

E-commerce revenue is derived from the online sale of consumer goods. We recognize E-commerce revenue from the sale of consumer goods in accordance with SEC Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition.” Under SAB 104, product revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sale price is fixed or determinable, and collectibility is reasonably assured. In general, we recognize E-commerce revenue upon the shipment of goods. We grant customers a right to return E-commerce products. Such returns are recorded as incurred and have been immaterial for the periods presented.

Software Revenue

Software revenue consists principally of fees for licenses of our SFEE software products, maintenance, consulting and training. We recognize all software revenue using the residual method in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition with Respect to Certain Transactions” and Emerging Issues Task Force 00-21 “Revenue Arrangements with Multiple Deliverables.” Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If evidence of the vendor-specific fair value of one or more undelivered elements does not exist, revenue is deferred and recognized when delivery of those elements occurs or when fair value can be established. Company-specific objective evidence of fair value of maintenance and other services is based on our customary pricing for such maintenance and/or services when sold separately. At the outset of the arrangement with the customer, we defer revenue for the fair value of its undelivered elements (e.g., maintenance, consulting and training) and recognize revenue for the remainder of the arrangement fee attributable to the elements initially delivered in the arrangement (i.e., software product) when the basic criteria in SOP 97-2 have been met. If such evidence of fair value for each undelivered element of the arrangement does not exist, we defer all revenue from the arrangement until such time that evidence of fair value does exist or until all elements of the arrangement are delivered.

Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, (iv) collectibility is probable and (v) the arrangement does not require services that are essential to the functionality of the software.

Persuasive evidence of an arrangement exists. We determine that persuasive evidence of an arrangement exists with respect to a customer when we have a written contract, which is signed by both us and the customer, or a purchase order from the customer when the customer has previously executed a standard license arrangement with us. We do not offer product return rights for our Software products.

Delivery has occurred. Our software may be either physically or electronically delivered to the customer. We determine that delivery has occurred upon shipment of the software pursuant to the billing terms of the agreement or when the software is made available to the customer through electronic delivery.

The fee is fixed or determinable. If at the outset of the customer engagement we determine that the fee is not fixed or determinable, we recognize revenue when the fee becomes due and payable. Fees due under a contract are generally deemed not to be fixed or determinable if a significant portion of the fee is beyond our normal payment terms, which are generally no greater than 120 days from the date of invoice.

Collectibility is probable. We determine whether collectibility is probable on a case-by-case basis. When assessing probability of collection, we consider the number of years in business, history of collection, and product acceptance for each customer. We typically sell to customers, for whom there is a history of successful collection. New customers are subject to a credit review process, in which we evaluate the customer’s financial position and ultimately such customer’s ability to pay. If we determine from the outset that collectibility is not probable based upon our review process, revenue is recognized as payments are received.

We allocate revenue on software arrangements involving multiple elements to each element based on the relative fair value of each element. Our determination of fair value of each element in multiple-element arrangements is based on vendor-specific objective evidence (“VSOE”). We align our assessment of VSOE for each element to the price charged when the same element is sold separately. We have analyzed all of the elements included in our multiple-element arrangements and determined that we have sufficient VSOE to allocate revenue to the maintenance, support and professional services components of our perpetual license arrangements. We sell our professional services separately, and have established VSOE for professional services on that basis. VSOE for maintenance and support is determined based upon the customer’s annual renewal rates for these elements. Accordingly, assuming all other revenue recognition criteria are met, we recognize revenue from perpetual licenses upon delivery using the residual method in accordance with SOP 98-9.

Services revenue consists of professional services, hosting and maintenance fees. In general, our professional services, which are comprised of software installation and integration, business process consulting and training, are not essential to the functionality of our software products. Our software products are fully functional upon delivery and implementation and do not require any significant modification or alteration for customer use. Customers purchase our professional services to facilitate the adoption of our technology and dedicate personnel to participate in the services being performed, but they may also decide to use their own resources or appoint other professional service organizations to provide these services. Software products are billed separately from professional services, which are generally billed on a time-and-materials basis. We recognize revenue from professional services as services are performed. Our customers’ software may be hosted at a third-party hosting location, upon request by our customers. Hosting fees are recognized as the hosting services are performed.

Maintenance agreements are typically priced based on a percentage of the product license fee and have a one-year term, renewable annually. Services provided to customers under maintenance agreements include technical product support and unspecified product upgrades. Deferred revenue from advanced payments for maintenance agreements is recognized ratably over the term of the agreement, which is typically one year.

We expense all manufacturing, packaging and distribution costs associated with software license sales as cost of license revenue.

Impairment of Long-Lived Assets

We continually evaluate whether events and circumstances have occurred that indicate the remaining estimated useful life of long-lived assets may warrant revision or that the remaining balance of long-lived assets may not be recoverable in accordance with Statement of Financial Accounting Standards “SFAS” No. 144, “Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of.” When factors indicate that long-lived assets should be evaluated for possible impairment, we use an estimate of the related undiscounted future cash flows over the remaining life of the long-lived assets in measuring whether they are recoverable. If the estimated undiscounted future cash flows exceed the carrying value of the asset, a loss is recorded as the excess of the asset’s carrying value over fair value. Long-lived assets and certain identifiable intangible assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.

Restructuring Costs and Other Special Charges

As discussed in Note 3 of the notes to the consolidated financial statements, we have recorded significant restructuring charges in connection with exiting our hardware systems, managed services, and professional services and Linux software engineering services businesses during the fiscal years ended 2002 and 2001. A significant portion of these charges related to excess facilities, which were subject to non-cancelable leases or other costs relating to the abandonment or disposal of property and equipment. During the third quarter of fiscal 2004 the Company relocated its Fremont, California headquarters to a smaller building in the same complex. In addition, during the third quarter of fiscal 2004, the Company reached an agreement in principal to sublet unoccupied portions of properties that it leases in Fremont, California and Sunnyvale, California. As a result of the change in circumstances, original accruals were reevaluated and adjusted accordingly. In the second quarter of fiscal 2005, a minor credit adjustment of $0.1 million was recorded to accurately reflect the current common area maintenance fees associated with the Fremont facilities. All charges as a result of restructuring activities have been recorded in accordance with Emerging Issues Task Force “EITF” 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs incurred in a Restructuring)”. Restructuring charges recorded in fiscal 2004 and 2005 were considered adjustments to the original restructuring plans, therefore, Statements of Financial Accounting Standards “SFAS” No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” was not applicable. The remaining accrual from non-cancelable lease payments is based on current circumstances. These accruals are subject to change should actual circumstances change. We will continue to evaluate and update, if applicable, these accruals quarterly.

Income Taxes

We are required to estimate our income taxes in each of the jurisdictions in which we operate as part of the process of preparing our consolidated financial statements. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets or liabilities. We must then assess the likelihood that our net deferred tax assets will be recovered from future taxable income and to the extent that we believe recovery is not likely, we must establish a valuation allowance. While we have considered future taxable income in assessing the need for the valuation allowance, in the event that we were to determine that we would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset valuation allowance would be made, increasing income in the period in which such determination was made.

Contingencies and Litigation

We are subject to proceedings, lawsuits and other claims. We assess the likelihood of any adverse judgments or outcomes to these matters as well as ranges of probable losses. A determination of the amount of loss contingency required, if any, is assessed in accordance with SFAS No. 5, “Contingencies and Commitments” and recorded if probable after careful analysis of each individual matter. The required loss contingencies may change in the future as the facts and circumstances of each matter change.

Results of Operations

We believe that the application of accounting standards is central to a company’s reported financial position, results of operations and cash flows. We review our annual and quarterly results, along with key accounting policies, with our audit committee prior to the release of financial results. In addition, we have not entered into any significant transactions with related parties. We do not use off-balance-sheet arrangements with unconsolidated related parties, nor do we use other forms of off-balance-sheet arrangements such as research and development arrangements.

The following table sets forth our operating results for the periods indicated as a percentage of net revenue, represented by selected items from the consolidated statements of operations. This table should be read in conjunction with the consolidated financial statements and the accompanying notes included in this Form 10-K.

	For the Year Ended July 31,

	2006			2005			2004

Consolidated Statements of Operations Data:
Online Media revenue		30.3	%		26.6	%		35.5	%
E-commerce revenue		46.8			48.7			46.0
Software revenue		22.9			24.7			18.3
Other revenue		—			—			0.2

Net revenue		100.0	%		100.0	%		100.0	%

Online Media cost of revenue		8.6			10.8			10.9
E-commerce cost of revenue		35.8			37.9			37.4
Software cost of revenue		3.1			3.4			6.8

Cost of revenue		47.5			52.1			55.1

Gross margin		52.5			47.9			44.9

Operating expenses:
Sales and marketing		22.8			32.1			36.2
Research and development		14.2			18.8			23.2
General and administrative		16.3			18.6			16.2
Impairment of Long Lived Assets		—			0.3			—
Restructuring costs and other special charges		—			(0.3	)		11.7
Amortization of deferred stock compensation		—			—			0.1

Total operating expenses		53.3			69.5			87.4

Loss from operations		(0.8	)		(21.6	)		(42.5	)
Interest and other income, net		3.8			3.1			12.3

Income (loss) from continuing operations		3.0	%		(18.5	)%		(30.2	)%

Net Revenue

	Year Ended July 31,						% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006		2005		2004

Software revenue	$	9,974	$	7,555	$	4,995		32	%		51	%
Online Media revenue		13,242		8,130		9,728		63	%		(16	)%
E-commerce revenue		20,416		14,918		12,567		37	%		19	%
Other revenue		—		—		49		NM			(100	)%

Net revenue	$	43,632	$	30,603	$	27,339		43	%		12	%

Net revenue increased during fiscal 2006 as compared to fiscal 2005 due primarily to increased revenue from our Online Media, E-commerce and Software businesses.

Net revenue increased during fiscal 2005 as compared to fiscal 2004 due primarily to increased revenue from our E-commerce and Software businesses, offset by a decrease in our Online Media revenue and other revenue derived from our previous hardware business.

Sales for the fiscal years ended 2006, 2005, and 2004 were primarily to customers located in the United States of America.

For the fiscal years ended July 31, 2006, 2005, and 2004, respectively no one customer represented 10% or greater of net revenue. Going forward, we do not anticipate that any one customer will represent more than 10% of net revenue.

Online Media Revenue

	Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006			2005			2004

Online Media revenue	$	13,242		$	8,130		$	9,728			63	%		(16	)%
Percentage of total net revenue		30	%		27	%		36	%

Online Media revenue is primarily derived from cash sales of advertising space on our various web sites, as well as royalty related arrangements and contextually-relevant advertising associated with advertising on these web sites. During fiscal 2004, Online Media revenue also included $1.4 million of barter revenue. There was no barter revenue in fiscal 2006 or 2005.

	Year Ended July 31,						% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006		2005		2004

Cash advertising	$	9,193	$	5,805	$	6,744		58	%		(14	)%
Barter advertising		—		—		1,427		0	%		(100	)%
Sponsorships		739		390		715		89	%		(45	)%
Donations		17		32		412		(47	)%		(92	)%
Other revenue		3,293		1,903		430		73	%		343	%

Online Media revenue	$	13,242	$	8,130	$	9,728		63	%		(16	)%

Cash advertising revenue is derived from advertisements or services delivered to advertisers. Such advertisements may be in the form of an advertising impression, a click, the display of a text link, the download of a file or the collection of some data, generally a lead. We measure our advertising revenue using the number of impressions displayed and the average CPM rate (i.e., the average rate at which we receive revenue per 1,000 banner advertisements (impressions) we display to users of our online services) charged for the impressions delivered.

Sponsorship revenue is derived from web marketing programs that are used to increase brand awareness. Revenue related to sponsorships is recognized ratably over the term of the marketing program or in conjunction with the delivery requirements set forth in the contract. The increase in sponsorship revenue in fiscal 2006 as compared to fiscal 2005 is due to new customers participating in our sponsorship and powerbar offerings. Sponsorship revenue in fiscal 2005 and 2004 relates to certain contracts with one customer, International Business Machines Corp. (“IBM”). The decrease in sponsorship revenue in fiscal 2005 as compared to fiscal 2004 was due to the expiration of one of those IBM contracts in the fourth quarter of fiscal 2004.

Other revenue consists primarily of paid search, contextually-relevant advertising and referral fees.

Barter advertising revenue was derived from banner advertising delivered in exchange for similar banner advertising on third-party web sites. Since July 31, 2004, we have not had any significant barter transactions. Prior to our fiscal year ended July 31, 2004, we recorded barter revenue transactions at their estimated fair value based on our historical experience of selling similar advertising for cash.

	Year Ended July 31,						% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

	2006		2005		2004

Cash advertising (in thousands)	$	9,193	$	5,805	$	6,744		58	%		(14	)%
Impressions delivered		473,920		538,151		1,162,028		(12	)%		(54	)%
Average CPM rate	$	19.40	$	10.79	$	5.80		80	%		86	%

The increase in cash advertising revenue during fiscal 2006 as compared to fiscal 2005 was due to an increase in the average CPM rate, offset by the lower number of impressions delivered. The increase in the average CPM rate was the result of targeted customer programs allowing for higher CPM rates to several large customers, while the decrease in the number of impressions delivered was primarily due to an increased focus on selling higher CPM campaigns and reduced sales to an individually-significant customer who received a volume discount.

The decrease in cash advertising revenue during fiscal 2005 as compared to fiscal 2004 was due to a significant decrease in the number of impressions delivered, offset by a substantial increase in the average contract CPM rate. The decrease in the number of impressions delivered was primarily due to the decline in online advertising associated with an individually significant customer who had received a volume discount. The increase in average CPM rates was the result of the decline in advertising associated with this individually significant customer, which drove the average CPM rate for fiscal 2004 down. In fiscal 2005, this customer represented only 4% of total cash advertising revenue. However, in fiscal 2004, this same customer represented 29% of cash advertising revenue.

We believe that our prominent position in serving the growing open source software and Linux markets, along with our favorable online visitor demographics, make us an attractive advertising vehicle for advertising customers.

E-commerce Revenue

	Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

	2006			2005			2004

E-commerce revenue (in thousands)	$	20,416		$	14,918		$	12,567			37	%		19	%
Percentage of total net revenue		47	%		49	%		46	%
Number of Orders (per year)		316,060			235,375			201,542			34	%		17	%
Average order size (in dollars)	$	64.60		$	63.38		$	62.35			2	%		2	%

E-commerce revenue is derived from the online sale of consumer goods, including shipping, net of any returns and allowances.

The growth in E-Commerce revenue in fiscal 2006 and 2005 was primarily due to increased consumer awareness of our web site as a result of a broader product offering which attracted a larger customer base, as well as web site enhancements and affiliate programs that drove more traffic to our web site. As a result of our efforts we experienced a 34% and 17% increase in the number of orders placed during fiscal 2006 and 2005, respectively. The average order size has not changed significantly from fiscal 2005 to fiscal 2006.

We expect E-commerce revenue to continue to grow as our E-commerce customer base grows.

Software Revenue

	Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006			2005			2004

Software revenue	$	9,974		$	7,555		$	4,995			32	%		51	%
Percentage of total net revenue		23	%		25	%		18	%
Aggregate # of customers sold to		164			130			97			26	%		34	%
Avg. contract value	$	129		$	106		$	75			22	%		41	%

Software revenue consists principally of fees for licenses of our SFEE software products, maintenance, hosting, consulting and training.

The growth during fiscal 2006 was primarily related to increased licensing revenue of $0.8 million, maintenance revenue of $0.8 million, hosting related revenue of $0.4 million and professional services of $0.4 million. We increased the number of customers to whom we have licensed SFEE to 164 and increased our average value of contracts sold during fiscal 2006 to $129,000. This is compared to 130 customers to whom we had licensed SFEE with an average value of contracts sold during fiscal 2005 of $106,000.

The growth in Software revenue during fiscal 2005 was primarily related to the SFEE licensing and maintenance components of revenue. We increased the number of customers to whom we have licensed SFEE to 130 and increased our average value of contracts sold during fiscal 2005 to $106,000. This is compared to 97 customers to whom we had licensed SFEE with an average value of contracts sold during fiscal 2004 of $75,000.

We expect Software revenue to continue to increase as we add new customers and we grow our returning customer base.

Other Revenue

	For the Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006			2005			2004

Other revenue	$	—		$	—		$	49			0	%		(100	)%
Percentage of total net revenue		0.0	%		0.0	%		0.2	%

Other revenue was derived from our former hardware and related customer support and professional services businesses. The decrease in other revenue in fiscal 2005 is the direct result of exiting these former businesses. We do not expect any such other revenue in the future.

Cost of Revenue/Gross Margin

	Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006			2005			2004

Cost of revenue	$	20,671		$	15,939		$	15,042			30	%		6	%
Gross margin		22,961			14,664			12,297			57	%		19	%
Gross margin %		53	%		48	%		45	%

Cost of revenue consists of personnel costs and related overhead associated with developing and delivering external content for our media sites and with providing software professional services, cost of equipment used for delivering our media content and product costs associated with our E-commerce business.

Gross margins increased in all business segments in fiscal 2006 as compared to fiscal 2005.

Cost of Revenue/Gross Margin by Segment

Online Media Cost of Revenue/Gross Margin

	Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006			2005			2004

Online Media cost of revenue	$	3,732		$	3,320		$	2,969			12	%		12	%
Online Media gross margin		9,510			4,810			6,759			98	%		(29	)%
Online Media gross margin%		72	%		59	%		69	%

Online Media cost of revenue consists of personnel costs and related overhead associated with developing the editorial content of our sites and personnel and related overhead, equipment and bandwidth associated with delivering our media content.

The increase in Online Media gross margin percentages for fiscal 2006 as compared to fiscal 2005 was primarily due to the 63% increase in Online Media revenue, partially offset by slightly higher cost of revenue of $0.4 million. The increase in cost of revenue was primarily due to an increase in the cost of our outsourcing our advertising serving system of $0.2 million and an increase in personnel overhead costs related to editorial content of $0.2 million.

The decrease in Online Media gross margin percentages for fiscal 2005 as compared to fiscal 2004 was primarily driven by the increase in Online Media cost of revenue on lower overall revenue volumes, primarily due to our elimination of our revenue generating barter programs. The increase in cost of revenue was primarily due to an increase in personnel costs related to editorial content contractors of $0.2 million and an increase in corporate overhead facilities costs of $0.2 million as a result of consolidating operations, offset by bandwidth costs associated with delivering advertising of $0.1 million and a decrease in depreciation expense.

We expect Online Media cost of revenue to increase in absolute dollars to support increased Online Media revenue and we expect Online Media gross margins to increase slightly as revenue grows.

E-commerce Cost of Revenue/Gross Margin

	Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006			2005			2004

E-commerce cost of revenue	$	15,605		$	11,591		$	10,225			35	%		13	%
E-commerce gross margin		4,811			3,327			2,342			45	%		42	%
E-commerce gross margin%		24	%		22	%		19	%

E-commerce cost of revenue consists of product costs, shipping and fulfillment costs and personnel and related overhead associated with the operations and merchandising functions.

E-commerce gross margin percentages increased for fiscal 2006 as compared to fiscal 2005. E-commerce cost of revenue in fiscal 2006 increased as compared to fiscal 2005 consistent with increased E-commerce revenue levels; however, merchandising expenses increased at a lower rate than the increase in revenue, resulting in a slight improvement in gross margin percentage. The increase in E-commerce cost of revenue in absolute dollars in fiscal 2006 as compared to fiscal 2005 was primarily due to increased product costs of $2.5 million, fulfillment costs of $0.6 million, shipping costs of $0.5 million, affiliate commission of $0.2 million and merchandising costs of $0.2 million. The increase in product costs was the result of increased E-commerce revenue levels. The increase in fulfillment costs was due to increased third party fulfillment costs resulting from an increased number of orders, increased levels of inventory managed during fiscal 2006 and increased rates charged by the fulfillment house. The increase in shipping costs was partially related to increased revenue levels and fuel surcharges, partially offset by lower shipping rates. The increase in affiliate commission is due to increased revenue levels. The increase in merchandising costs was due to increased personnel and related overhead costs to increase the range of our product offering.

E-commerce gross margin percentages increased for fiscal 2005 as compared to fiscal 2004 as a result of higher product margins due to product mix, offset by a slight deterioration in shipping and fulfillment margins. The increase in E-commerce cost of revenue in absolute dollars in fiscal 2005 as compared to fiscal 2004 was primarily due to increased product costs of $0.6 million, shipping costs of $0.6 million and fulfillment costs of $0.2 million. The increase in product costs was the result of increased E-commerce revenue levels. The increase in shipping costs was partially related to increased revenue levels and partially due to rate increases and fuel surcharges by both UPS and DHL. The increase in fulfillment costs was partially related to increased revenue levels and partially due to the transition associated with changing our third-party fulfillment partner in the later part of the fourth quarter of fiscal year 2004.

We expect E-commerce cost of revenue in absolute dollars to increase proportionately with E-commerce revenue. In addition, we expect E-commerce overall gross margins to continue to improve slightly as volume grows.

Software Cost of Revenue/Gross Margin

	Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006			2005			2004

Software cost of revenue	$	1,334		$	1,028		$	1,860			30	%		(45	)%
Software gross margin		8,640			6,527			3,135			32	%		108	%
Software gross margin %		87	%		86	%		63	%

Software cost of revenue consists of personnel and related overhead costs and outside service provider costs associated with delivering software, customer hosting, support and professional services.

Software gross margin percentage for fiscal 2006 increased 1% as compared to fiscal 2005. The increase in gross margin was primarily the result of increased revenue of $2.4 million, offset by increased cost of revenue of $0.3 million. The increase in cost of revenue is primarily related to increased costs of providing services to customers and costs associated with hosting customer installations.

The increase in our Software gross margin percentages for fiscal 2005 as compared to fiscal 2004 was primarily the result of lower outside contractor costs, decreased personnel costs due to a decrease in headcount and leveraging our fixed personnel costs while increasing revenue levels. The increased margin associated with lower outside contractor costs accounted for $0.3 million. The increased margin associated with decreased personnel accounted for $0.2 million, and the increased margin associated with leveraging our fixed personnel costs accounted for $0.3 million.

We expect Software cost of revenue to increase as we increase our support and professional services organization to support our expanding customer base. We also expect our Software gross margin to fluctuate depending on the license, support and services components of Software revenue.

Operating Expenses

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of personnel and related overhead expenses, including sales commission, for personnel engaged in sales, marketing and sales support functions, as well as costs associated with trade shows, advertising and promotional activities.

	Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006			2005			2004

Sales and Marketing	$	9,968		$	9,828		$	9,910			1	%		(1	)%
Percentage of total net revenue		23	%		32	%		36	%
Headcount		32			35			30

The slight increase in absolute dollars spent on sales and marketing in fiscal 2006 as compared to 2005 was primarily related to an increase in commission of $0.7 million and an increase in credit card fees associated with our E-commerce business of $0.2 million, partially offset by lower payroll and severance costs of $0.4 million and lower consulting expenses of $0.1 million, lower recruiting fees of $0.1 million and lower discretionary marketing expenses of $0.1 million. The increase in commission expense was a direct result of increased revenue across the Software and Online Media businesses. The increase in credit card fees was directly related to the year-over-year increase in our E-commerce business. The lower expenses for payroll and severance were a result of lower headcount in fiscal 2006 as compared with fiscal 2005 and no severance expense having been recorded in fiscal 2005. Lower consulting expenses was a result of our discontinued use of a sales consultant for our Software segment, lower recruiting fees were due to fewer new hires and lower discretionary marketing expenses were primarily due to lower levels of research and online advertising in our Online Media segment. The decrease in sales and marketing expenses as a percentage of net revenue was primarily due to increased revenue levels.

The slight decrease in absolute dollars spent on sales and marketing in fiscal 2005 as compared to fiscal 2004 was primarily related to a decrease in our Online Media marketing expense of $1.4 million related to barter, offset by increases in employee expenses of $0.8 million, commission expenses of $0.3 million, credit card fees of $0.1 million and marketing expense of $0.2 million. The decline in our barter marketing expense was due to the elimination of our revenue generating barter related programs in the first quarter of fiscal 2005. The $0.8 million increase in employee expense was primarily related to an increase in headcount. The $0.3 million in commission expense was a direct result of increased revenue related to our Software segment. The increase in credit card fees was related to our E-commerce segment and was the result of increased sales volumes. The increase in marketing expense was related to public relations for our Online Media segment. The decrease as a percentage of net revenue was due to increased revenue levels.

We believe that our sales and marketing expenses in absolute dollars will increase in the future as we intend to grow our sales force. However, in the future, we expect sales and marketing expenses to decrease slightly as a percentage of revenue.

Research and Development Expenses

Research and development (“R&D”) expenses consist primarily of personnel and related overhead expenses for software engineers involved in our Online Media and Software segments. We expense all of our research and development costs as they are incurred.

	Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006			2005			2004

Online Media R&D	$	2,767		$	1,799		$	1,541			54	%		17	%
E-commerce R&D		247			234			178			6	%		31	%
Software R&D		3,183			3,726			4,635			(15	)%		(20	)%

Total Research & Development	$	6,197		$	5,759		$	6,354			8	%		(9	)%

Percentage of total net revenue		14	%		19	%		23	%
Headcount		35			32			32

The increase in research and development expenses in absolute dollars in fiscal 2006 compared to fiscal 2005 was primarily due to increases in Online Media research and development expenses, offset in part by decreases in Software expenses. The increase in Online Media expenses is primarily related to increased personnel and related overhead expenses and increased contractor expenses related to enhancements of the performance of our SourceForge.net web site. Personnel and related overhead expenses, including allocated facility expenses, increased approximately $0.7 million as a result of five additional employees and contractor expenses increased $0.1 million. The decrease in Software expenses is related to a decrease in employee-related expenses of $0.3 million due to a decline in headcount and lower consulting expenses of $0.2 million resulting primarily from the lower use of a contractor. The decrease as a percentage of net revenue was primarily due to our spending levels increasing at a lower rate than our revenue growth. We expect research and development expenses to increase in absolute dollars, but not change significantly as a percentage of revenue in the future.

The decrease in absolute dollars in fiscal 2005 as compared to fiscal 2004 was primarily due to a decrease in allocated facility expenses of $0.6 million. The decrease in allocated facility expenses was primarily related to rent and depreciation. Rent expense decreased in fiscal 2005 as compared to fiscal 2004 as a result of our moving into a smaller facility late in the third quarter of fiscal 2004. Depreciation expense decreased in fiscal 2005, due to our moving into the smaller facility and writing off the remaining assets associated with the larger facility occupied in fiscal 2004. The decrease as a percentage of net revenue was primarily due to our decreased spending levels as described above as well as increased revenue levels.

In accordance with SFAS No. 86, “Accounting for the Cost of Computer Software to be Sold, Leased, or Otherwise Marketed,” development costs incurred in the research and development of new software products are expensed as incurred until technological feasibility in the form of a working model has been established, at which time such costs are capitalized, subject to a net realizable value evaluation. Technological feasibility is established upon the completion of an integrated working model. To date, our software development has been completed concurrent with the establishment of technological feasibility and, accordingly, all software development costs have been charged to research and development expense in the accompanying consolidated statements of operations. Going forward, should technological feasibility occur prior to the completion of our software development, all costs incurred between technological feasibility and software development completion will be capitalized.

General and Administrative Expenses

General and administrative expenses consist of personnel and related expenses for finance and administrative personnel, bad debt and professional fees for accounting and legal services.

	Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006			2005			2004

General & Administrative	$	7,115		$	5,686		$	4,421			25	%		29	%
Percentage of total net revenue		16	%		19	%		16	%
Headcount		19			18			19

The increase in general and administrative expenses in absolute dollars in fiscal 2006 as compared to fiscal 2005 was primarily related to stock-based compensation expense of $0.5 million, increased bonus expense of $0.5 million, increased personnel and related overhead expenses of $0.3 million, Board of Director expenses of $0.2 million, contractor expenses of $0.1 million, recruiting fees of $0.1 million and higher bad debt expenses of $0.2 million, resulting from increased revenue levels, partially offset by decreased accounting fees of $0.4 million, relating from lower fees associated with our second year of compliance with the Sarbanes-Oxley Act of 2002 and lower legal fees of $0.2 million. The decrease in general and administrative expense as a percentage of net revenue was primarily due to the increase in revenue. We expect general and administrative expenses to increase from fiscal 2006 levels in absolute dollars and decrease as a percentage of revenue in the future.

The increase in general and administrative expenses in fiscal 2005 as compared to fiscal 2004 was primarily related to the reversal of legal expenses in the first quarter of fiscal 2004 of $1.2 million, $0.9 million of which was associated with the IPO Securities Litigation that was ultimately paid by one of our insurers and $0.3 million of which related to a lawsuit that was favorably resolved. Excluding these reversals, general and administrative expenses increased slightly in fiscal 2005 as compared to fiscal 2004. The increase, excluding reversals of legal expenses, was primarily related to increased accounting fees, offset by decreased employee expenses, recruiting expenses and allocated facility expenses. The increase in accounting fees of $0.9 million was due to additional costs associated with complying with the Sarbanes-Oxley Act of 2002. The decrease in employee expenses of $0.3 million was associated with lower bonuses earned in fiscal 2005 as compared with those earned in fiscal 2004. The decrease in recruiting expenses of $0.2 million was associated with the placement fee for one of the company’s executives in the second and third quarters of 2004. The decrease in allocated facility expenses of $0.5 million was primarily related to rent and depreciation. Rent expense has decreased for fiscal 2005 as compared to fiscal 2004 as a result of moving into a smaller facility late in the third quarter of fiscal 2004. Depreciation expense has decreased as well due to moving into the smaller facility and writing off the remaining assets associated with the larger facility occupied in fiscal 2004. The increase as a percentage of net revenue was primarily due to our increased expense levels as described above.

Restructuring Costs and Other Special Charges

In fiscal 2001 and 2002, we adopted plans to exit our hardware systems and hardware-related software engineering and professional services businesses, as well as exit a sublease agreement and to reduce our general and administrative overhead costs. We exited these activities to pursue our current Online Media, E-commerce and Software businesses and reduce our operating losses to improve cash flow. We recorded restructuring charges of $168.5 million related to exiting these activities, including charges related to excess facilities from non-cancelable leases. During the third quarter of fiscal 2004, we relocated our Fremont, California headquarters to a smaller building in the same complex. As a result of the change in circumstances, original accruals were reevaluated and we accordingly recorded a restructuring charge of $2.9 million. Included in the $2.9 million dollar restructuring charge was $2.5 million of expense related to writing off leasehold improvements and fixed assets and an additional $0.4 million expense related to excess facilities from non-cancelable leases. In addition, during the third quarter of fiscal 2004, we reached agreements in principle to sublet unoccupied portions of properties that we leased in Sunnyvale, California and lease in Fremont, California, which were finalized in the fourth quarter of fiscal 2004. As a result of the change in circumstances due to the agreement in principle, original accruals were reevaluated and we accordingly recorded a restructuring charge of $0.3 million in the third quarter of fiscal 2004. The $3.2 million total charge to restructuring expenses in fiscal 2004 was recorded in the consolidated statement of operations for that period. In the second quarter of fiscal 2005, a minor credit adjustment of $0.1 million was recorded to accurately reflect the current common area maintenance fees associated with the Fremont facilities. The remaining accrual from non-cancelable lease payments, which continue through 2010, is based on current circumstances. These accruals are subject to change should actual circumstances change. We will continue to evaluate and update, if applicable, these accruals quarterly. As of July 31, 2006, we had an accrual of approximately $6.1 million outstanding related to these non-cancelable leases, all of which was originally included in operating expenses.

All charges as a result of restructuring activities have been recorded in accordance with Emerging Issues Task Force “EITF” 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs incurred in a Restructuring)”. Restructuring charges recorded in fiscal 2004 were considered adjustments to the original restructuring plans, therefore, Statements of Financial Accounting Standards “SFAS” No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” was not applicable.

Below is a summary of the changes to the restructuring liability (in thousands):

Changes in the total accrued restructuring liability	Balance at Beginning of Period		Charged to Costs and Expenses			Deductions			Balance at End of Period

For the year ended:
July 31, 2004	$	14,889	$	713		$	(4,319	)	$	11,283
July 31, 2005	$	11,283	$	(101	)	$	(3,327	)	$	7,855
July 31, 2006	$	7,855	$	—		$	(1,748	)	$	6,107

Components of the total accrued restructuring liability	Short Term		Long Term		Total Liability

As of July 31, 2004	$	3,440	$	7,843	$	11,283
As of July 31, 2005	$	1,748	$	6,107	$	7,855
As of July 31, 2006	$	1,592	$	4,515	$	6,107

Amortization of Deferred Stock Compensation

In connection with the grant of stock options to employees during fiscal 1999 and prior to our initial public offering in fiscal 2000, we recorded deferred stock compensation within stockholders’ equity that was amortized on an accelerated basis in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”) 28 over the vesting period for the individual award. The amortization expense relates to options awarded to employees in all operating expense categories, however, the amortization of deferred stock compensation has not been separately allocated to these categories. We expensed deferred stock compensation of $20,000 for fiscal 2004. Deferred stock compensation was fully amortized as of July 31, 2004. As such, there was no deferred stock compensation expense during fiscal 2006 and 2005.

Share-Based Compensation Expense

In December 2004, the FASB issued SFAS 123—revised 2004 (“SFAS 123R”), “Share-Based Payment” which requires the measurement of all share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in our consolidated statements of income. We have adopted the provisions of SFAS 123R effective August 1, 2005 (the beginning of our fiscal 2006). Prior to August 1, 2005, we accounted for stock option using SFAS 123. During fiscal 2006, we recognized $0.7 million in compensation expense related to options granted to employees and directors. At July 31, 2006, total compensation cost related to nonvested stock options not yet recognized was $5.3 million which is expected to vest over a weighted-average term of 3.7 years.

On June 8, 2005, our Compensation Committee of the Board of Directors approved the vesting acceleration of certain unvested, out-of-the-money stock options outstanding under our employee stock option plans, effective June 7, 2005. Vesting was accelerated for stock options that had exercise prices greater than $1.67 per share, which was the closing price of our common stock on June 7, 2005. This action was taken to reduce the impact of future compensation expense that we would otherwise be required to recognize in future consolidated statements of operations pursuant to SFAS 123R, which was applicable to us beginning in the first fiscal quarter of 2006. As a result of the acceleration, we estimate a reduction in future compensation expense by approximately $8.1 million over fiscal years 2006, 2007 and 2008.

Intangible Assets

Intangible assets are amortized on a straight-line basis over three to five years. Intangible asset amortization of $4,000, $12,000 and $12,000 was recorded in fiscal 2006, 2005 and 2004, respectively. The intangible asset carrying value at July 31, 2006 was $4,000 and related to domain and trade names associated with our current Software and OSTG businesses. This balance has been included in “Other Assets” in the Consolidated Balance Sheets. We continually evaluate whether events or circumstances have occurred that indicate the remaining estimated useful lives of these intangible assets may not be recoverable. No events or circumstances occurred during fiscal 2006 that would indicate a possible impairment in the carrying value of intangible assets at July 31, 2006.

Remeasurement of Warrant Liability, Interest and Other Income, Net

On November 6, 2003, we entered into a securities purchase agreement in which we completed a private placement of 3,529,412 shares of our common stock with The Riverview Group LLC (“Riverview”) at an issue price of $4.25 per share for aggregate proceeds of approximately $15 million (the “Private Placement”). In connection with the Private Placement, the Company retained Wharton Capital Partners Ltd. (“Wharton”) to act as a financial consultant and placement agent. Also in connection with the Private Placement, Riverview and Wharton received three-year warrants to purchase a total of 705,883 and 25,000 shares of our common stock, respectively, at an exercise price of $6.00 and $6.14 per share, respectively (collectively, the “Warrants”). We entered into a registration rights agreement with Riverview on November 6, 2003 (the “Registration Rights Agreement”) in which we agreed to provide certain registration rights under the Securities Act of 1933, as amended and the rules and regulations promulgated thereunder, and applicable state securities laws with respect to the common stock and the Warrants issued to Riverview.

Pursuant to the terms of the Registration Rights Agreement, we filed a registration statement (the “Registration Statement”) on Form S-3 in order to register the common stock and Warrants issued in the Private Placement. The SEC declared the Registration Statement effective on April 30, 2004. Before the effective date of the Registration Statement, the shares of our common stock sold in the Private Placement and the shares of our common stock underlying the Warrants did not have the same rights as the other shares which were included in the Equity section of the Consolidated Balance sheet. Therefore, the shares of our common stock sold in the Private Placement and the shares of our common stock underlying the Warrants were classified as liabilities on the Consolidated Balance sheet. Liabilities must be reported at fair value as of the balance sheet date. Initially the Warrants were valued as of November 6, 2003, and were revalued on January 31, 2004 using the Black-Scholes valuation model and then, on April 30, 2004, the effective date of the Registration Statement, revalued again using the same Black-Scholes valuation model. As a result of these remeasurements, a non-cash credit adjustment of $1.9 million was recorded to properly value the liability. This credit adjustment was offset by a $0.3 million non-cash expense which was recorded as a result of not having the common stock shares associated with the Private Placement registered. Both adjustments have been recorded in “Remeasurement of warrant liability” in the Consolidated Statement of Operations. As a result of the Registration Statement becoming effective on April 30, 2004, the remaining liability for the Warrants of $0.6 million was reclassified to equity as of that date. The Company is required to maintain the effectiveness of the Registration Statement on a commercially reasonable basis.

Related Party Transactions

As of July 31, 2006, we hold an investment of approximately 14% in VA Linux Systems Japan, K.K. (“VA Linux Japan”). We continually evaluate whether events or circumstances have occurred that indicate the remaining value of the investment may be impaired. In fiscal 2006, no impairment was recorded on this investment. Based on the valuation performed at July 31, 2005, a small impairment was recorded for $0.1 million during the fourth quarter of fiscal 2005. There is no quoted market price for this investment; accordingly, fair value was estimated by management based on the estimated fair value of the underlying net assets. This investment is reported under our Software segment. The impairment has been included in “Impairment of long-lived assets” in the Consolidated Statements of Operations and Other Comprehensive Income/(Loss)”. As of July 31, 2006, we had an investment balance of $0.4 million. This balance has been included in “Other Assets” in the Consolidated Balance Sheets. VA Linux Japan acts as a reseller of our SFEE application to customers in Japan and, pursuant to a license agreement with us, resyndicates certain OSTG web sites for the Japanese market. There were $33,000 and $59,000 of related-party receivables and $129,000 and $47,000 of related-party deferred revenue associated with VA Linux Japan as of July 31, 2006 and July 31, 2005, respectively that are included in trade receivables and deferred revenue in the accompanying Consolidated Balance Sheets. There were no related-party receivables and deferred revenue associated with VA Linux Japan as of July 31, 2004 that are included in trade receivables and deferred revenue in the accompanying Consolidated Balance Sheets. There were $0.6 million, $0.5 million and $0.2 million of related-party revenue associated with VA Linux Japan for the years ended July 31, 2006, July 31, 2005 and July 31, 2004, respectively.

Interest and Other Income, Net

	Year Ended July 31,									% Change Fiscal 2006 to 2005			% Change Fiscal 2005 to 2004

($ in thousands)	2006			2005			2004

Interest Income	$	1,784		$	914		$	911			95	%		0	%
Interest Expense	$	(10	)	$	(39	)	$	(5	)		(74	)%		680	%
Other Income (Expense)