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

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes thereto, located in Item 1 of this quarterly report.

FORWARD-LOOKING STATEMENTS

This quarterly report contains forward-looking statements. These forward-looking statements include predictions regarding: -

-- OUR FUTURE REVENUES, COST OF REVENUES, RESEARCH AND DEVELOPMENT
EXPENSES, SELLING, GENERAL AND ADMINISTRATIVE EXPENSES, AMORTIZATION
OF OTHER INTANGIBLE ASSETS AND GROSS MARGIN;

-- GROWTH AND OPPORTUNITIES WITHIN OUR TARGET MARKETS;

-- OUR STRATEGY RELATING TO SPEECH AND LANGUAGE TECHNOLOGIES;

-- THE POTENTIAL OF FUTURE PRODUCT RELEASES;

-- OUR PRODUCT DEVELOPMENT PLANS AND INVESTMENTS IN RESEARCH AND
DEVELOPMENT;

-- FUTURE ACQUISITIONS;

-- INTERNATIONAL OPERATIONS AND LOCALIZED VERSIONS OF OUR PRODUCTS; AND

-- LEGAL PROCEEDINGS AND LITIGATION MATTERS.

You can identify these and other forward-looking statements by the use of words such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "intends," "potential," "continue" or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements.

Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in this quarterly report under the heading "Risk Factors" All forward-looking statements included in this document are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statements.

OVERVIEW OF THE BUSINESS

ScanSoft is a leading provider of software that allows users to incorporate documents, images and speech into digital applications. Our products and technologies automate manual processes and help enterprises, professionals and consumers increase productivity, reduce costs and save time. Our products are built upon digital capture and speech technologies, and are sold as solutions into the financial, legal, healthcare, government, telecommunications and automotive industries. We focus on markets where we can exercise market leadership, where significant barriers to entry exist and where we possess competitive advantages, because of the strength of our technologies, products, services, channels and business processes.

On June 15, 2004, we acquired all of the outstanding shares of Telelogue, Inc. ("Telelogue), a provider of automated directory assistance applications for telecommunications service providers, in exchange for cash consideration. The consideration consists of an

amount equal to $2,000,000 in cash (less certain expenses), of which $500,000 was placed in escrow to cover certain indemnification obligations, the assumption of certain obligations and a contingent payment of up to $2,000,000 in cash to be paid, if at all, on or about July 15, 2005, upon the achievement of certain performance goals.

On March 30, 2004, we amended our loan and security agreement with Silicon Valley Bank for a revolving loan in a principal amount not to exceed $20.0 million, collateralized by substantially all of our personal property, but not our intellectual property. At the date of this quarterly report on Form 10-Q, no amounts were outstanding under the Credit Facility and $15.6 million was available for borrowing, with approximately $1.4 million committed under this line of credit for outstanding Letters of Credit.

On December 19, 2003, we acquired all of the outstanding shares of LocusDialog Inc. ("LocusDialog"), a provider of speech-enabled, auto-attendant applications, such as call routing and auto attendant functions. LocusDialog has installed nearly 1,000 applications worldwide, handling approximately 500 million calls annually. Consideration for the transaction comprised 2.3 million shares of our common stock at a per share value of $5.31 (the average closing price of ScanSoft common stock for a total of five days immediately prior to and subsequent to the announcement of the acquisition) having a value of $12.4 million and transaction costs of $0.7 million.

On August 11, 2003, we acquired all of the outstanding stock of SpeechWorks International, Inc. ("SpeechWorks"), a leading provider of software products and professional services that enable enterprises, telecommunications carriers and government organizations to offer automated, speech-activated services over any telephone, in exchange for 0.860 of a share of our common stock for each outstanding share of SpeechWorks stock. This transaction resulted in the issuance of approximately 32.5 million shares of our common stock, representing approximately 33% of our outstanding common stock after the completion of the acquisition. The SpeechWorks purchase price of $175.5 million includes the value of the ScanSoft common stock issued at a per share value of $5.26 (the average closing price of ScanSoft common stock for a total of five days immediately prior to and subsequent to the announcement of the acquisition) and transaction costs of $4.5 million. Included in the transaction costs is a warrant, valued at $0.2 million, for the purchase of 150,000 shares of our common stock. In addition, the purchase price includes the value of 184,850 shares of restricted common stock issued to replace previously outstanding SpeechWorks restricted common stock, of $0.7 million, based on the closing price of our common stock on the date of acquisition. The value of the unvested restricted common stock has been recorded as deferred compensation.

On January 30, 2003, we completed the acquisition of the Speech Processing Telephony and Voice Control business units of Royal Philips Electronics N.V. ("Philips"), and related intellectual property, on the terms set forth in the purchase agreement dated October 7, 2002, as amended. The Telephony business unit offers speech-enabled services including directory assistance, interactive voice response and voice portal applications for enterprise customers, telephony vendors and carriers. The Voice Control business unit offers a product portfolio including small footprint speech recognition engines for embedded applications such as voice-controlled climate, navigation and entertainment features in automotive vehicles, as well as voice dialing for mobile phones. As consideration for these business units and intellectual property, we paid 3.1 million euros ($3.4 million) in cash at closing, subject to adjustment in accordance with the provisions of the purchase agreement, as amended, and agreed to pay an additional 1.0 million euros in cash prior to December 31, 2003, issued a 5.0 million euro note payable due December 31, 2003 and bearing 5.0% interest per annum and issued a $27.5 million three-year, zero-interest subordinated debenture, convertible at any time at Philips' option into shares of our common stock at $6.00 per share. Prior to December 31, 2003, we paid both the 5.0 million euro promissory note and the additional 1.0 million euro payable in accordance with the provisions of the purchase agreement. In addition, prior to December 31, 2003, in accordance with provisions of the purchase agreement, the parties agreed upon a purchase price adjustment resulting in a decrease to the total purchase consideration, and a payment to be made by Philips to ScanSoft of approximately $3.0 million. ScanSoft received this payment on January 5, 2004.

                                                       THREE MONTHS ENDED        SIX MONTHS ENDED
                                                            JUNE 30,                  JUNE 30,
                                                      -------------------      ------------------
                                                       2004         2003        2004        2003
                                                      -----        -----       -----       -----
Revenues:
  Product licenses ..............................      75.2%        96.9%       75.9%       96.6%
  Professional services .........................      24.8          3.1        24.1         3.4
                                                      -----        -----       -----       -----
    Total revenue ...............................     100.0%       100.0%      100.0%      100.0%
Cost of revenues:
  Cost of product licenses ......................       7.7         10.5         7.9        11.1
  Cost of professional services - stock based
    compensation ................................        --           --          --          --
    -- all other expenses .......................      17.2          6.0        16.5         4.8
  Cost of revenue from amortization of intangible
    assets(1) ...................................       6.1          9.6         6.3         8.5
                                                      -----        -----       -----       -----
    Total cost of revenues ......................      31.0         26.1        30.7        24.4
                                                      -----        -----       -----       -----
  Research and development
    -- stock based compensation .................       0.2           --         0.2          --
    -- all other expenses .......................      18.7         30.1        20.1        27.9
  Selling, general and administrative
    -- stock based compensation .................       0.9          0.1         0.7         0.1
    -- all other expenses .......................      46.8         49.9        48.7        48.7
  Amortization of other intangible assets (1) ...       1.4          1.5         1.5         1.4
  Restructuring and other charges, net (2) ......        --          2.9         1.0         2.4
                                                      -----        -----       -----       -----
    Total costs and expenses ....................      99.0        110.6       102.9       104.9
                                                      -----        -----       -----       -----
Income (loss) from operations ...................       1.0        (10.6)       (2.9)       (4.9)
                                                      -----        -----       -----       -----
Other income (expense), net .....................      (0.4)         1.4         0.3         0.7
                                                      -----        -----       -----       -----
Income (loss) before income taxes ...............       0.6         (9.2)       (2.6)       (4.2)
Provision for (benefit) from income taxes .......       1.5%         1.4%        1.1%        1.4%
                                                      -----        -----       -----       -----
Net income (loss) ...............................      (0.9)%      (10.6)%      (3.7)%      (5.6)%
                                                      -----        -----       -----       -----

(2) See Note 10 of Notes to Consolidated Financial Statements.

GENERAL

We derive our revenue from sales of our software products to customers through distribution partners and value-added resellers, royalty revenues from OEM partners, license fees from sales of our products to customers and from professional services, which include, but are not limited to, custom software applications and other services considered essential to the functionality of the software, training, and maintenance associated with software license transactions. Our speech technologies enable voice-activated services over a telephone, transform speech into text and text into speech, and permit voice control of devices and applications. Our digital capture technologies transform text, images and files into various digital formats. During the three month period ended June 30, 2004, Speech and Digital Capture represented approximately 65% and 35%, respectively, of our net revenue.

Cost of product license revenue consists primarily of material and fulfillment costs and third party royalties paid to other vendors.

Cost of professional services revenue consists primarily of engineering costs, both internal and external, associated with certain contracts which are accounted for under the percentage-of-completion method of accounting and project-specific travel expenses.

Cost of revenue from amortization of intangible assets consists of the amortization of acquired patents and core and completed technology.

Research and development expense consists primarily of salary and benefits costs of engineers. We believe that the development of new products and the enhancement of existing products are essential to our success. Accordingly, we plan to continue to invest in research and development activities. To date, we have not capitalized any internal development costs as the cost incurred after technological feasibility but before release of product has not been significant.

Selling expenses include salaries, commissions, advertising, direct mail, public relations, trade shows, travel and other related sales and marketing expenses. General and administrative expenses include personnel costs for administration, finance, human resources, information systems and general management, in addition to legal and accounting expenses and other professional services. We attempt to control selling, general and administrative expense; however, if revenue continues to grow, we expect selling, general and administrative expense to increase to support our growing operations. In addition, we may increase selling, general and administrative expenses in advance of revenue to support expected future revenue growth in specific product lines or geographic regions.

Stock-based compensation expenses result from non-cash charges for common shares issued with exercise or purchase prices that are less than the fair market value of the common stock on the date of grant.

Amortization of other intangible assets excludes amortization of acquired patents and core and completed technology which is included in cost of revenue from amortization of intangible assets.

Total Revenue

Total revenue for the three months ended June 30, 2004 increased by $18.4 million, or 66%, from the comparable period in 2003. The overall growth in revenue is attributed to $7.8 million growth from our product revenue and $10.6 million in growth from professional services. Total revenue for the six months ended June 30, 2004 increased by $33.3 million, or 60%, from the comparable period 2003. The overall revenue growth for the first half of 2004 was made up of $13.7 million in product revenues and $19.6 million in professional services revenue.

Geographic revenue classification is based on the country in which the sale is invoiced. Revenue for the three months ended June 30, 2004 was 72% North America and 28% international versus 70% and 30%, respectively for the comparable period in 2003. Revenues for the six months ended June 30, 2004 were segregated geographically 70% North America and 30% international, versus 72% North America and 28% international for the same period in 2003.

A number of the Company's OEM partners distribute their products throughout the world and do not provide us with the geographical dispersion of their products. We believe, if provided with this information, our geographical revenue classification would indicate a higher international percentage. Based on an estimate that factors our OEM partners' geographical revenue mix to our revenues generated from these OEM partners, revenue for the three months ended June 30, 2004 is approximately 69% North America and 31% international, compared to 62% and 38%, respectively, for the comparable period in 2003. Based on this allocation, the revenues for the first half 2004 is approximately 68% North America and 32% international, as compared to 64% North America and 36% international for the same period, 2003.

For fiscal year 2004, we expect revenue growth of 37% to 48% from the fiscal year 2003 total. We believe that growth will occur throughout all of our product lines.

Within the networked speech market, our anticipated growth is attributable to certain competitive advantages, such as superior products, channel expertise, packaged applications and professional services. By leveraging our advantages, we expect to gain market share by providing solutions for industries including financial services, telecommunications, healthcare, utilities, government, and travel and entertainment. Our anticipated growth in network speech will largely result from two specific applications - call center automation and directory assistance.

Within the embedded speech market, we anticipate continued growth, specifically in the automotive, electronic games and handsets markets, resulting in a significant increase over 2003 revenues. We expect to benefit from a number of continued design wins and new applications and devices that our customers and partners bring to global markets. In addition, we expect certain legislation and safety initiatives for using devices in automobiles to contribute to future demand for our solutions. Additionally, we intend to extend our solutions further in the learning and accessibility markets.

Within our productivity applications, we expect to benefit from three important trends -- IT spending in healthcare, networked scanning, and PDF solutions. We expect to invest in and see growth from our dictation product applications through opportunities in healthcare organizations looking for productivity solutions that can automate processes, cut costs, and offer an alternative to outsourcing. In digital capture, our OmniPage and PaperPort products are positioned to take advantage of the growing networked scanning markets through our major OEM partners. Within the PDF market, we have seen early success from our PDF products and expect to see growth as we continue to invest in this line of products.

We expect a similar mix of product and service revenue as presented in our three most recent quarters. The majority of our services revenue is attributable to our networked speech initiatives where we sell solutions that comprise a combination of technologies, applications and professional services. Trends and markets that affect our product revenues in networked and embedded revenue can also be ascribed to our services revenue.

Product Revenue

Product revenue for the three months ended June 30, 2004 increased by $7.8 million, or 29%, from the comparable period in 2003. The increase in revenue from the comparable period 2003 is attributed to a $4.4 million increase in speech revenue, as well as a $3.4 million increase in digital capture revenue. Product revenue for the six months ended June 30, 2004 increased by $13.7 million, or 26%, from the comparable period in 2003. The increase in revenue from the comparable period 2003 is ascribed to a $8.9 million increase in speech revenue, as well as a $4.8 million increase in digital capture revenue.

The growth in speech revenue is attributed to growth and increased demand in all speech segments - enterprise, telephony, embedded, and dictation was primarily due to the acquisition of SpeechWorks, Locus Dialog, and Telelogue. For the three months ended June 30, 2004, the acquisitions contributed approximately $8.4 million in revenue, an increase of 48% over legacy ScanSoft speech solutions for enterprise, telephony and embedded markets. This increase was partially offset in comparison by a $2.7 million decrease in our legacy ScanSoft speech revenue. In addition, our dictation productivity applications decreased $1.3 million in the three months ended June 30, 2004, due entirely to the launch of Dragon Naturally Speaking v.7 in late Q1 and early Q2 of last year.

For the six months ended June 30, 2004, the acquisitions contributed approximately $14.8 million in revenue, an increase of 26% over legacy ScanSoft speech solutions for enterprise, telephony and embedded markets. This increase was partially offset in comparison by a $5.1 million decrease in our legacy ScanSoft speech revenue and a $3.0 million decrease due to a large OEM transaction with one customer in March 2003, that was not repeated again in 2004. In addition, our dictation productivity applications decreased $0.7 million in the six months ended June 30, 2004, due entirely to the launch of Dragon Naturally Speaking v.7 in late Q1 and early Q2 of last year.

The $3.4 million increase in our digital capture revenue for the three months ended June 30, 2004, was due primarily to an increase of $3.5 million, from our PDF Converter product line, which was launched in September 2003. We experienced an overall increase in our OCR product revenues of $1.4 million, which included a $2.1 million year-over-year increase within our OmniPage product line, as well as a $0.4 million increase in our Capture Development Kit products. This was offset partially by a $1.2 million decrease in our TextBridge product line as certain OEM partners migrate from TextBridge to OmniPage products. In addition, we experienced a decrease of $1.7 million year-over-year in our paper management revenue due to the launch of PaperPort 9.0 late in March 2003.

The $4.8 million increase in our digital capture revenue for the six months ended June 30, 2004, was due primarily to an increase of $4.8 million, from our PDF Converter product line, which was launched in September 2003. We experienced an overall increase in our OCR product revenues of $2.7 million, which included a $3.4 million year-over-year increase within our OmniPage product line, as well as a $0.6 million increase in our Capture Development Kit products. This was offset partially by a $2.0 million decrease in our TextBridge product line as certain OEM partners migrate from TextBridge to OmniPage products. In addition, we experienced a decrease of $3.0 million year-over-year in our paper management revenue due to the launch of PaperPort 9.0 late in March 2003.

The following table presents the breakdown of our product revenue by distribution channel:

                  THREE MONTHS           SIX MONTHS
                  ENDED JUNE 30,        ENDED JUNE 30,
                 ---------------       ---------------
                 2004       2003       2004       2003
                 ----       ----       ----       ----
VAR/Retail ...    37%        38%        38%        38%
Direct .......    16%        29%        17%        29%
OEM ..........    47%        33%        45%        33%
                 ---        ---        ---        ---
                 100%       100%       100%       100%
                 ===        ===        ===        ===

The increase in our OEM product revenues as a percentage of revenue, for the three and six months ended June 30, 2004 as compared to the same period 2003, was primarily due to the acquisitions of SpeechWorks and Locus Dialog. Additionally, the Direct channel decreased, as a percentage of product revenue, due to launches of both our Dragon Naturally Speaking v7.0 and PaperPort v9.0 in Q1 and Q2 of 2003, which are both distributed directly.

Service Revenue

Service revenue for the three months ended June 30, 2004 increased by $10.6 million from the comparable period in 2003. Previously, service revenue was immaterial, comprised of non-recurring engineering fees for speech and imaging applications. The substantial increase in service revenue from the comparable period 2003 is attributed to the formation of a professional services organization in conjunction with the acquisition of SpeechWorks, which was completed in August 2003. Additionally, we saw a $0.3 million increase in service revenue from our digital capture products, as well as a $0.4 million increase in service revenue from our dictation product lines.

Service revenue for the six months ended June 30, 2004 increased by $19.6 million from the comparable period in 2003. Previously, service revenue was immaterial, comprised of non-recurring engineering fees for speech and imaging applications. The substantial increase in service revenue from the comparable period 2003 is attributed to the formation of a professional services organization in conjunction with the acquisition of SpeechWorks, which was completed in August 2003. Additionally, we recorded a $0.7 million increase in service revenue from our digital capture products, as well as a $0.5 million increase in service revenue from our dictation product lines.

Cost of Product License Revenue

Cost of product license revenue for the three months ended June 30, 2004 was $3.5 million, or 10.2%, of product license revenue, compared to $2.9 million, or 10.8%, for the comparable period in 2003. Cost of product license revenue for the six months ended June 30, 2004 was $7.0 million, or 10.4%, of product license revenue, compared to $6.2 million, or 11.5%, for the comparable period in 2003. The increase in cost of product license revenue in absolute dollars for these periods ended June 30, 2004 was directly attributable to the overall increase in our product license revenue. The decrease in cost of product license revenue as a percentage of revenue was due productivity gains in our manufacturing and fulfillment operations, as well as decreased customer service costs. For the remainder of 2004, we expect cost of product license revenue, as a percentage of revenue, to be consistent with the six months ended June 30, 2004.

Cost of Professional Services Revenue

As we continue to grow our professional services business, we expect the costs of professional service revenue to be more comparable to the three and six month periods ended June 30, 2004 versus the same periods ended June 30, 2003. Cost of professional services revenue for the three months ended June 30, 2004 was $7.9 million, or 69.4%, of professional services revenue, compared to $1.7 million, or 194%, for the comparable period in 2003. Cost of professional services revenue for the six months ended June 30, 2004 was $14.7 million, or 68.4%, of professional services revenue, compared to $2.7 million, or 144%, for the comparable period in 2003. The increase in cost of professional services revenue in absolute dollars for the three-month period ended June 30, 2004 was directly attributable to the increase in engineering costs related to professional services revenue resulting from the Philips and SpeechWorks acquisitions and increased technical support costs primarily related to the creation of a customer service department in Europe. We expect cost of revenues as a percentage of total revenues to increase slightly during the third quarter, as we increased professional services staffing to meet our solutions demand. But, we expect this ratio to decrease during the fourth quarter as a result of higher utilization of our new services personnel and anticipated increases in revenue during the fourth quarter.

Cost of professional services-stock based compensation is related to the issuance of common stock to certain of our executives with exercise or purchase prices that are less than

the fair market value of the common stock on the date of grant.

Cost of Revenue from Amortization of Intangible Assets

Cost of revenue from amortization of intangible assets for the three months ended June 30, 2004 was $2.8 million, or 6.1%, of total revenue, compared to $2.7 million, or 9.6%, for the comparable period in 2003. The increase in cost of revenue from amortization of intangible assets for the three months ended June 30, 2004 in absolute dollars is attributable to $0.2 million related to the SpeechWorks acquisition which was completed on August 11, 2003 and $0.1 million related to the LocusDialog acquisition which was completed on December 19, 2003, partially offset by $0.1 million of intangible assets that became fully amortized during fiscal year 2003.

Cost of revenue from amortization of intangible assets for the six months ended June 30, 2004 was $5.6 million, or 6.3%, of total revenue, compared to $4.7 million, or 8.5%, for the comparable period in 2003. The increase in cost of revenue from amortization of intangible assets in absolute dollars is attributable to $0.5 million of amortization related to the exclusive worldwide license of certain desktop dictation products acquired on March 31, 2003, $0.1 million related to the Philips acquisition which was completed on January 30, 2003, $0.2 million related to the SpeechWorks acquisition which was completed on August 11, 2003 and $0.3 million related to the LocusDialog acquisition which was completed on December 19, 2003. This was partially offset by $0.1 million of intangible assets that became fully amortized during fiscal year 2003. During 2004, we expect cost of revenue from amortization of intangible assets to be approximately $11.0 million based on our current level of intangible assets.

Research and Development Expense

Research and development expense for the three months ended June 30, 2004 was $8.6 million, or 18.7%, of total revenue, compared to $8.4 million, or 30.1%, for the comparable period in 2003. The increase in research and development expenses for the three months ended June 30, 2004 in absolute dollars is due to increased costs of $0.8 million related to speech and language development efforts, partially offset by decreased costs of $0.6 million associated with imaging development efforts. The increase in speech and language development efforts is primarily related to increased headcount and related costs of approximately $1.1 million resulting from both the Philips and SpeechWorks acquisitions. The decrease in imaging related development efforts is primarily related to a reduction of headcount and related costs of approximately $0.6 million primarily resulting from the transfer of certain research and development activities from our corporate headquarters to Budapest during the three month period ended June 30, 2003.

Research and development expense for the six months ended June 30, 2004 was $17.8 million, or 20.1%, of total revenue, compared to $15.5 million, or 27.9%, for the comparable period in 2003. The increase in research and development expenses for the six months ended June 30, 2004 is due to increased costs of $3.5 million related to speech and language development efforts, partially offset by decreased costs of $1.2 million associated with imaging development efforts. The increase in speech and language development efforts is primarily related to increased headcount and related costs of approximately $3.1 million resulting from both the Philips and SpeechWorks acquisitions. The decrease in imaging related development efforts is primarily related to a reduction of headcount and related costs of approximately $0.9 million primarily resulting from the transfer of certain research and development activities from our corporate headquarters to Budapest during the three month period ended June 30, 2003.

While we will continue to invest significantly in research and development, we expect research and development expenses as a percentage of revenue to continue to decline during the second half of 2004 due to an increase in revenue. Research and development expenses-stock based compensation is related to the issuance of common stock to certain of our executives with exercise or purchase prices that are less than the fair market value of the common stock on the date of grant.

Selling, General and Administrative Expense

Selling, general and administrative expense for the three months ended June 30, 2004 was $21.6 million, or 46.8%, of total revenue, compared to $13.8 million, or 49.9%, for the comparable period in 2003. The increase in selling, general and administrative expense for the three months ended June 30, 2004 was the result of increased compensation costs of approximately $4.6 million resulting from the addition of sales and marketing and general and administrative employees primarily due to the fiscal year 2003 acquisitions. The remaining increase in selling, general and administrative expenses is due primarily to increased facilities charges of $1.2 million resulting from increased rent and related insurance expenses, increased professional fees of approximately $0.6 million, and travel expenses of $0.7 million for the three month period ended June 30, 2004.

Selling, general and administrative expense for the six months ended June 30, 2004 was $43.3 million, or 48.7%, of total revenue, compared to $27.1 million, or 48.7%, for the comparable period in 2003. The increase in selling, general and administrative expense for the six months ended June 30, 2004 was the result of increased compensation costs of approximately $10.3 million resulting from the addition of sales and marketing employees and general and administrative employees primarily due to the fiscal year 2003 acquisitions. The remaining increase in selling, general and administrative expenses is due primarily to increased facilities charges of $2.8 million, resulting from increased rent and related insurance expenses, increased professional fees of approximately $1.0 million and travel expenses of $1.5 million. In

addition, during the three months ended June 30, 2004 we incurred approximately $0.6 million related to compliance with recently issued regulatory requirements bringing the total six months costs to $0.7 million. We expect selling, general and administrative expenses in absolute dollars to remain consistent over the remainder of 2004 but decline as a percentage of revenue as revenue increases.

Selling, general and administrative expenses-stock based compensation of approximately $0.4 million and $0.7 million for the three and six month periods ended June 30, 2004, is related to the issuance of common stock to certain of our executives with exercise or purchase prices that are less than the fair market value of the common stock on the date of grant.

Amortization of Other Intangible Assets

Amortization of other intangible assets for the three months ended June 30, 2004, was $0.6 million, or 1.4%, of total revenue, compared to $0.4 million, or 1.5%, for the comparable period in 2003. The increase in amortization of other intangible assets is attributable to $0.4 million related to the SpeechWorks acquisition which was completed on August 11, 2003, partially offset by $0.2 million of intangible assets that became fully amortized during fiscal year 2003.

Amortization of other intangible assets for the six months ended June 30, 2004, was $1.3 million or 1.5% of total revenue, compared to $0.8 million or 1.4% for the comparable period in 2003. The increase in amortization of other intangible assets is attributable to $0.9 million related to the SpeechWorks acquisition which was completed on August 11, 2003, partially offset by $0.3 million of intangible assets that became fully amortized during fiscal year 2003. During 2004, we expect amortization of other intangible assets to be approximately $2.7 million based on our current level of intangible assets.

Restructuring and Other Charges, Net

During the six months ended June 30, 2004, we recorded a charge of $0.8 million related to separation agreements with two former members of our senior management team. Included in this amount are non-cash compensation charges of $0.4 million related to the acceleration of restricted common stock and stock options.

During the three and six month period ended June 30, 2003, the Company committed to a plan to transfer certain research and development activities currently located at the corporate headquarters to Budapest resulting in the elimination of 21 employees. The Company recorded a restructuring charge in the amount of $0.4 million for severance payments to these employees. In addition, the Company recorded a charge in the amount of $0.4 million for severance payments to a former member of the senior management team.

In connection with the Philips acquisition, we eliminated 25 ScanSoft personnel across all functional areas resulting in approximately $0.5 million in severance related restructuring costs in the three month period ended March 31, 2003.

Income (Loss) from Operations

As a result of the above factors, income from operations was $0.5 million for the three months ended June 30, 2004 or 1.0% of total revenue, compared to a loss of $(3.0) million or (10.6)% of revenue for the comparable period in 2003. Loss from operations was $(2.5) million for the six months ended June 30, 2004 or (2.9)% of total revenue, compared to $(2.8) million or (4.9)% of total revenue for the comparable period in 2002.

Other Income (Expense), Net

Interest income was $0.2 million and $0.1 million for the three months ended June 30, 2004 and 2003, respectively. Interest expense was $0.1 million and $0.2 million for the three months ended June 30, 2004 and 2003, respectively. Other expense of $0.3 million for the three months ended June 30, 2004 includes foreign currency losses of $0.1 million.

Interest income was $0.3 million and $0.1 million for the six months ended June 30, 2004 and 2003, respectively. Interest expense was $0.2 million and $0.3 million for the six months ended June 30, 2004 and 2003, respectively. Other income of $0.2 million for the six months ended June 30, 2004 consists primarily of receipt of $0.6 million in settlements of a previously written off receivable balance related to the Philips and SpeechWorks acquisitions, partially offset by foreign currency losses.

Income (Loss) Before Income Taxes

Income before income taxes was $0.3 million for the three months ended June 30, 2004 or 0.6% of total revenue, compared with loss of ($2.6) million or (9.3%) for the comparable period in 2003.

Loss before income taxes was ($2.2) million for the six months ended June 30, 2004 or (2.6%) of total revenue, compared with loss of ($2.4) million or (4.3%) for the comparable period in 2003.

Income Taxes

The provision for income taxes for the three months ended June 30, 2004 was $0.7 million, or 1.5%, of total revenue, compared to $0.4 million, or 1.3%, in the comparable period for 2003. The provision for income taxes consists primarily of foreign taxes relating to operations in Canada and Europe and deferred tax provisions of $0.2 million arising out of differences between tax and financial statement treatment of goodwill. The provision for income taxes for the six months ended June 30, 2004 was $1.0 million, or 1.1%, of total revenue, compared to $0.7 million, or 1.3%, in the comparable period for 2003. The provision for income taxes consists of foreign taxes of $0.5 million relating primarily to European operations, foreign withholding taxes of $0.1 million and deferred tax provisions of $0.4 million arising out of differences between the tax and financial statement treatment of goodwill.

Net Income (Loss)

As a result of all these factors, net loss totaled ($0.4) million or (0.9%) of total revenue for the three months ended June 30, 2004, compared with a loss of ($2.9) million or (10.6%) of total revenue for the comparable period in 2003. As a result of all these factors, net loss totaled ($3.2) million or (3.7%) of total revenue for the six months ended June 30, 2004, compared with a loss of ($3.1) million or (5.6%) of total revenue for the comparable period in 2003.

LIQUIDITY AND CAPITAL RESOURCES

As of June 30, 2004, we had cash and cash equivalents of $22.6 million, $22.3 million of marketable securities and net working capital of $29.7 million as compared to $42.6 million in cash and cash equivalents and net working capital of $44.3 million at December 31, 2003.

Net cash provided by operating activities for the six months ended June 30, 2004 was $2.9 million compared to $6.4 million for the comparable period in 2003. Cash provided by operations in the 2004 period came primarily from income from operations, after adjustments for non-cash amortization, depreciation and stock based compensation, significant collections of accounts receivable, offset by payments of an increase in prepaid expenses and payments of accrued expenses and a decrease in deferred revenue. Cash provided by operations in the 2003 period came primarily from income from operations, after adjustments for non-cash amortization and depreciation, a significant reduction in accounts receivable balances resulting from collections, and lower inventory balances partially offset by payments of accrued expenses, including those assumed in the Philips acquisition, and an increase in other current assets.

Net cash used in investing activities for the six months ended June 30, 2004 was $24.7 million compared to cash used of $11.5 million for the comparable period in 2003. Net cash used in investing activities during 2004 consisted of $2.1 million in capital expenditures, $3.3 million of payments associated with acquisitions and the purchase of $22.7 million of marketable securities, partially offset by $3.1 million payment received due to a final purchase price adjustment related to the Philips acquisition and $0.3 related to the maturity of certain marketable securities. Net cash used in investing activities during the 2003 period consisted of $1.0 million in capital expenditures, which included costs to build-out facilities in both North America and Europe, $4.3 million of payments associated with acquisitions and $6.1 million of payments associated with an exclusive licensing agreement.

Net cash provided by financing activities for the six months ended June 30, 2004 was $1.8 million compared to $3.8 million for the comparable period in 2003. Net cash provided by financing activities during 2004 consists of proceeds of $4.9 million from the issuance of common stock in connection with employee stock compensation plans and $0.6 million of proceeds form the issuance of common stock warrants. This was offset by a $0.4 million payment to the former Caere President and CEO in connection with the settlement of the non-competition and consulting agreement, $2.8 million of payments associated with an exclusive licensing agreement and $0.5 million related to payments on outstanding equipment lines of credit. Net cash provided by financing activities during the six months ended June 30, 2003 consisted of proceeds of $1.2 million from the issuance of common stock in connection with employee stock compensation plans and net proceeds of $6.8 million, excluding offering costs of $1.3 million paid in the prior year, from the underwritten offering of our common stock. This was offset by a $0.8 million payment to the former Caere President and CEO in connection with the settlement of the non-competition and consulting agreement, and the payment of the $3.3 million note payable related to the acquisition of Lernout & Hauspie assets during 2001.

Although we generated $2.9 million and $5.2 million of cash from operations during the six month period ended June 30, 2004 and the fiscal year ended 2003, respectively, and exited the quarter with a cash and cash equivalents balance of $23.3 million and marketable securities of $21.7 million, there can be no assurance that we will be able to continue to generate cash from operations or secure additional equity or debt financing if required. The large increase in our cash and investment balances has come primarily from the SpeechWorks

acquisition. In connection with the Philips Speech Processing Telephony and Voice Control Business Unit acquisition, we issued a $27.5 million, zero interest convertible debenture due January 2006. In connection with the SpeechWorks acquisition we acquired certain long-term lease obligations that begin to come due in the next 12-24 months. Additionally, in connection with the exclusive license agreement entered into on March 31, 2003, we made a payment of $2.8 million on April 5, 2004 and are required to make a final payment totaling $2.8 million on or before March 31, 2005. We have sustained recurring losses from operations in each reporting period through December 31, 2001. We have reported a net loss of $(3.2) million and $(5.5) million for the six month period ended June 30, 2004 and the fiscal year ended December 31, 2003, respectively. We had an accumulated deficit of $155.7 million at June 30, 2004. We believe that the actions taken in connection with our acquisitions, including restructuring actions and other cost reduction initiatives, have reduced operating expenses to levels which, in combination with expected future revenues, will continue to generate positive cash flow. Therefore, we believe that cash flows from future operations in addition to cash on hand, including our marketable securities and amounts available under our line of credit will be sufficient to meet our working capital, investing, financing and contractual obligations, including the debt obligation issued in connection with the Philips acquisition, and the lease obligations assumed in the SpeechWorks acquisition, as they become due for the foreseeable future.

The following table outlines our contractual payment obligations as of June 30, 2004:

                                                          PAYMENTS DUE BY PERIOD
                                           -----------------------------------------------------
                                                                                          MORE
                                                       LESS THAN     2-3        4-5      THAN 5
CONTRACTUAL OBLIGATIONS                      TOTAL      1 YEAR      YEARS      YEARS      YEARS
-----------------------                    ---------   ---------  ---------   -------   --------
                                                                (IN THOUSANDS)
Convertible debenture                      $  27,524         --   $  27,524        --   $     --
Deferred payments for technology license       2,671      2,671          --        --         --
Operating leases                              32,823      4,644       7,931     5,050     15,198
Equipment line of credit                         788        603         185        --         --
Standby letters of credit                      1,438        344          46        46      1,002
Royalty commitments                              900        130         620        70         80
Purchase commitments                             975        975          --        --         --
Imputed interest                                 129        129          --        --         --
                                           ---------   --------   ---------   -------   --------
Total contractual cash obligations         $  67,248   $  9,496   $  36,306   $ 5,166   $ 16,280
                                           =========   ========   =========   =======   ========

Through June 30, 2004, we have not entered into any off balance sheet arrangements or transactions with unconsolidated entities or other persons.

FOREIGN OPERATIONS

Because we have international subsidiaries and distributors that operate and sell our products outside the United States, we are exposed to the risk of changes in foreign currency exchange rates or declining economic conditions in these countries. In certain circumstances, we have entered into forward exchange contracts to hedge against foreign currency fluctuations on intercompany balances with our foreign subsidiaries. We use these contracts to reduce our risk associated with exchange rate movements, as the gains or losses on these contracts are intended to offset any exchange rate losses or gains on the hedged transaction. We do not engage in foreign currency speculation. Hedges are designated and documented at the inception of the hedge and are evaluated for effectiveness monthly. Forward exchange contracts hedging firm commitments qualify for hedge accounting when they are designated as a hedge of the foreign currency exposure and they are effective in minimizing such exposure.

On November 3, 2003, we entered into a forward exchange contract to hedge our foreign currency exposure related to 3.5 million euros of intercompany receivables from our Belgian subsidiary. The contract has a one year term that expires on November 1, 2004. For the six month period ended June 30, 2004, we recorded a net exchange rate gain of approximately $42,000 in other comprehensive income on the intercompany receivable and associated forward exchange contract. On November 5, 2003, we entered into a forward exchange contract to hedge our foreign currency exposure related to 7.5 million Singapore dollars of intercompany receivables from our Singapore subsidiary. The contract, as amended, expires on July 31, 2004. For the six month period ended June 30, 2004, we recorded a net exchange rate gain of approximately $0.1 million on the intercompany receivable and associated forward exchange contract.

With our increased international presence in a number of geographic locations and with international revenues projected to increase in 2004, we are exposed to changes in foreign currencies including the euro, Canadian dollar, Japanese yen and the Hungarian forint. Changes in the value of the euro or other foreign currencies relative to the value of the U.S. dollar could adversely affect future revenues and operating results.

RECENT ACCOUNTING PRONOUNCEMENTS

In March 2004, the Emerging Issues Task Force ("EITF") reached a consensus on EITF No. 03-6, "Participating Securities and Two-Class Method under FASB Statement No 128, Earning Per Share." EITF No. 03-6 addresses a number of questions regarding the computation of earnings per share ("EPS") by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock.

The issue also provides further guidance in applying the two-class method of calculating EPS. It clarifies what constitutes a participating security and how to apply the two class method of computing EPS once it is determined that a security is participating, including how to allocate undistributed earning to such a security. The consensus reached on EITF No. 03-6 is effective for fiscal periods beginning after March 31, 2004. Prior period earnings per share amounts should be restated to conform to the consensus to ensure comparability year over year. We have evaluated the impact, the adoption of EITF No. 03-6 would have on our results of operations and financial condition, and determined that as we are currently operating in a net loss position, the adoption of EITF No. 03-6 has no impact on our results of operations and financial position.

RISK FACTORS

You should carefully consider the risks described below when evaluating our company and when deciding whether to invest in us. The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently deem immaterial may also impair our business operations and financial situation. Our business, financial condition and results of operations could be seriously harmed if any of these risks actually occurs. As a result, the trading price of our common stock may decline and you can lose part or all of your investment in our common stock.

Risks Related to Our Business

Our operating results may fluctuate significantly from period to period, and this may cause our stock price to decline. Our revenue and operating results have fluctuated in the past and, and we expect our revenue and operating results to continue to fluctuate in the future. Given this fluctuation, we believe that quarter to quarter comparisons of our revenue and operating results are not necessarily meaningful or an accurate indicator of our future performance. As a result, our results of operations may not meet the expectations of securities analysts or investors in the future. If this occurs, the price of our stock would likely decline. Factors that contribute to fluctuations in our operating results include the following:

-- slowing sales by our distribution and fulfillment partners to their customers, which may place pressure on these partners to reduce purchases of our products;

-- volume, timing and fulfillment of customer orders;

-- rapid shifts in demand for products given the highly cyclical nature of the retail software industry;

-- the loss of, or a significant curtailment of, purchases by any one or more of our principal customers;

-- concentration of operations with one manufacturing partner and ability to control expenses related to the manufacture, packaging and shipping of our boxed software products;

-- customers delaying their purchase decisions in anticipation of new versions of products;

-- introduction of new products by us or our competitors;

-- seasonality in purchasing patterns of our customers, where purchases tend to slow in the third fiscal quarter;

-- reduction in the prices of our products in response to competition or market conditions;

-- returns and allowance charges in excess of recorded amounts;

-- timing of significant marketing and sales promotions;

-- write-offs of excess or obsolete inventory and accounts receivable that are not collectible;

-- increased expenditures incurred pursuing new product or market opportunities;

-- inability to adjust our operating expenses to compensate for shortfalls in revenue against forecast; and

-- general economic trends as they affect retail and corporate sales.

Due to the foregoing factors, among others, our revenue and operating results are difficult to forecast. Our expense levels are based in significant part on our expectations of future revenue, and we may not be able to reduce our expenses quickly to respond to a shortfall in projected revenue. Therefore, our failure to meet revenue expectations would seriously harm our operating results, financial condition and cash flows.

We have a history of operating losses, and we may incur losses in the future, which may require us to raise additional capital on unfavorable terms. We sustained recurring losses from operations in each reporting period through December 31, 2001. We reported a net loss of $(3.2) million and $(5.5) million for the six-month period ended June 30, 2004 and the fiscal year ended December 31, 2003, respectively. We had an accumulated deficit of $155.7 million at June 30, 2004. If we are unable to regain profitability, the market price for our stock may decline, perhaps substantially. We cannot assure you that our revenues will grow or that we will achieve or maintain profitability in the future. If we do not achieve profitability, we may be required to raise additional capital to maintain or grow our operations. The terms of any additional capital, if available at all, may be highly dilutive to existing investors or contain other unfavorable terms, such as a high interest rate and restrictive covenants.

Our business could be harmed if we do not successfully manage the integration of the businesses that we acquire. As part of our business strategy, we have in the past acquired, and expect to continue to acquire, other businesses and technologies. Our acquisition of the speech and language technology operations of Lernout & Hauspie Speech Products N.V. and certain of its affiliates, including L&H Holdings USA, Inc. (collectively, L&H), our acquisition of the Speech Processing Telephony and Voice Control business units from Philips, our acquisition of SpeechWorks International, Inc. and our acquisition of LocusDialog, Inc. required substantial integration and management efforts. Our recently completed acquisition of Telelogue, Inc. will likely pose similar challenges. Acquisitions of this nature involve a number of risks, including:

-- difficulty in transitioning and integrating the operations and personnel of the acquired businesses, including different and complex accounting and financial reporting systems;

-- potential disruption of our ongoing business and distraction of management;

-- potential difficulty in successfully implementing, upgrading and deploying in a timely and effective manner new operational information systems and upgrades of our finance, accounting and product distribution systems;

-- difficulty in incorporating acquired technology and rights into our products and technology;

-- unanticipated expenses and delays in completing acquired development projects and technology integration;

-- management of geographically remote units both in the united states and internationally;

-- impairment of relationships with partners and customers;

-- entering markets or types of businesses in which we have limited experience; and

-- potential loss of key employees of the acquired company.

As a result of these and other risks, we may not realize anticipated benefits from our acquisitions. Any failure to achieve these benefits or failure to successfully integrate acquired businesses and technologies could seriously harm our business.

Our operating results could be adversely affected as a result of purchase accounting treatment, and the corresponding impact of amortization of other intangibles, relating to our acquisitions completed during 2003 and 2004. Under accounting principles generally accepted in the United States of America, we have accounted for our acquisitions using the purchase method of accounting. Under

purchase accounting, we record the market value of our common stock or other form of consideration issued in connection with the acquisition and the amount of direct transaction costs as the cost of acquiring the company or business. We have allocated that cost to the individual assets acquired and liabilities assumed, including various identifiable intangible assets such as acquired technology, acquired trade names and acquired customer relationships based on their respective fair values. Intangible assets generally will be amortized over a five to ten year period. Goodwill is not subject to amortization but is subject to at least an annual impairment analysis, which may result in an impairment charge if the carrying value exceeds its implied fair value. As a result of this future amortization, purchase accounting treatment of these acquisitions could decrease our net income in the foreseeable future, which could have a material and adverse effect on the market value of our common stock.

Acquisitions may cause dilution to our existing stockholders or require us to use or raise additional cash. In connection with past acquisitions, we issued a substantial number of shares of our common stock as transaction consideration. We may continue to issue equity securities for future acquisitions that would dilute our existing stockholders, perhaps significantly depending on the terms of the acquisition. From time to time, we have also used cash or issued debt instruments as transaction consideration. These debt instruments typically contain various restrictions and covenants relating to our ability to operate our business. We may incur debt in connection with future acquisitions, which, if available at all, may place additional restrictions on our ability to operate our business.

A large portion of our product revenue is dependent on continued demand for our products from OEM partners, and a significant reduction in OEM revenue would seriously harm our business, results of operations, financial condition and stock price. Many of our technologies are licensed to partners that incorporate our technologies into solutions that they sell to their customers. These types of partners are knows as OEM partners. OEM revenue represented 44% and 57% of our consolidated revenue for the year ended December 31, 2003 and for the six months ended June 30, 2004, respectively. The commercial success of our licensed products depends to a substantial degree on the efforts of these OEM partners in developing and marketing their products incorporating our technologies. The integration of our technologies into their products takes significant time, effort and investment, and products incorporating our technologies may not be successfully implemented or marketed by our OEM partners. If our OEM partners do not adequately incorporate our technologies into their products, or if our OEM partners do not generate significant sales from products that incorporate our technologies, our revenues and results of operations will be adversely affected. Moreover, a select few of our OEM partners account for a majority of our OEM revenues. Since these partners are not required to continue to bundle or embed our software, and they may choose the software products of our competitors in addition to, or in place of, our products, the loss of any of these significant OEM partners as a customer would seriously harm our business, results of operations, financial condition and our stock price.

Sales of our document and PDF conversion products and our digital paper management products represented approximately 40% and 32%, of our revenue for the year ended December 31, 2003 and for the six month period ended June 30, 2004, respectively, and any reduction in revenue from these product areas could seriously harm our business. Historically, a small number of product areas have generated a substantial portion of our revenues. For the year ended December 31, 2003, our document and PDF conversion products represented approximately 26% of our revenue and our digital paper management products represented approximately 14% of our revenue. For the six months ended June 30, 2004, our document and PDF conversion products represented approximately 20% of our revenue and our digital paper management products represented approximately 12% of our revenue. A significant reduction in the revenue contribution in absolute dollars from these product areas could seriously harm our business, results of operations, financial condition, cash flows and stock price.

We rely on a small number of distribution and fulfillment partners, including 1450, Digital River, Ingram Micro and Tech Data, to distribute many of our products, and any adverse change in our relationship with such partners may adversely impact our ability to deliver products. Our products are sold through, and a substantial portion of our revenue is derived from, a network of over 2000 channel partners, including value-added resellers, computer superstores, consumer electronic stores, mail order houses, office superstores and eCommerce Web sites. We rely on a small number of distribution and fulfillment partners, including 1450, Digital River, Ingram Micro and Tech Data to serve this network of channel partners. For the six month period ended June 30, 2004, two distribution and fulfillment partners, Ingram Micro and Digital River, accounted for 14% and 8% of our consolidated revenue, respectively. For the year ended December 31, 2003, Ingram Micro and Digital River, accounted for 16% and 13% of our consolidated revenue, respectively. A disruption in these distribution and fulfillment partner relationships could negatively affect our ability to deliver products, and hence our results of operations in the short term. Any prolonged disruption for which we are unable to arrange alternative fulfillment capabilities could have a more sustained adverse impact on our results of operations.

A significant portion of our accounts receivable is concentrated among our largest customers, and non-payment by any of them will adversely affect our financial condition. Although we perform ongoing credit evaluations of our distribution and fulfillment partners' financial condition and maintain reserves for potential credit losses, we do not require collateral or other form of security

from our major customers to secure payment. While, to date, losses due to non-payment from customers have been within our expectations, we cannot assure you that instances or extent of non-payment will not increase in the future. At June 30, 2004, Ingram Micro, Tech Data and Digital River represented 13%, 3% and 4%, of our net accounts receivable, respectively. At December 31, 2003, Ingram Micro, Tech Data and Digital River represented 20%, 5% and 5%, of our net accounts receivable, respectively. If these or any of our other significant customers were unable to pay us in a timely fashion, or if we were to experience significant credit losses in excess of our reserves, our results of operations, cash flows and financial condition would be seriously harmed.

Speech technologies may not achieve widespread acceptance by businesses, which could limit our ability to grow our speech business. We have invested and expect to continue to invest heavily in the acquisition, development and marketing of speech technologies. The market for speech technologies is relatively new and rapidly evolving. Our ability to increase revenue in the future depends in large measure on acceptance of speech technologies in general and our products in particular. The continued development of the market for our current and future speech solutions will also depend on the following factors:

-- consumer demand for speech-enabled applications;

-- development by third-party vendors of applications using speech technologies; and

-- continuous improvement in speech technology.

Sales of our speech products would be harmed if the market for speech software does not continue to develop or develops more slowly than we expect, and, consequently, our business could be harmed and we may not recover the costs associated with our investment in our speech technologies.

The markets in which we operate are highly competitive and rapidly changing, and we may be unable to compete successfully. There are a number of companies that develop or may develop products that compete in our targeted markets. The individual markets in which we compete are highly competitive, and are rapidly changing. Within digital capture, we compete directly with ABBYY, I.R.I.S. and NewSoft. Within speech, we compete with AT&T, Fonix, IBM, Nuance Communications and Rhetorical. Vendors such as Adobe and Microsoft offer solutions that can be considered alternatives to some of our solutions. In addition, a number of smaller companies produce technologies or products that are in some markets competitive with our solutions. Current and potential competitors have established, or may establish, cooperative relationships among themselves or with third parties to increase the ability of their technologies to address the needs of our prospective customers.

The competition in these markets could adversely affect our operating results by reducing the volume of the products we sell or the prices we can charge. Some of our current or potential competitors have significantly greater financial, technical and marketing resources than we do. These competitors may be able to respond more rapidly than we can to new or emerging technologies or changes in customer requirements. They may also devote greater resources to the development, promotion and sale of their products than we do.

Some of our customers, such as Microsoft, have developed or acquired products or technologies that compete with our products and technologies. These customers may give higher priority to the sale of these competitive products or technologies. To the extent they do so, market acceptance and penetration of our products, and therefore our revenue, may be adversely affected.

Our success will depend substantially upon our ability to enhance our products and technologies and to develop and introduce, on a timely and cost-effective basis, new products and features that meet changing customer requirements and incorporate technological advancements. If we are unable to develop new products and enhance functionalities or technologies to adapt to these changes, or if we are unable to realize synergies among our acquired products and technologies, our business will suffer.

The failure to successfully implement, upgrade and deploy in a timely and effective manner new information systems and upgrades of our finance and accounting systems to address certain issues identified in connection with our fiscal 2003 year-end audit could harm our business. In connection with its audit of our 2003 consolidated financial statements, PricewaterhouseCoopers LLP ("PwC"), our independent auditors, advised in a management letter to our Audit Committee of four conditions that could adversely affect our ability to initiate, record, process and report financial data consistent with management's assertions. These conditions include the fact that we may lack the necessary corporate accounting resources to meet the accelerated filing deadline requirements in 2004 mandated by the SEC, while at the same time staffing the demands of our worldwide Oracle implementation and Sarbanes-Oxley requirements. Another condition cited is that we have a dependence on key personnel in our finance and accounting organization, the loss of whom could impair our ability to perform timely financial reporting, especially prior to the completion of our worldwide Oracle

implementation and our readiness efforts related to our obligations under
Section 404 of the Sarbanes-Oxley Act of 2002. In addition, we discuss the other two conditions raised by PwC later in this document under Item 4. Controls and Procedures.

From 1997 through June 30, 2004, we have made eight significant business acquisitions. As a result, we continue to have several financial systems in use. The incompatibility between these systems requires significant manual efforts within finance and accounting to complete our financial reporting. Therefore, substantial knowledge of our policies and procedures and the process for initiating, recording, processing, summarizing and reporting financial information is resident in the knowledge of personnel involved in the financial reporting process.

To improve the efficiency and quality of our accounting and financial reporting systems, we commenced, in the third quarter of 2003, a worldwide implementation of the Oracle e-Business suite. In addition, we have retained a third-party consulting firm that is assisting management and staff to formalize and document our business and financial processes and controls in preparation for our compliance with Section 404 of the Sarbanes-Oxley Act of 2002. While we believe that these actions will address the conditions raised in PwC's letter, we have been and will continue to be required to devote substantial resources to these activities during 2004. Failure to successfully implement these systems or formalize and document these processes and controls in a timely, effective and efficient manner could result in the disruption of our operations, our inability to comply with our Sarbanes-Oxley obligations and the inability to report our financial results in a timely manner.

Our results could be harmed by economic, political, regulatory and other risks associated with these and other international regions. Since we sell our products worldwide, our business is subject to risks associated with doing business internationally. We anticipate that revenue from international operations will represent an increasing portion of our total revenue. Reported international revenue for the year ended December 31, 2003 and the six-month period ended June 30, 2004 represented 28% and 29% of our consolidated revenue for those periods, respectively. Most of these international revenues are generated by sales in Europe and Asia. A number of our OEM partners distribute their products throughout the world and do not provide us with the geographical dispersion of their products. However, based on an estimate that factors our OEM partners' geographical revenue mix to our revenue generated from these OEM partners, international revenue would have represented approximately 35% and 32% of our consolidated revenue for the year ended December 31, 2003 and the six month period ended June 30, 2004, respectively. In addition, some of our products are developed and manufactured outside the United States. A significant portion of the development and manufacturing of our speech products are completed in Belgium, and a significant portion of our digital capture research and development is conducted in Hungary. In connection with the Philips acquisition, we have added an additional research and development location in Germany, and in connection with the acquisition of Locus Dialog, we have added an additional research and development location in Montreal, Canada. Accordingly, our future results could be harmed by a variety of factors associated with international sales and operations, including:

-- changes in a specific country's or region's political or economic conditions;

-- trade protection measures and import or export licensing requirements imposed by the United States or by other countries;

-- compliance with foreign and domestic laws and regulations;

-- negative consequences from changes in applicable tax laws;

-- difficulties in staffing and managing operations in multiple locations in many countries;

-- difficulties in collecting trade accounts receivable in other countries; and

-- less effective protection of intellectual property.

We are exposed to fluctuations in foreign currency exchange rates. Because we have international subsidiaries and distributors that operate and sell our products outside the United States, we are exposed to the risk of changes in foreign currency exchange rates or declining economic conditions in these countries. In certain circumstances, we have entered into forward exchange contracts to hedge against foreign currency fluctuations on intercompany balances with our foreign subsidiaries. We use these contracts to reduce our risk associated with exchange rate movements, as the gains or losses on these contracts are intended to offset any exchange rate losses or gains on the hedged transaction. We do not engage in foreign currency speculation. Hedges are designated and documented at the inception of the hedge and are evaluated for effectiveness monthly. Forward exchange contracts hedging firm commitments qualify for hedge accounting when they are designated as a hedge of the foreign currency exposure and they are effective in minimizing such

exposure. With our increased international presence in a number of geographic locations and with international revenues projected to increase in 2004, we are exposed to changes in foreign currencies including the euro, Canadian dollar, Japanese yen and the Hungarian forint. Changes in the value of the euro or other foreign currencies relative to the value of the U.S. dollar could adversely affect future revenues and operating results.

If we are unable to attract and retain key personnel, our business could be harmed. If any of our key employees were to leave us, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any successor obtains the necessary training and experience. Our employment relationships are generally at-will and we have had key employees leave us in the past. We cannot assure you that one or more key employees will not leave us in the future. We intend to continue to hire additional highly qualified personnel, including software engineers and operational personnel, but we may not be able to attract, assimilate or retain qualified personnel in the future. Any failure to attract, integrate, motivate and retain these employees could harm our business.

RISKS RELATED TO OUR INTELLECTUAL PROPERTY AND TECHNOLOGY.

Unauthorized use of our proprietary technology and intellectual property will adversely affect our business and results of operations. Our success and competitive position depend in large part on our ability to obtain and maintain intellectual property rights protecting our products and services. We rely on a combination of patents, copyrights, trademarks, service marks, trade secrets, confidentiality provisions and licensing arrangements to establish and protect our intellectual property and proprietary rights. Unauthorized parties may attempt to copy aspects of our products or to obtain, license, sell or otherwise use information that we regard as proprietary. Policing unauthorized use of our products is difficult and we may not be able to protect our technology from unauthorized use. Additionally, our competitors may independently develop technologies that are substantially the same or superior to ours and that do not infringe our rights. In these cases, we would be unable to prevent our competitors from selling or licensing these similar or superior technologies. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States. Although the source code for our proprietary software is protected both as a trade secret and as a copyrighted work, litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Litigation, regardless of the outcome, can be very expensive and can divert management efforts.

Third parties have claimed and may claim in the future that we are infringing their intellectual property, and we could be exposed to significant litigation or licensing expenses or be prevented from selling our products if such claims are successful. From time to time, we are subject to claims that we or our customers may be infringing or contributing to the infringement of the intellectual property rights of others. We may be unaware of intellectual property rights of others that may cover some of our technologies and products. If it appears necessary or desirable, we may seek licenses for these intellectual property rights. However, we may not be able to obtain licenses from some or all claimants, the terms of any offered licenses may not be acceptable to us, and we may not be able to resolve disputes without litigation. Any litigation regarding intellectual property could be costly and time-consuming and could divert the attention of our management and key personnel from our business operations. In the event of a claim of intellectual property infringement, we may be required to enter into costly royalty or license agreements. Third parties claiming intellectual property infringement may be able to obtain injunctive or other equitable relief that could effectively block our ability to develop and sell our products.

On August 5, 2004, Compression Labs, Inc. filed an action against us in the United States District Court for the Eastern District of Texas for patent infringement. In the lawsuit, Compression Labs alleges that we are infringing United States Patent No. 4,698,672 entitled "Coding System for Reducing Redundancy." We have not yet evaluated the merits of this lawsuit.

On April 23, 2004, Millennium L.P. filed an action against us in the United States District Court for the Southern District of New York claiming patent infringement. Damages are sought in an unspecified amount. In the lawsuit, Millennium alleges that we are infringing United States Patent No. 5,258,855 entitled "Information Processing Methodology"; No. 5,369,508 entitled "Information Processing Methodology"; No. 5,625,465 entitled "Information Processing Methodology"; No. 5,768,416 entitled "Information Processing Methodology"; and No. 6,094,505 entitled "Information Processing Methodology." We believe this claim has no merit, and we intend to defend the action vigorously.

On July 15, 2003, Elliott Davis ("Davis") filed an action against SpeechWorks in the United States District Court for the Western District for New York (Buffalo) claiming patent infringement. Damages are sought in an unspecified amount. In addition, on November 26, 2003, Davis filed an action against ScanSoft in the United States District Court for the Western District for New York (Buffalo) also claiming patent infringement. Damages are sought in an unspecified amount. SpeechWorks filed an Answer and

Counterclaim to Davis's Complaint in its case on August 25, 2003 and ScanSoft filed an Answer and Counterclaim to Davis's Complaint in its case on December 22, 2003. We believe these claims have no merit, and we intend to defend the actions vigorously.

On November 27, 2002, AllVoice Computing plc filed an action against us in the United States District Court for the Southern District of Texas claiming patent infringement. Damages are sought in an unspecified amount. We filed an Answer on December 23, 2002. We believe this claim has no merit and we intend to defend the action vigorously.

We believe that the final outcome of the current litigation matters described above will not have a significant adverse effect on our financial position and results of operations. However, even if our defense is successful, the litigation could require significant management time and could be costly. Should we not prevail in these litigation matters, we may be unable to sell and/or license certain of our technologies we consider to be proprietary, and our operating results, financial position and cash flows could be adversely impacted.

Our software products may have bugs, which could result in delayed or lost revenue, expensive correction, liability to our clients and claims against us. Complex software products such as ours may contain errors, defects or bugs. Defects in the solutions or products that we develop and sell to our customers could require expensive corrections and result in delayed or lost revenue, adverse client reaction and negative publicity about us or our products and services. Customers who are not satisfied with any of our products may also bring claims against us for damages, which, even if unsuccessful, would likely be time-consuming to defend, and could result in costly litigation and payment of damages. Such claims could harm our reputation, financial results and competitive position.

RISKS RELATED TO OUR CORPORATE STRUCTURE AND ORGANIZATION AND OUR COMMON STOCK.

The holdings of our two largest stockholders may enable them to influence matters requiring stockholder approval. On March 19, 2004, Warburg Pincus, a global private equity firm agreed to purchase all outstanding shares of our stock held by Xerox Corporation for approximately $80 million. As of June 30, 2004, Warburg Pincus beneficially owned approximately 11.2% of our outstanding common stock, including warrants exercisable for up to 3,025,732 shares of our common stock and 3,562,238 shares of our outstanding Series B Preferred Stock, each of which is convertible into one share of our common stock. The State of Wisconsin Investment Board (SWIB) is our second largest stockholder, owning approximately 9.2% of our common stock as of June 30, 2004. Because of their large holdings of our capital stock relative to other stockholders, Warburg and SWIB, acting individually or together, have a strong influence over matters requiring approval by our stockholders.

The market price of our common stock has been and may continue to be subject to wide fluctuations. Our stock price historically has been and may continue to be volatile. Various factors contribute to the volatility of our stock price, including, for example, quarterly variations in our financial results, new product introductions by us or our competitors and general economic and market conditions. While we cannot predict the individual effect that these factors may have on the market price of our common stock, these factors, either individually or in the aggregate, could result in significant volatility in our stock price during any given period of time. Moreover, companies that have experienced volatility in the market price of their stock often are subject to securities class action litigation. If we were the subject of such litigation, it could result in substantial costs and divert management's attention and resources.

Compliance with changing regulation of corporate governance and public disclosure may result in additional expenses. Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new regulations promulgated by the Securities and Exchange Commission and Nasdaq National Market rules, are resulting in increased general and administrative expenses for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies, our business may be harmed.

We have implemented anti-takeover provisions, which could discourage or prevent a takeover, even if an acquisition would be beneficial to our stockholders. Provisions of our certificate of incorporation, bylaws and Delaware law, as well as other organizational documents could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include:

-- a preferred shares rights agreement;

-- authorized "blank check" preferred stock;

-- prohibiting cumulative voting in the election of directors;

-- limiting the ability of stockholders to call special meetings of stockholders;

-- requiring all stockholder actions to be taken at meetings of our stockholders; and

-- establishing advance notice requirements for nominations of directors and for stockholder proposals.