UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2005

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

For the transition period from                                          to                                         .

BLACKBAUD, INC.

(Exact name of Registrant as specified in its charter)

Delaware
(State or other jurisdiction of		11-2617163
incorporation or organization)		(I.R.S. Employer Identification No.)

2000 Daniel Island Drive
Charleston, South Carolina 29492
(Address of principal executive offices, including zip code)

(843) 216-6200
(Registrant’s telephone number, including area code)

     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 þ NO o

     Indicate by check mark whether registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

YES o NO þ

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

YES o NO þ

     The number of shares of the Registrant’s Common Stock outstanding as of November 10, 2005 was 42,530,285.

 

 

BLACKBAUD, INC.

TABLE OF CONTENTS

		Page No.
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004 (unaudited)			1
Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2005 and 2004 (unaudited)			2
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2004 (unaudited)			3
Consolidated Statements of Stockholders’ Equity and Comprehensive Income for the Nine Months Ended September 30, 2005 and the Year Ended December 31, 2004			4
Condensed Notes to Consolidated Financial Statements (unaudited)			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			17
Item 3. Quantitative and Qualitative Disclosures About Market Risk			34
Item 4. Controls and Procedures			34
PART II. OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			35
Item 6. Exhibits			35
Signatures			36
EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I- FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

BLACKBAUD, INC.

		September 30,				December 31,
		2005				2004
Assets
Current assets:
Cash and cash equivalents		$	20,703			$	42,144
Accounts receivable, net of allowance of $1,299 and $1,420, respectively			22,348				19,580
Prepaid expenses and other current assets			11,945				1,806
Deferred tax asset, current portion			1,022				542
Total current assets			56,018				64,072
Property and equipment, net			7,389				7,199
Deferred tax asset			75,480				87,522
Goodwill			2,194				1,673
Intangible assets, net			415				—
Other assets			139				342
Total assets		$	141,635			$	160,808
Liabilities and Stockholders’ Equity
Current liabilities:
Trade accounts payable		$	2,742			$	2,653
Current portion of capital lease obligations			—				44
Accrued expenses and other current liabilities			14,736				16,019
Deferred revenue			59,736				51,593
Total current liabilities			77,214				70,309
Long-term deferred revenue			1,209				710
Total liabilities			78,423				71,019
Commitments and contingencies (Note 9)
Stockholders’ equity:
Preferred stock; 20,000,000 shares authorized, none outstanding			—				—
Common stock, $0.001 par value; 180,000,000 shares authorized, 45,888,206 and 42,549,056 shares issued at September 30, 2005 and December 31, 2004, respectively			46				43
Additional paid-in capital			63,816				55,292
Deferred compensation			(485	)			(1,064	)
Treasury stock, at cost; 3,998,013 shares at September 30, 2005			(56,229	)			—
Accumulated other comprehensive income			167				355
Retained earnings			55,897				35,163
Total stockholders’ equity			63,212				89,789
Total liabilities and stockholders’ equity		$	141,635			$	160,808

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

BLACKBAUD, INC.

		Three months ended September 30,								Nine months ended September 30,
		2005				2004				2005				2004
Revenue
License fees		$	7,291			$	6,244			$	22,063			$	18,614
Services			14,486				12,145				40,070				32,808
Maintenance and subscriptions			20,005				17,101				57,779				49,126
Other revenue			1,362				920				3,443				2,849
Total revenue			43,144				36,410				123,355				103,397
Cost of revenue
Cost of license fees			1,077				975				3,166				2,468
Cost of services (of which $55, $(1,211), $229 and $(644)) in the three months ended September 30, 2005 and 2004 and the nine months ended September 30, 2005 and 2004, respectively, was stock-based compensation expense (benefit))			7,236				4,930				20,996				16,482
Cost of maintenance and subscriptions (of which $6, $(168), $28 and $(106)) in the three months ended September 30, 2005 and 2004 and the nine months ended September 30, 2005 and 2004, respectively, was stock-based compensation expense (benefit))			3,083				2,544				9,071				8,130
Cost of other revenue			1,166				802				3,101				2,578
Total cost of revenue			12,562				9,251				36,334				29,658
Gross profit			30,582				27,159				87,021				73,739
Operating Expenses
Sales and marketing			8,595				6,858				25,088				20,151
Research and development			5,309				4,541				15,640				13,245
General and administrative			4,405				3,408				12,246				9,462
Amortization			10				—				10				32
Costs of initial public offering			—				805				—				2,455
Stock based compensation expense (benefit)			1,546				(1,138	)			(2,970	)			55
Total operating expenses			19,865				14,474				50,014				45,400
Income from operations			10,717				12,685				37,007				28,339
Interest income			190				79				770				133
Interest expense			(12	)			(18	)			(37	)			(268	)
Other (expense) income, net			(32	)			(4	)			(34	)			342
Income before provision for income taxes			10,863				12,742				37,706				28,546
Income tax provision			3,143				5,155				10,592				11,619
Net income		$	7,720			$	7,587			$	27,114			$	16,927
Earnings per share
Basic		$	0.18			$	0.18			$	0.64			$	0.40
Diluted		$	0.17			$	0.16			$	0.58			$	0.36
Common shares and equivalents outstanding
Basic weighted average shares			41,961,726				42,536,961				42,628,278				42,480,059
Diluted weighted average shares			45,017,221				46,515,156				46,676,356				46,466,986
Dividends per share		$	0.05			$	—			$	0.15			$	—
Summary of stock-based compensation expense (benefit)
Cost of services		$	55			$	(1,211	)		$	229			$	(644	)
Cost of maintenance and subscription revenue			6				(168	)			28				(106	)
Total cost of revenue			61				(1,379	)			257				(750	)
Sales and marketing			38				(670	)			182				(194	)
Research and development			22				(833	)			119				(517	)
General and administrative			1,486				365				(3,271	)			766
Total operating expense			1,546				(1,138	)			(2,970	)			55
Total stock based compensation expense (benefit)		$	1,607			$	(2,517	)		$	(2,713	)		$	(695	)

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

BLACKBAUD, INC.

		Nine months ended September 30,
		2005				2004
Cash flows from operating activities
Net income		$	27,114			$	16,927
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization			2,026				1,889
Provision for doubtful accounts and sales returns			711				32
Stock based compensation benefit			(2,404	)			(695	)
Amortization of deferred financing fees			36				156
Deferred taxes			11,613				7,555
Benefit on exercise of stock options			6,033				—
Changes in assets and liabilities Accounts receivable			(3,427	)			(2,365	)
Prepaid expenses and other assets			(9,963	)			(267	)
Trade accounts payable			96				(230	)
Accrued expenses and other current liabilities			(1,203	)			2,353
Deferred revenue			8,452				8,040
Total adjustments			11,970				16,468
Net cash provided by operating activities			39,084				33,395
Cash flows from investing activities
Purchase of property and equipment			(2,223	)			(1,616	)
Purchase of net assets of acquired companies			(938	)			(97	)
Net cash used in investing activities			(3,161	)			(1,713	)
Cash flows from financing activities
Repayments on long-term debt and capital lease obligations			(44	)			(5,105	)
Proceeds from exercise of stock options			5,475				642
Purchase of treasury stock			(56,229	)			—
Dividend payments to stockholders			(6,380	)			—
Payment of deferred financing fees			—				(161	)
Net cash used in financing activities			(57,178	)			(4,624	)
Effect of exchange rate on cash and cash equivalents			(186	)			(384	)
Net (decrease) increase in cash and cash equivalents			(21,441	)			26,674
Cash and cash equivalents, beginning of period			42,144				6,708
Cash and cash equivalents, end of period		$	20,703			$	33,382

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

Blackbaud, Inc.

CONSOLIDATED STATEMENTS OF STOCKHOLDER’S EQUITY AND COMPREHENSIVE INCOME

(in thousands, except share amounts)

																							Accumulated
															Additional								Other												Total
		Comprehensive					Common Stock								Paid-in				Treasury				Comprehensive				Deferred				Retained				Stockholders'
		Income					Shares				Amount				Capital				Stock				(Loss) Income				Compensation				Earnings				Equity (Deficit)
Balance, December 31, 2003								42,408,872			$	41,613			$	—							$	518			$	(4,795	)		$	22,522			$	59,858
Exercise of stock options			—					140,184				480				194				—				—				—				—				674
Translation adjustment, net of tax		$	(163	)				—				—				—				—				(163	)			—				—				(163	)
Deferred compensation			—					—				82				12,903				—				—				(14,764	)			—				(1,779	)
Reversal of deferred compensation related to option cancellations			—					—				(82	)			(34	)			—				—				116				—				—
Amortization of deferred compensation			—					—				—				—				—				—				18,379				—				18,379
Tax impact of exercise of nonqualified stock options			—					—				—				179				—				—				—				—				179
Reclassification of additional paid-in capital due to addition of par value			—					—				(42,050	)			42,050				—				—				—				—				—
Net income			12,641					—				—				—				—				—				—				12,641				12,641
Comprehensive income		$	12,478
Balance, December 31, 2004								42,549,056				43				55,292				—				355				(1,064	)			35,163				89,789
Exercise of stock options			—					2,466,368				2				12,273				—				—				—				—				12,275
Purchase of treasury shares			—					—				—				—				(56,229	)			—				—				—				(56,229	)
Payment of dividends			—					—				—				—				—				—				—				(6,380	)			(6,380	)
Translation adjustment, net of tax		$	(188	)				—				—				—				—				(188	)			—				—				(188	)
Deferred compensation			—					—				—				(3,092	)			—				—				3,401				—				309
Reversal of deferred compensation related to option cancellations			—					—				—				(45	)			—				—				45				—				—
Amortization of deferred compensation			—					—				—				—				—				—				(2,751	)			—				(2,751	)
Tax impact of exercise of nonqualified stock options			—					—				—				6,000				—				—				—				—				6,000
Net option exercise			—					859,957				1				(6,766	)			—				—				—				—				(6,765	)
Restricted stock grant			—					12,825				—				154				—				—				(154	)			—				—
Amortization of restricted stock			—					—				—				—				—				—				38				—				38
Net income			27,114					—				—				—				—				—				—				27,114				27,114
Comprehensive income		$	26,926
Balance, September 30, 2005								45,888,206			$	46			$	63,816			$	(56,229	)		$	167			$	(485	)		$	55,897			$	63,212

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

BLACKBAUD, INC.

1. Organization

Blackbaud, Inc. (the “Company”) is the leading global provider of software and related services designed specifically for nonprofit organizations and provides products and services that enable nonprofit organizations to increase donations, reduce fundraising costs, improve communications with constituents, manage their finances and optimize internal operations. As of September 30, 2005 the Company had approximately 13,000 active customers distributed across multiple verticals within the nonprofit market including religion; education; foundations; health and human services; arts and cultural; public and societal benefits; environment and animal welfare; and international foreign affairs.

2. Delaware reincorporation; initial public offering

On July 16, 2004, the Company was reincorporated under the laws of the State of Delaware and, accordingly, under its certificate of incorporation effective beginning on that date, its authorized stock consists of 180,000,000 shares of common stock, par value $0.001 per share, and 20,000,000 shares of preferred stock, par value $0.001 per share.

The Company’s registration statement, filed on Form S-1 (Registration No. 333-112978) under the Securities Act of 1933, in connection with the initial public offering of its common stock, was declared effective by the Securities and Exchange Commission (the “SEC”) on July 22, 2004. On July 27, 2004 the Company completed its initial public offering in which selling stockholders sold a total of 8,098,779 shares of common stock for $8.00 per share (before underwriter discounts and commissions), for an aggregate public offering price of $64,790,232. On August 2, 2004, the underwriters exercised their over-allotment option for the purchase of 1,214,817 shares of common stock at $8.00 per share for an additional aggregate public offering price of $9,718,536. All of the shares sold in this offering were sold by selling stockholders and, accordingly, the Company did not receive any proceeds from the sale of shares in this offering. The Company expensed the costs of its initial public offering in its statement of operations, which were $2,455,000 for the nine months ended September 30, 2004. These costs were primarily comprised of printing, legal and accounting fees.

3. Summary of significant accounting policies

Unaudited interim financial statements

The interim consolidated financial statements as of September 30, 2005 and for the three and nine months ended September 30, 2005 and 2004, respectively, have been prepared by the Company pursuant to the rules and regulations of the SEC for interim financial reporting. These consolidated statements are unaudited and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments and accruals) necessary to state fairly the consolidated balance sheets, consolidated operating results, changes in stockholders’ equity and consolidated cash flows for the periods presented in accordance with accounting principles generally accepted in the United States of America. The consolidated balance sheet at December 31, 2004 has been derived from the audited consolidated financial statements at that date. Operating results for the three and nine months ended September 30, 2005 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2005 or any other future period. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted in accordance with the rules and regulations for interim reporting of the SEC. These interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

Basis of consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Use of estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Areas of the financial statements where estimates may have the most significant effect include the allowance for sales returns and doubtful accounts, lives of tangible and intangible assets, impairment of long-lived assets, realization of deferred tax assets, stock option compensation, revenue recognition, and provision for income taxes. Changes in the facts or circumstances underlying these estimates could result in material changes and actual results could differ from these estimates.

Reclassifications

Certain amounts in the prior year consolidated balance sheet revenues, statement of operations, statement of cash flows and notes to the consolidated financial statements have been reclassified to conform to the 2005 presentation.

Revenue recognition

The Company’s revenue is generated primarily by licensing its software products and providing support, training, consulting, technical, hosting and other professional services for those products. The Company recognizes revenue in accordance with the American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, as modified by SOPs 98-4 and 98-9, as well as Technical Practice Aids issued from time to time by the American Institute of Certified Public Accountants, and in accordance with the SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements”.

Under these pronouncements, the Company recognizes revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been delivered, title and risk of loss have transferred to the customer, the fee is fixed or determinable and collection of the resulting receivable is probable. The Company uses a signed agreement as evidence of an arrangement. Delivery occurs when the product is delivered. The Company’s typical license agreement does not include customer acceptance provisions. If acceptance provisions are provided, delivery is deemed to occur upon acceptance. The Company considers the fee to be fixed or determinable unless the fee is subject to refund or adjustment or is not payable within the Company’s standard payment terms. The Company considers payment terms greater than 90 days to be beyond its customary payment terms. The Company deems collection probable if the Company expects that the customer will be able to pay amounts under the arrangement as they become due. If the Company determines that collection is not probable, the Company postpones recognition of the revenue until cash collection. The Company sells software licenses with maintenance and, frequently, professional services. The Company allocates revenue to delivered components, normally the license component of the arrangement, using the residual value method based on objective evidence of the fair value of the undelivered elements, which is specific to the Company. Fair value for the maintenance services associated with the Company’s software licenses is based upon renewal rates stated in the Company’s agreements, which vary according to the level of the maintenance program. Fair value of professional services and other products and services is based on sales of these products and services to other customers when sold on a stand-alone basis.

The Company recognizes revenue from maintenance services ratably over the contract term, which is principally one year. Maintenance revenue also includes the right to unspecified product upgrades on an if-and-when available basis. Subscription revenue includes fees for hosted solutions, data enrichment services and hosted online training programs. Subscription-based revenue and any related set-up fees are recognized ratably over the twelve-month service period of the contracts, as there is no discernible pattern of usage.

The Company’s services, which include consulting, installation and implementation services, are generally billed based on hourly rates plus reimbursable travel and lodging related expenses. For small service engagements, less than approximately $50,000, the Company frequently contracts for and bills based on a fixed fee plus reimbursable travel and lodging related expenses. The Company recognizes this revenue upon completion of the work performed. When the Company’s services include software customization, these services are provided to support customer requests for assistance in creating special reports and other minor enhancements that will assist with efforts to improve operational efficiency and/or to support business process improvements. These services are not essential to the functionality of the Company’s software and rarely exceed three months in duration. The Company recognizes

revenue as these services are performed. When the Company sells hosting separately from consulting, installation and implementation services, it recognizes that revenue ratably over the service period.

The Company sells training at a fixed rate for each specific class, at a per attendee price, or at a packaged price for several attendees, and revenue is recognized only upon the customer attending and completing training. During the second quarter of 2005, the Company introduced the Blackbaud Training Pass for The Raiser’s Edge, which permits customers to attend unlimited training, subject to certain restrictions, during the annual contract period. The Training Pass is recognized ratably over the annual service period of the contracts, as there is no apparent pattern of usage. The Company recognizes revenue from donor prospect research and data modeling service engagements upon delivery.

To the extent that the Company’s customers pay for the above-described services in advance of delivery, the amounts are recorded in deferred revenue.

Deferred compensation and stock-based compensation plans

The Company accounts for stock option compensation based on the provisions of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees”, which states that no compensation expense is recorded for stock options or other stock-based awards to employees that are granted with an exercise price equal to or above the estimated fair value per share of the Company’s common stock on the grant date. Certain of the Company’s option grants are accounted for as variable awards under the provisions of APB No. 25. These provisions require the Company to account for these variable awards and record deferred compensation for the difference between the exercise price and the fair market value of the stock at each reporting date. Deferred compensation is amortized using the accelerated method over the vesting period of the related stock option in accordance with FASB Interpretation (“FIN”) No. 28. Statement of Financial Accounting Standards Number 123, revised 2004, (“SFAS No. 123R”) is effective and will be implemented for the year beginning January 1, 2006. See the New Accounting Pronouncement section of this footnote.

Amortization of deferred compensation resulted in the Company recognizing stock option compensation expense of $1,607,000 and a benefit of $2,517,000 for the quarters ended September 30, 2005 and 2004, respectively. Amortization of deferred compensation resulted in the Company recognizing stock option compensation benefit of $2,713,000 for the nine months ended September 30, 2005, which is principally the result of (i) stock option compensation expense recorded in the third quarter of $896,000 resulting from adjusting the deferred compensation associated with 1.2 million options held by our CEO from the closing stock price at June 30, 2005 of $13.50 to the closing stock price at September 30, 2005 of $14.17, (ii) stock option compensation expense recorded in the third quarter of $41,000 and $492,000 resulting from adjusting the deferred compensation associated with 0.1 million and 1.4 million options exercised or surrendered by the Company’s CEO from the closing price of $13.50 per share at June 30, 2005 to the closing price on the date of the transactions of $13.86 and $13.83 per share on July 7, 2005 and August 4, 2005, respectively, (iii) stock option compensation expense recorded in the second quarter of $2,648,000 resulting from adjusting the deferred compensation associated with the 2.7 million options held by the Company’s CEO from the closing price of $12.60 per share at March 31, 2005 to the closing price of $13.50 per share at June 30, 2005, (iv) stock option compensation expense recorded in the second quarter of $430,000 resulting from adjusting the deferred compensation associated with 0.8 million options exercised or surrendered by the Company’s CEO from the closing price of $12.60 per share at March 31, 2005 to the closing price of $13.06 per share on June 1, 2005, the date of the transaction, and (v) a stock option compensation benefit recorded in the first quarter of $7,908,000 resulting from adjusting the deferred compensation associated with the 3.5 million options held by the Company’s CEO from the closing price of $14.64 per share at December 31, 2004 to the closing price of $12.60 per share at March 31, 2005. The remaining 1.2 million options as of September 30, 2005 held by the Company’s CEO will be accounted for as a variable award until the grant is fully exercised, forfeited, or expires unexercised.

Additionally, stock option compensation expense of approximately $178,000 and $689,000 was recorded in the three and nine months ended September 30, 2005, respectively, resulting from the amortization of deferred compensation associated with approximately 3.0 million options held by employees, previously subject to variable accounting, which became fixed upon completion of the initial public offering and which will be recognized over the remaining vesting period. These options are no longer being accounted for as variable awards following the occurrence of the initial public offering in July 2004.

The Company has adopted the disclosure requirements of Statement of Financial Accounting Standard, (“SFAS”) No. 123, “Accounting for Stock Based Compensation”, as amended by SFAS No. 148, “Accounting for Stock Based Compensation Transition and Disclosure”, which requires compensation expense to be disclosed based on the fair value of the options granted at the date of the grant.

Had compensation cost been determined under the market value method using Black-Scholes valuation principles, net income would have been adjusted to the following pro forma amounts:

		Three months ended September 30,								Nine months ended September 30,
(in thousands, except share amounts)		2005				2004				2005				2004
Net income, as reported		$	7,720			$	7,587			$	27,114			$	16,927
Total stock-based compensation expense (benefit), net of related tax effects, included in the determination of net income as reported			1,151				(1,843	)			(2,021	)			(500	)
Total stock-based compensation (expense) benefit, net of related tax effects, that would have been included in the determination of net income if the fair value method had been applied to all awards			(1,382	)			(1,007	)			(184	)			(2,022	)
Pro forma net income		$	7,489			$	4,737			$	24,909			$	14,405
Earnings per share:
Basic, as reported		$	0.18			$	0.18			$	0.64			$	0.40
Basic, pro forma		$	0.18			$	0.11			$	0.58			$	0.34
Diluted, as reported		$	0.17			$	0.16			$	0.58			$	0.36
Diluted, pro forma		$	0.17			$	0.10			$	0.53			$	0.31

The pro forma amount reflects all options granted. Pro forma compensation cost might not be representative of that expected in future years.

Significant assumptions used in the Black-Scholes option pricing model computations are as follows:

		Three months ended								Nine months ended
		September 30,								September 30,
		2005				2004				2005				2004
Volatility			82.03	%			78.02	%			82.03	%			78.02	%
Dividend yield			1.40	%			0.00	%			1.40	%			0.00	%
Risk-free interest rate			3.80	%			3.68	%			3.80	%			3.68	%
Expected option life in years			6.55				7.90				6.55				7.90

Income taxes

Prior to October 13, 1999, the Company was organized as an S corporation under the Internal Revenue Code and, therefore, was not subject to federal income taxes. The Company historically made distributions to its stockholders to cover the stockholders’ anticipated tax liability. In connection with the recapitalization agreement, the Company converted its U.S. taxable status from an S corporation to a C corporation and, accordingly, since October 14, 1999 has been subject to federal and state income taxes. Upon this conversion and in connection with the recapitalization, the Company recorded a one-time benefit of $107,000,000 to establish a deferred tax asset as a result of the recapitalization agreement. This amount was recorded as a direct increase to equity in the statements of stockholders’ equity. The Company has not recorded a valuation allowance against this item in its deferred tax asset as of September 30, 2005 or December 31, 2004, as the Company believes it will be able to utilize this benefit, which is dependent upon the Company’s ability to generate taxable income.

Also included in the Company’s deferred tax asset at December 31, 2004 were state income tax credits, net of federal taxes at 34.8%, of approximately $4.0 million that begin to expire in 2015. The Company established a

valuation allowance against these credits when the asset was recorded because, based on information available at that time, it was not deemed more likely than not that these credits would be realized. During the second quarter of 2005, as a result of profitable results in 2004 and 2003, expectations of future profitability and utilization of related state NOLs, the Company released $2.9 million of the valuation allowance, net of federal taxes, related to these state income tax credits. This resulted in a credit to its income tax expense of $2.9 million during the second quarter.

Additionally, certain state tax credits whose use was previously restricted to reducing state franchise taxes, became available to offset state income tax as a result of a clarification in enacted tax law during the third quarter. Accordingly, a deferred tax asset was established during the third quarter of 2005 of $2.2 million, net of federal taxes at 34.8%, related to the associated future reduction of state taxes. A valuation allowance was established for $1.3 million of the $2.2 million representing the portion of the credits not deemed more likely than not to be utilized.

Significant judgment is required in determining the provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. The Company records its interim tax provision at the anticipated tax rates based on estimates of annual pretax income. To the extent that the final results differ from these estimated amounts that were initially recorded, such differences will impact the income tax provision in the period in which such determination is made and could have an impact on the deferred tax asset. The Company’s deferred tax assets and liabilities are recorded at an amount based upon a blended U.S. Federal income tax rate of 34.8%. This rate is based on the Company’s expectation that the Company’s deductible and taxable temporary differences will reverse over a period of years, during which, except for 2005 and 2006 due to anticipated stock option exercises that will reduce taxable income, the Company will have annual taxable income exceeding $10,000,000 per year. If the Company’s results of operations worsen in the future, such that the Company’s annual taxable income will be expected to fall below $10,000,000, the Company will adjust its deferred tax assets and liabilities to an amount reflecting the reduced expected U.S. Federal income tax rate, consistent with the corresponding expectation of lower taxable income. If such change is determined to be appropriate, it will affect the provision for income taxes during the period that the determination is made.

New accounting pronouncements

In November 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 153 “Exchanges of Nonmonetary Assets – An Amendment of APB No. 29”. The provisions of this statement are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. This statement eliminates the exception to fair value for exchanges of similar productive assets and replaces it with a general exception for exchange transactions that do not have commercial substance or are not expected to result in significant changes in the cash flows of the reporting entity. The Company does not believe that the adoption of SFAS No. 153 will have a significant effect on its financial statements.

On December 16, 2004, the FASB issued No. SFAS No. 123 (revised 2004), “Share-Based Payment”, which is a revision of SFAS No. 123. SFAS No. 123 (R) supersedes APB 25, “Accounting for Stock Issued to Employees”, and amends SFAS No. 95 “Statement of Cash Flows.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However SFAS No. 123(R) requires all share-based payments to employees to be recognized in the statement of operations based on their fair values. In April 2005, the Securities and Exchange Commission delayed the implementation of SFAS 123(R) until the first fiscal year beginning after June 15, 2005. SFAS 123(R) will be effective for the Company beginning in 2006. The impact of adoption of SFAS 123(R) cannot be predicted at this time because the Company has not yet determined its transition method and because it will depend on levels of share-based payments granted in the future.

On June 7, 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and Statement No. 3, Reporting Accounting Changes in Interim Financial Statements” (SFAS No. 154). SFAS No. 154 changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, most voluntary changes in accounting principles were required to be recognized by way of a cumulative effect adjustment within net income during the period of the change. SFAS No. 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the changes. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the Statement does not change the transition provisions of any existing accounting pronouncements. The Company does not

believe adoption of SFAS No. 154 will have a material effect on its consolidated financial position, results of operations or cash flows.

In March 2005, the FASB issued Financial Interpretation No. 47 (“FIN 47”), “Accounting for Conditional Asset Retirement Obligations – an interpretation of FASB Statement No. 143.” FIN 47 requires asset retirement obligations to be recorded when a legal obligation exists even though the timing and/or method of the settlement of such obligations is conditional on a future event. The Company is currently evaluating the effect that the adoption of FIN 47 will have on its financial condition and results of operations but does not believe that the adoption will have a material impact.

4. Acquisition

In April 2005, Blackbaud acquired the net assets of a software distribution company based in the United Kingdom for $438,000. The transaction was accounted for in accordance with Statement of Financial Accounting Standards No. 141, “Business Combinations.” The purchase price has been allocated to the assets acquired and the liabilities assumed based upon their estimated fair values at the date of the acquisition. The excess consideration above the fair value of the net assets acquired of $353,000 was recorded as goodwill in April 2005. Additionally, an identifiable intangible asset of $235,000 consisting of existing customer relationships were recorded and will be amortized over its estimated useful life of 12 years.

In September 2005, Blackbaud acquired the net assets of a document management and image retrieval company based in the United Kingdom for $442,000. The transaction was accounted for in accordance with SFAS No. 141. The purchase price has been allocated to the assets acquired and the liabilities assumed based upon their estimated fair values at the date of the acquisition. The excess consideration above the fair value of the net assets acquired of $235,000 was recorded as goodwill in September 2005. Additionally, an identifiable intangible asset of $195,000 consisting of existing customer relationships was recorded and will be amortized over its estimated useful life of 12 years.

5. Earnings per share

The Company computes earnings per common share in accordance with SFAS No. 128, “Earnings Per Share”. Under the provisions of SFAS No. 128, basic earnings per share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing net income available to common stockholders by the weighted average number of common shares and dilutive potential common shares then outstanding. Potential common shares consist of shares issuable upon the exercise of stock options. Diluted earnings per share for the three and nine months ended September 30, 2005 does not include the effect of 15,000 potential common shares, as they are anti-dilutive. There were no anti-dilutive potential common shares outstanding for the three months ended September 30, 2005 and for the three and nine months ended September 30, 2004.

The following table sets forth the computation of basic and fully diluted earnings per share:

(in thousands
except share and
per share amounts)		Three months ended September 30,								Nine months ended September 30,
		2005				2004				2005				2004
Numerator:
Net income		$	7,720			$	7,587			$	27,114			$	16,927
Denominator:
Weighted average common shares			41,961,726				42,536,961				42,628,278				42,480,059
Add effect of dilutive securities: Employee stock options			3,055,495				3,978,195				4,048,078				3,986,927
Weighted average common shares assuming dilution			45,017,221				46,515,156				46,676,356				46,466,986
Earnings per share:
Basic		$	0.18			$	0.18			$	0.64			$	0.40
Diluted		$	0.17			$	0.16			$	0.58			$	0.36

6. Prepaid expenses and other current assets

Prepaid expenses and other current assets consisted of the following as of September 30, 2005 and December 31, 2004.

(in thousands)		September 30, 2005				December 31, 2004
Deferred sales commission costs		$	—			$	344
Prepaid rent			40				106
Prepaid insurance			560				358
Prepaid data costs			73				65
Prepaid real estate commissions			61				79
Prepaid software maintenance and royalties			592				527
Prepaid income taxes			10,260				—
Other			359				327
		$	11,945			$	1,806

7. Accrued expenses and other current liabilities

Accrued expenses and other current liabilities consisted of the following as of September 30, 2005 and December 31, 2004.

(in thousands)		September 30, 2005				December 31, 2004
Accrued bonuses		$	2,251			$	4,090
Accrued cash component of stock option compensation			3,159				3,472
Accrued commissions and salaries			1,372				1,032
Customer credit balances			1,018				675
Taxes payable			3,046				4,220
Accrued accounting and legal costs			1,036				491
Accrued health care costs			1,121				508
Other			1,733				1,531
		$	14,736			$	16,019

8. Credit Agreement

On September 30, 2004, the Company entered into a $30.0 million revolving credit facility, which replaced its prior $15.0 million revolving credit facility that was canceled in July 2004. Amounts borrowed under the $30.0 million revolving credit facility bear interest, at the Company’s option, at a variable rate based on either the prime rate, federal funds rate or LIBOR plus a margin of between 0.5% and 2.0% based on the Company’s consolidated leverage ratio as defined. Amounts outstanding under the facility are not secured by a lien on the Company’s assets, but are guaranteed by the Company’s operating subsidiaries and the facility is subject to covenants, including a maximum leverage ratio, minimum interest coverage ratio and minimum net worth. There were no principal or interest amounts outstanding under the facility as of September 30, 2005. The termination date of the facility is September 30, 2007.

9. Commitments and contingencies

Lease agreement

On October 13, 1999, the Company entered into a lease agreement for office space with Duck Pond Creek, LLC, which is owned by certain current and former minority stockholders of the Company. The term of the lease is for ten years with two five-year renewal options by the Company. The annual base rent of the lease is $4,316,000 payable in equal monthly installments. The base rate escalates annually at a rate equal to the change in the consumer price index, as defined in the agreement.

The Company has subleased a portion of its headquarters facility under various agreements extending through 2008. Under these agreements, rent expense was reduced by $118,000 and $117,000 for the three months ended September 30, 2005 and 2004, respectively, and by $354,000 and $341,000 for the nine months ended September 30, 2005 and 2004, respectively. The operating lease commitments will be reduced by minimum aggregate sublease commitments of $474,000, $481,000, $475,000, and $128,000 for the years 2005, 2006, 2007, and 2008, respectively. The Company has also received and expects to receive through 2015, quarterly South Carolina state incentive payments as a result of locating its headquarters facility in Berkeley County, South Carolina. These amounts are recorded as a reduction of rent expense and were $413,000 and $341,000 for the three months ended September 30, 2005 and 2004, respectively, and $1,093,000 and $852,000 for the nine months ended September 30, 2005 and 2004, respectively.

Other commitments

The Company has a commitment of $200,000 payable annually through 2009 for certain naming rights with an entity principally owned by an individual who, prior to the Company’s public offering on July 22, 2004, was a minority stockholder of the Company. The Company incurred expense under this agreement of $50,000 for each of the three-month periods ended September 30, 2005 and 2004 and $150,000 for each of the nine-month periods ended September 30, 2005 and 2004.

The Company utilizes third party relationships in conjunction with its products. The contractual arrangements vary in length from one to three years. In certain cases, these arrangements require a minimum annual purchase commitment. The Company incurred expense under these arrangements of $181,000 and $121,000 for the three-month periods ended September 30, 2005 and 2004, respectively, and $493,000 and $352,000 for the nine-month periods ended September 30, 2005 and 2004, respectively.

Legal contingencies

The Company is subject to legal proceedings and claims which have arisen in the ordinary course of business. The Company does not believe the amount of potential liability with respect to these actions will have a material adverse effect upon the Company’s financial position or results of operations.

10. Income taxes

Income taxes for the three-month period ended September 30, 2005 were calculated using the projected effective tax rate for fiscal 2005 in accordance with SFAS No. 109. The Company estimates that in the fiscal year ending December 31, 2005, it will have an effective tax rate of approximately 38.2%. The Company’s effective tax rate for the three months ended September 30, 2005 was 28.9%. The Company’s effective tax rate for the three-month period ended September 30, 2004 was 40.5%.

During its second quarter the Company reversed a portion of its valuation allowance against certain state tax credits. The Company’s deferred tax asset at December 31, 2004 included state income tax credits, net of federal taxes at 34.8%, of approximately $4.0 million that begin to expire in 2015. The Company established a valuation allowance against these credits when the assets were recorded because, based on information available at that time, it was not deemed probable that the deferred tax assets would be realized. During 2005, as a result of profitable results in 2004 and 2003, expectations of future profitability and utilization of related state NOLs, the Company released $2.9 million of the valuation allowance on the deferred tax asset related to these state income tax credits. This resulted in a credit to its income tax expense of $2.9 million during the second quarter of 2005.

Additionally, certain state tax credits whose use was previously restricted to reducing state franchise taxes became available to offset state income tax as a result of a clarification in enacted tax law during the third quarter. Accordingly, a deferred tax asset was established during the third quarter of 2005 of $2.2 million, net of federal taxes at 34.8%, related to the associated future reduction of state taxes. A valuation allowance was established for $1.3 million of the $2.2 million representing the portion of the credits not deemed more likely than not to be utilized.

11.		Stockholders’ equity
On February 1, 2005, the Company’s Board of Directors approved an annual cash dividend policy of $0.20 per share for the year ending December 31, 2005. On February 1, 2005, the Company declared its first quarter dividend of $0.05 per share payable on February 28, 2005 to stockholders of record on February 14, 2005. On April 27, 2005 the Company declared its second quarter dividend of $0.05 per share payable on May 29, 2005 to stockholders of record on May 15, 2005. On July 27, 2005, the Company declared its third quarter dividend of $0.05 per share payable on August 30, 2005 to stockholders of record on August 15, 2005.

On February 1, 2005, the Company’s Board of Directors approved a stock repurchase program that authorized the Company to buy back up to $35,000,000 of its outstanding shares of common stock. The shares could be purchased in conjunction with a public offering of Blackbaud stock, from time to time on the open market or in privately negotiated transactions depending upon market conditions and other factors, all in accordance with the requirements of applicable law. In total, the Company repurchased 861,076 shares under this program at an average price per share of $12.34. This program was terminated on June 3, 2005.

On May 31, 2005, the Company’s Board of Directors approved a self-tender offer to purchase up to 2,620,690 shares of its common stock for $14.50 per share. On June 3, 2005, the Company commenced the self tender offer to purchase shares of its common which expired on July 1, 2005. On July 5, 2005, the Company’s Board of Directors approved the purchase of an additional 344,827 shares under the self tender offer and on July 13, 2005, the Company completed the purchase of 2,965,517 shares of its common stock for a total of $43.0 million.

On July 26, 2005, the Company’s Board of Directors approved a stock repurchase program that authorized the Company to buy back up to $35,000,000 of its outstanding shares of common stock. The shares could be purchased in conjunction with a public offering of Blackbaud stock, from time to time on the open market or in privately negotiated transactions depending upon market conditions and other factors, all in accordance with the requirements of applicable law. Under the program, during the third quarter of 2005, the Company purchased 171,420 shares of its common stock at an average price of $13.38 per share. The Company accounts for treasury stock under the cost method which resulted in an increase to the treasury stock balance of $2,293,000 as of September 30, 2005.

12. Segment information

The Company has adopted SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”. SFAS No. 131 establishes standards for the reporting by business enterprises of information about operating segments, products and services, geographic areas and major customers. The method of determining what information is reported is based on the way that management organizes the operating segments within the Company for making operational decisions and assessments of financial performance. The Company has determined that its reportable segments are those that are based upon internal financial reports that disaggregate operating information into six reportable segments. The Company’s chief operating decision maker, as defined in SFAS No. 131, is its chief executive officer, or CEO.

The CEO uses the information presented in these reports to make certain operating decisions. The CEO does not review any report presenting segment balance sheet information. The segment revenues and direct controllable costs, which include salaries, related benefits, third party contractors, data expense and classroom rentals, for the three and nine months ended September 30, 2005 and 2004 were as follows:

																		Maintenance
		License				Consulting				Education				Analytic				and
(in thousands)		fees				services (1)				services (2)				services (3)				subscriptions				Other				Total
Three months ended September 30, 2005
Revenue		$	7,291			$	8,823			$	4,296			$	1,367			$	20,005			$	1,362			$	43,144
Direct controllable costs			1,077				4,154				1,312				878				2,475				1,160				11,056
Segment income			6,214				4,669				2,984				489				17,530				202				32,088
Corporate costs not allocated(4)																											1,506
Operating expenses																											19,865
Interest (income) expense, net																											(178	)
Other (income) expense, net																											32
Income before provision for income taxes																										$	10,863

						Consulting				Education				Analytic				Maintenance and
(in thousands)		License fees				services(1)				services (2)				services(3)				subscriptions				Other				Total
Three months ended September 30, 2004
Revenue		$	6,244			$	6,286			$	4,378			$	1,481			$	17,101			$	920			$	36,410
Direct controllable costs			975				3,408				1,266				728				2,106				795				9,278
Segment income			5,269				2,878				3,112				753				14,995				125				27,132
Corporate costs not allocated(4)																											(26	)
Operating expenses																											14,474
Interest (income) expense, net																											(61	)
Other (income) expense, net																											3
Income before provision for income taxes																										$	12,742

						Consulting				Education				Analytic				Maintenance and
(in thousands)		License fees				services(1)				services (2)				services(3)				subscriptions				Other				Total
Nine months ended September 30, 2005
Revenue		$	22,063			$	23,421			$	12,398			$	4,251			$	57,779			$	3,443			$	123,355
Direct controllable costs			3,166				11,782				3,720				2,702				7,203				3,077				31,650
Segment income			18,897				11,639				8,678				1,549				50,576				366				90,705
Corporate costs not allocated(4)																											4,684
Operating expenses																											50,014
Interest (income) expense, net																											(733	)
Other (income) expense, net																											34
Income before provision for income taxes																										$	37,706

																		Maintenance
		License				Consulting				Education				Analytic				and
(in thousands)		fees				services (1)				services (2)				services (3)				subscriptions				Other				Total
Nine months ended September 30, 2004
Revenue		$	18,614			$	17,508			$	11,377			$	3,923			$	49,126			$	2,849			$	103,397
Direct controllable costs			2,468				9,029				3,590				2,100				6,404				2,555				26,146
Segment income			16,146				8,479				7,787				1,823				42,722				294				77,251
Corporate costs not allocated(4)																											3,512
Operating expenses																											45,400
Interest (income) expense, net																											135
Other (income) expense, net																											(342	)
Income before provision for income taxes																										$	28,546

⁽¹⁾ This segment consists of consulting, installation and implementation services.

⁽²⁾ The segment consists of customer training and other education services.

⁽³⁾ This segment consists of donor prospect research and data modeling services.

⁽⁴⁾ Includes facilities, depreciation, and tech services costs plus stock-based compensation.

13. Subsequent events

On October 31, 2005, the Company declared its fourth quarter dividend of $0.05 per share payable on November 30, 2005 to stockholders of record on November 15, 2005.

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements reflect our current view with respect to future events and financial performance and are subject to risks and uncertainties, including those set forth under “Cautionary Statement” included in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report, that could cause actual results to differ materially from historical or anticipated results.

Overview

We are the leading global provider of software and related services designed specifically for nonprofit organizations. Our products and services enable nonprofit organizations to increase donations, reduce fundraising costs, improve communications with constituents, manage its finances and optimize internal operations. We have focused solely on the nonprofit market since our incorporation in 1982 and have developed our suite of products and services based upon our extensive knowledge of the operating challenges facing nonprofit organizations. As of September 30, 2005 we had approximately 13,000 customers. Our customers operate in multiple verticals within the nonprofit market, including religion, education, foundations, health and human services, arts and cultural, public and societal benefits, environment and animal welfare, and international foreign affairs.

We derive revenue from licensing software products and providing a broad offering of services, including consulting, training, installation, implementation, and donor prospect research and modeling services, as well as ongoing customer support and maintenance. Consulting, training and implementation are generally not essential to the functionality of our software products and are sold separately. Accordingly, we recognize revenue from these services separately from license fees.

Critical accounting policies and estimates

Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, the reported amounts of revenue and expenses during the reporting period and related disclosures of contingent assets and liabilities. The most significant estimates and assumptions relate to our allowance for sales returns and doubtful accounts, lives of tangible and intangible assets, impairment of long-lived assets, stock-based compensation, revenue recognition, and provision for income taxes and realization of deferred tax assets. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. On an ongoing basis, we reconsider and evaluate our estimates and assumptions. We are not aware of any circumstances in the past that have caused these estimates and assumptions to be materially wrong. Furthermore, we are not currently aware of any material changes in our business that might cause these assumptions or estimates to differ significantly.

Significant judgments and estimates are used in the application of the critical accounting policies listed below, and accordingly, are reflected in the preparation of our consolidated financial statements.

Revenue recognition

We recognize revenue in accordance with the provisions of the American Institute of Certified Public Accountants Statement of Position, or SOP, 97-2, “Software Revenue Recognition”, as amended by SOP 98-4 and SOP 98-9, as well as Technical Practice Aids issued from time to time by the American Institute of Certified Public Accountants, and in accordance with the SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements”.

We recognize revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been delivered, title and risk of loss has transferred to the customer, the fee is fixed or determinable and collection of the resulting receivable is probable. Delivery occurs when the product is delivered. Our typical license

agreement does not include customer acceptance provisions. If acceptance provisions are provided, delivery is deemed to occur upon acceptance. We consider the fee to be fixed or determinable unless the fee is subject to refund or adjustment or is not payable with our standard payment terms. We consider payment terms greater than 90 days to be beyond our customary payment terms. We deem collection probable if we expect that the customer will be able to pay amounts under the arrangement as they become due. If we determine that collection is not probable, we postpone recognition of the revenue until cash collection. We sell software licenses with maintenance and, frequently, professional services. We allocate revenue to delivered components, normally the license component of the arrangement, using the residual value method based on objective evidence of the fair value of the undelivered elements, which is specific to our company. Fair value for the maintenance services associated with our software licenses is based upon renewal rates stated in our agreements, which vary according to the level of the maintenance program. Fair value of professional services and other products and services is based on sales of these products and services to other customers when sold on a stand-alone basis.

We recognize revenue from maintenance services ratably over the contract term, which is usually one year. Maintenance revenue also includes the right to unspecified product upgrades on an if-and-when available basis. Subscription revenue includes fees for hosted solutions, data enrichment services and hosted online training programs. Subscription-based revenue and any related set-up fees are recognized ratably over the twelve-month service period of the contracts. Hosting revenues are recognized ratably over the thirty-six month period of the hosting contracts.

Our services, which include consulting, installation and implementation services, are generally billed based on hourly rates plus reimbursable travel and lodging related expenses. For small service engagements, less than approximately $50,000, we frequently contract for and bill based on a fixed fee plus reimbursable travel and lodging related expenses. We recognize this revenue upon completion of the work performed. When our services include software customization, these services are provided to support customer requests for assistance in creating special reports and other minor enhancements that will assist with efforts to improve operational efficiency and/or to support business process improvements. These services are not essential to the functionality of our software and rarely exceed three months in duration. We recognize revenue as these services are performed. When we sell hosting separately from consulting, installation and implementation services, we recognize that revenue ratably over the service period.

We sell training at a fixed rate for each specific class, at a per attendee price, or at a packaged price for several attendees, and revenue is recognized only upon the customer attending and completing training. During the second quarter of 2005, we introduced the Blackbaud Training Pass, which permits customers to attend unlimited training, subject to certain restrictions, during the annual contract period. This revenue is recognized ratably over the contract period that is typically one year. We recognize revenue from donor prospect research and data modeling service engagements upon delivery.

To the extent that our customers pay for the above-described services in advance of delivery, we record those amounts in deferred revenue.

Sales returns and allowance for doubtful accounts

We provide customers a 30-day right of return and maintain a reserve for returns. We estimate the amount of this reserve based on historical experience. Provisions for sales returns are charged against the related revenue items.

We maintain an allowance for doubtful accounts at an amount we estimate to be sufficient to provide adequate protection against losses resulting from extending credit to our customers. In judging the adequacy of the allowance for doubtful accounts, we consider multiple factors including historical bad debt experience, the general economic environment, the need for specific customer reserves and the aging of our receivables. Any necessary provision is reflected in general and administrative expense. A considerable amount of judgment is required in assessing these factors and if any receivables were to deteriorate, an additional provision for doubtful accounts could be required.

Valuation of long-lived and intangible assets and goodwill

We review identifiable intangible and other long-lived assets for impairment when events change or circumstances indicate the carrying amount may not be recoverable. Events or changes in circumstances that indicate the carrying amount may not be recoverable include, but are not limited to, a significant decrease in the market value of the

business or asset acquired, a significant adverse change in the extent or manner in which the business or asset acquired is used or significant adverse change in the business climate. If such events or changes in circumstances occur, we use the undiscounted cash flow method to determine whether the asset is impaired. Cash flows would include the estimated terminal value of the asset and exclude any interest charges. To the extent that the carrying value of the asset exceeds the undiscounted cash flows over the estimated remaining life of the asset, we measure the impairment using discounted cash flows. The discount rate utilized would be based on our best estimate of the Company’s risks and required investment returns at the time the impairment assessment is made.

In accordance with Statement of Financial Accounting Standard, or SFAS No. 142, “Goodwill and Other Intangible Assets”, we test goodwill for impairment annually in the fourth quarter, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test compares the fair value of the reporting unit with its carrying amount. If the carrying amount exceeds its fair value, impairment is indicated. We measure the impairment as the excess of the recorded goodwill over its fair value which could materially adversely impact our financial position and results of operations.

Stock-based compensation

We account for stock-based compensation under the provisions of Accounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees”. Under this pronouncement, there is generally no cost associated with options that are granted with an exercise price equal to or above the fair value per share of our common stock on the date of grant. Because there was no public market for our stock prior to our initial public offering in July 2004, our board of directors estimated the fair value of our common stock by considering a number of factors, including our operating performance, significant events in our history, trends in the broad market for technology stocks and the expected valuation we would obtain in an initial public offering. Prior to our initial public offering, grants under two of our option plans, covering approximately 6.5 million shares, contained provisions that resulted in them being treated as variable awards under APB No. 25. The effect of this accounting is that an amount equal to the difference between the exercise price of the options and the estimated current fair value is charged to deferred compensation and amortized as an expense over the related vesting periods of the grants using the accelerated method outlined in FASB Financial Interpretation Number 28, or FIN No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Awards Plans”. Under variable award accounting, the affected option grants continue to be marked to market until such time as the amount of related compensation is deemed fixed. Options for approximately 3.0 million shares are no longer being accounted for as variable awards following the occurrence of our initial public offering in July 2004. Of the remaining 3.5 million shares held by our Chief Executive Officer, 0.8 million and 1.5 million were either exercised or surrendered in “net” exercises completed during the second and third quarters of 2005, respectively. Additionally, 0.1 million options were exercised during the third quarter of 2005 in a traditional exercise transaction. The remaining 1.2 million options will continue to be accounted for as a variable award until the grant is fully exercised, is forfeited, or expires unexercised.

We have separately disclosed stock-based compensation throughout this discussion and in our financial statements and we have shown a reconciliation of stock-based compensation as it relates to sales and marketing, research and development, and general and administrative expenses on the statement of operations because, in managing our operations, we believe such costs significantly affect our ability to better understand and manage other operating expenses and cash needs.

We have also disclosed in note 3 of the Notes to the unaudited consolidated financial statements the pro forma effects of accounting for our stock-based compensation in accordance with SFAS No. 123, “Accounting for Stock Based Compensation”, as well as the underlying assumptions.

We used the following assumptions in the calculation of stock-based compensation expense for options granted in accordance with SFAS No. 123:

		Three months ended								Nine months ended
		September 30,								September 30,
		2005				2004				2005				2004
Volatility			82.03	%			78.02	%			82.03	%			78.02	%
Dividend yield			1.40	%			0.00	%			1.40	%			0.00	%
Risk-free interest rate			3.80	%			3.68	%			3.80	%			3.68	%
Expected option life in years			6.55				7.90				6.55				7.90

Deferred taxes

Significant judgment is required in determining our income taxes in each of the jurisdictions in which we operate. This process involves 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 a net deferred tax asset, which is included on our consolidated balance sheet. The final tax outcome of these matters might be different than that which is reflected in our historical income tax provisions, benefits and accruals. Any difference could have a material effect on our income tax provision and net income in the period in which such a determination is made.

Prior to October 13, 1999, we were organized as an S corporation under the Internal Revenue Code and, therefore, were not subject to federal income taxes. We historically made distributions to our stockholders to cover the stockholders’ anticipated tax liability. In connection with the recapitalization agreement, we converted our U.S. taxable status from an S corporation to a C corporation. Accordingly, since October 14, 1999 we have been subject to federal and state income taxes. Upon this conversion and in connection with the recapitalization, we recorded a one-time benefit of $107.0 million to establish a deferred tax asset as a result of the recapitalization agreement.

We must assess the likelihood that the net deferred tax asset will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance, we must include an expense within the tax provision in the statement of operations. We have not recorded a valuation allowance against this item in its deferred tax asset as of September 30, 2005 and December 31, 2004 because we expect to be able to fully utilize this benefit. The ability to utilize this benefit is solely dependent on our ability to generate future taxable income. Based on current estimates of revenue and expenses, we expect future taxable income will be more than sufficient to recover the annual amount of tax amortization permitted. Even if actual results are significantly below our current estimates, the recovery still remains likely and no valuation allowance would be necessary.

Also included in deferred tax asset at December 31, 2004 were state income tax credits, net of federal taxes at 34.8%, of approximately $4.0 million that begin to expire in 2015. We established a valuation allowance against these credits when the assets were recorded because, based on information available at that time, it was not deemed more likely than not that these credits would be realized. During the second quarter of 2005, as a result of profitable results in 2004 and 2003, expectations of future profitability and utilization of related state NOLs, we released $2.9 million of the valuation allowance related to these state income tax credits. This resulted in a credit to our income tax expense of $2.9 million during the second quarter of 2005.

Additionally, certain state tax credits whose use was previously restricted to reducing state franchise taxes became available to offset state income tax as a result of a clarification in enacted tax law during the third quarter of 2005. Accordingly, a deferred tax asset was established during the third quarter of 2005 of $2.2 million, net of federal taxes at 34.8%, related to the associated future reduction of state taxes. A valuation allowance was established for $1.3 million of the $2.2 million representing the portion of the credits not deemed more likely than not to be utilized.

Our deferred tax assets and liabilities are recorded at an amount based upon a blended U.S. Federal income tax rate of 34.8%. This rate is based on our expectation that our deductible and taxable temporary differences will reverse over a period of years during which, except for 2005 and 2006, we will have annual taxable income exceeding $10.0 million per year. If our results of operations worsen in the future, such that our annual taxable income will be expected to fall below $10.0 million, we will adjust our deferred tax assets and liabilities to an amount reflecting the reduced expected U.S. Federal income tax rate, consistent with the corresponding expectation of lower taxable

income. If such change is determined to be appropriate, it will affect the provision for income taxes during the period that the determination is made.

Contingencies

We are subject to the possibility of various loss contingencies in the normal course of business. We accrue for loss contingencies when a loss is estimable and probable.

Results of operations

The following table sets forth our statements of operations data expressed as a percentage of total revenue for the periods indicated.

		Three months ended								Nine months ended
		September 30,								September 30,
		2005				2004				2005				2004
Revenue
License fees			16.9	%			17.1	%			17.9	%			18.0	%
Services			33.6				33.4				32.5				31.7
Maintenance and subscriptions			46.4				47.0				46.8				47.5
Other revenue			3.1				2.5				2.8				2.8
Total revenue			100.0				100.0				100.0				100.0
Cost of revenue
Cost of license fees			2.5				2.7				2.6				2.4
Cost of services			16.8				13.5				17.0				15.9
Cost of maintenance and subscriptions			7.1				7.0				7.4				7.9
Cost of other revenue			2.7				2.2				2.5				2.5
Total cost of revenue			29.1				25.4				29.5				28.7
Gross profit			70.9				74.6				70.5				71.3
Operating expenses
Sales and marketing			19.9				18.8				20.3				19.5
Research and development			12.3				12.5				12.7				12.8
General and administrative			10.2				9.4				9.9				9.2
Amortization			0.0				0.0				0.0				0.0
Costs of initial public offering			0.0				2.2				0.0				2.4
Stock based compensation (benefit)			3.6				(3.1	)			(2.4	)			0.0
Total operating expenses			46.0				39.8				40.5				43.9
Income from operations			24.9				34.8				30.0				27.4
Interest income			0.4				0.2				0.6				0.1
Interest expense			0.0				0.0				0.0				(0.2	)
Other (expense) income, net			(0.1	)			0.0				0.0				0.3
Income before provision for income taxes			25.2				35.0				30.6				27.6
Income tax provision			7.3				14.2				8.6				11.2
Net income			17.9	%			20.8	%			22.0	%			16.4	%