Management's  Discussion  and  Analysis of  Financial  Condition  and Results of
Operations

     Results  of  Operations  The  following   discussion   should  be  read  in
conjunction  with  the  Consolidated  Financial  Statements  and  Notes  thereto
contained elsewhere in this Annual Report.

Revenue (Dollars  in  millions)
                                            Percent            Percent
                                     1997    change     1996    change     1995
                                     ----    ------     ----    ------     ----
Software revenue
   Domestic                        $ 89.7        2%   $ 87.6       12%   $ 77.9
   International                     43.0      (19%)    53.1       39%     38.2
                                     ----      ---      ----       --      ----
   Total software revenue          $132.7       (6%)  $140.7       21%   $116.1
      Percentage of total revenue     53%                52%                51%
Service revenue
   Domestic                        $ 68.0       11%   $ 61.4       29%   $ 47.5
   International                     21.3        3%     20.7        5%     19.7
                                     ----        -      ----        -      ----
   Total service revenue           $ 89.3        9%   $ 82.1       22%   $ 67.2
      Percentage of total revenue     36%                31%                29%
Hardware revenue
   Domestic                        $ 20.4      (28%)  $ 28.3        3%   $ 27.4
   International                      9.0      (49%)    17.8       (5%)    18.7
                                      ---      ---      ----       --      ----
   Total hardware revenue          $ 29.4      (36%)  $ 46.1        --   $ 46.1
      Percentage of total revenue     12%                17%                20%
                                      --                 --                 --
Total revenue                      $251.4       (7%)  $268.9        17%  $229.4
                                   ======       ==    ======        ==   ======

     Software  revenue from the  licensing of the  Company's  software  products
decreased 6% in 1997 due to a decrease in new domestic  orders  during the first
quarter of 1997 and a decrease in new international  orders for the year, offset
by  increased  demand  experienced  domestically  during  the third  and  fourth
quarters.  The 21% increase in 1996 is attributable to an increase in the volume
of product  shipments  from the addition of new products and reselling  partners
and additional revenue generated through the Company's co-marketing  arrangement
with Hewlett-Packard  Company (HP). The Company believes software revenue growth
rates for 1997 and 1996 were  negatively  impacted by  difficulties  experienced
with  integrating  the Saros  Corporation  (Saros) and  Watermark  Software Inc.
(Watermark) sales organizations into FileNET's sales organization.
     Service  revenue  consists of revenue from software  maintenance  services,
professional services, training, repairs and supplies. Service revenue increased
9% in 1997 due to an  increase  in the  customer  installed  base,  offset  by a
decrease in  international  professional  services  revenue and the  decrease in
revenue related to the sale and repair of spare parts to HP noted below. The 22%
increase in 1996 was due to the growth of the Company's customer installed base,
an increase in training due primarily to the training of new resellers,  and the
recognition  of $7.6  million of revenue from the sale and repair of spare parts
in connection with the continued transition of hardware  maintenance  activities
to HP. There were no such sales in 1995.
     Hardware  revenue is generated  primarily from the sale of 12-inch  optical
storage  and  retrieval  libraries  (OSAR) and  third-party  hardware.  Hardware
revenue  decreased 36% in 1997 due to a decrease in new orders  experienced both
domestically  and  internationally,  attributable  to  the  Company's  focus  on
increasing its higher margin  software  revenue.  The Company  expects  hardware
revenue to continue to decline in both  absolute  dollars and as a percentage of
total revenue as it continues to transition its business toward software-related
revenue.


                                       18
<PAGE>

     Domestic  revenues  remained  flat in 1997 compared to an increase of $24.5
million, or 16%, in 1996 due to the decrease in hardware revenue noted above and
slower software growth.  International  revenue decreased $18.3 million, or 20%,
compared with an increase of $15.0  mil-lion,  or 20%, in 1996.  The decrease in
international revenue in 1997 from 1996 was due to a weakness in European orders
and, to a lesser extent,  the strengthening of the U.S. dollar.  The increase in
1996 was due to continued  growth of software and service  revenue offset by the
anticipated decrease in hardware revenue.  International revenue as a percentage
of total revenue  decreased to 30% in 1997 from 34% in 1996 and 33% in 1995. The
decrease in 1997 is due to the decrease in  international  revenues noted above.
In the  future,  the  Company  expects  inter-national  revenue to  continue  to
represent a  significant  percentage  of total revenue as it continues to expand
its operations  internationally.  However,  the current  economic  crisis in the
Asia-Pacific  region could adversely  affect  international  sales. In addition,
international   revenues  could  be  adversely   affected  if  the  U.S.  dollar
strengthens against international currencies.

Cost of Revenue (Dollars in millions)

                                            Percent            Percent
                                     1997    change     1996    change     1995
                                     ----    ------     ----    ------     ----
Cost of software revenue            $14.8      (10%)   $16.5        9%    $15.1
   Percentage of software revenue     11%                12%                13%
Cost of service revenue             $56.5        5%    $53.6       21%    $44.3
   Percentage of service revenue      63%                65%                66%
Cost of hardware revenue            $20.3      (31%)   $29.6        3%    $28.8
   Percentage of hardware revenue     69%                64%                62%
                                      --                 --                 --
Cost of total revenue               $91.6       (8%)   $99.7       13%    $88.2
                                    =====       ==     =====       ==     =====

     The cost of software revenue  includes  royalties paid to third parties and
the cost of software distribution.  The cost of software revenue as a percentage
of software  revenue  decreased to 11% in 1997 from 12% in 1996 and 13% in 1995.
The decrease in 1997 is due to savings related to the  consolidation of software
distribution  activities.  The  decrease  in 1996 was due to a  decrease  in the
amount of  capitalized  software  amortized  in 1996 and savings  related to the
consolidation of software distribution activities.
     The cost of service  revenue  includes  software  support and  professional
services personnel,  supplies, and the cost of third-party hardware maintenance.
The cost of service revenue as a percentage of service revenue  decreased to 63%
in 1997 from 65% in 1996 and 66% in 1995. The decreases are primarily due to the
transition of hardware  maintenance  to HP,  offset by lower margins  associated
with international maintenance.
     The  cost  of  hardware   revenue  includes  the  Company's  cost  of  OSAR
manufacturing,   third-party   purchased  hardware  and  the  cost  of  hardware
integration personnel.  The cost of hardware revenue as a percentage of hardware
revenue  increased to 69% in 1997 from 64% in 1996 and 62% in 1995. The increase
in 1997  is due to a  decrease  in  hardware  revenue  without  a  corresponding
decrease in fixed costs  related to the  Company's  hardware  manufacturing  and
integration  activities.  The increase in 1996 was due to a less  favorable  mix
from  the  Company's  OSAR  product  line and  lower  margins  from  third-party
purchased equipment.

Research  and  Development  and  Selling,  General and  Administrative  Expenses
(Dollars in millions)

                                            Percent            Percent
                                      1997    change     1996    change     1995
                                      ----    ------     ----    ------     ----
Research and development            $ 39.6        8%   $ 36.5       48%    $24.7
   Percentage of total revenue         16%                14%                11%
Selling, general and administrative $125.1        6%   $117.8       22%    $96.5
   Percentage of total revenue         50%                44%                42%


                                       19
<PAGE>
Management's  Discussion  and  Analysis of  Financial  Condition  and Results of
Operations

     Research and development  expenses  increased 8% in 1997 primarily due to a
general  increase in salaries.  The 48% increase in 1996 was due to the addition
of development personnel and the related facilities and depreciation expenses to
fund new development  activities.  Research and  development  expense in 1995 is
after capitalized software development costs of $1.6 million.
     As a  percentage  of  total  revenue,  research  and  development  expenses
increased to 16% in 1997 from 14% in 1996 and 11% in 1995.  The increase in 1997
is due to the decrease in revenue compounded by the increased level of spending.
The  increase  in 1996  was due to the  increase  in  research  and  development
personnel to sup-port new development  activities without  corresponding revenue
growth and a decrease in the amount of capitalized software development costs.
     The Company expects that competition for qualified technical personnel will
remain  intense for the  foreseeable  future and may result in higher  levels of
compensation  expense for the Company.  The Company  believes  that research and
development  expenditures,  including  compensation of technical personnel,  are
essential to  maintaining  its  competitive  position and expects these costs to
continue to constitute a significant percentage of revenue.
     Selling,  general and administrative  expenses increased 6% in 1997 and 22%
in 1996.  The  increase in 1997 was due  primarily  to the  Company's  continued
international  expansion  and  higher  legal  costs  (see  Note 11 of  Notes  to
Consolidated  Financial Statements for a description of legal proceedings).  The
increase in 1996 was due primarily to an increase in the number of marketing and
sales support  personnel  employed  internationally  as the Company expanded its
international  reseller and sales  operations  and to an increase in commissions
associated with higher revenues.  In 1997,  selling,  general and administrative
expenses as a percentage of total revenue  increased to 50% from 44% in 1996 and
42% in 1995 primarily due to increasing  expense levels without a  corresponding
increase in revenues.
     Merger,  Restructuring,  Write-off  of  Purchased  In-process  Research and
Development and Other Costs The $6.0 million in restructuring  and other charges
in 1997  represents the costs of  consolidating  the Watermark  business  unit's
Burlington,  Massachusetts  engineering  and marketing  functions  with those at
FileNET's Costa Mesa,  California location,  as well as a reduction in headcount
in certain  other areas of the  Company.  The  restructuring  and other  charges
include  approximately  $1.9 million for severance  payments for 111  employees,
$2.2  million for the  write-off of impaired  assets,  $0.4 million for facility
closing costs and $1.5 million of other charges.
     The  $16.0  million  merger,   restructuring  and  write-off  of  purchased
in-process research and development costs in 1996 consisted of $10.0 million for
the write-off of purchased  in-process research and development costs related to
the  International  Financial Systems Ltd. (IFSL)  acquisition,  $4.2 million in
merger costs related to the Saros acquisition, and $1.8 million in restructuring
costs related to the Saros and Watermark acquisitions. The restructuring charges
represent  the  costs  of  consolidating   the  various   companies'  sales  and
administrative  functions and include $1.4 million for severance payments for 30
employees and $0.4 million for the write-off of certain contractual  obligations
and other costs.
     The  $6.4  million  merger,   restructuring   and  write-off  of  purchased
in-process  research and development costs in 1995 consisted of a charge for the
buyout of certain  Watermark  European  marketing and  manufacturing  rights,  a
write-off of capitalized  research and development expenses for FileNET projects
made redundant by the Watermark acquisition and other direct acquisition-related
fees and expenses.
     At December  31,  1997,  accrued  restructuring  and other  charges of $3.0
million are included in other accrued liabilities.  The Company anticipates that
the remaining restructuring costs will be expended during 1998.
     Other Income Other income, net of other expenses,  was $3.2 million in 1997
and $2.8 million in both 1996 and 1995. The increase in 1997 is primarily due to
increased interest income on a higher balance of cash and marketable securities.
     Provision  for Income Taxes The provision for income taxes was a benefit of
$2.2  million in 1997,  compared  to charges of $4.5  million  and $8.1  million
recorded in 1996 and 1995, respectively.  The 1997 effective tax rate was (28%).
The Company's 1996 effective tax rate is not  meaningful,  as the 1996 provision
was impacted by the write-off of purchased  in-process  research and development
as  part  of the  acquisition  of  IFSL,  with  no  corresponding  tax  benefit,
nondeductible  costs associated with the Saros merger and earnings  generated in
certain  international  jurisdictions,  partially  offset by the  benefit of tax
losses incurred in the United States.  The Company's  effective tax rate was 50%
in 1995.
     The Company currently anticipates that its effective tax rate for 1998 will
be approximately  30%. However,  the actual tax rate may differ due to a variety
of factors  including  the  geographical  mix of revenues and the ability to use
certain deferred tax assets.

                                       20
<PAGE>

     Foreign Currency  Fluctuations and Inflation The Company's  performance can
be affected by changes in foreign  currency values relative to the U.S.  dollar,
as discussed above, in relation to the Company's revenue and operating expenses.
The  impact  to net  income  from  foreign  exchange  transactions  and  hedging
activities  is  immaterial  for  all  periods  reported.  The  foreign  currency
translation  adjustment included in stockholders'  equity decreased $5.8 million
during  1997 over  1996 due  primarily  to the  weakness  of the Irish  currency
against the U.S. dollar applied to the Company's net assets in Ireland.
     Management  believes that inflation has not had a significant impact on the
prices of the Company's  products,  the cost of its materials,  or its operating
results during 1995 through 1997.

                              Financial Condition

     Liquidity  and Capital  Resources As of December 31, 1997,  combined  cash,
cash  equivalents,  and marketable  securities  (short and long-term) were $71.8
million, an increase of $4.5 million from the $67.3 million at the end of 1996.
     Cash provided by operating activities in 1997 was $24.8 million.  Cash used
by the net loss for the year was offset by lower  accounts  receivable  balances
associated  with a lower  average  days  sales  outstanding,  lower  inventories
associated with the Company's  decrease in hardware revenue and additions to net
income for  depreciation  and  amortization.  Cash used by investing  activities
totaled $11.3 million, consisting of capital expenditures offset by the net sale
and maturity of marketable  securities.  Cash used by financing  activities  was
$2.6  million and was the result of the  repurchase  of common  stock  offset by
proceeds  from the issuance of common stock in  connection  with the exercise of
employee stock options and the employee stock purchase plan.
     Cash used by operating  activities in 1996 was $1.8 million. The balance is
primarily  due to a net  loss  and the  effect  of  higher  accounts  receivable
balances   associated   with  higher  revenue  and  higher  average  days  sales
outstanding,  offset  in  part  by the  non-cash  additions  to net  income  for
write-off of  capitalized  and  purchased  in-process  research and  development
costs,  depreciation  and  amortization  of capitalized  software.  Cash used by
investing  activities totaled $16.7 million,  consisting of capital expenditures
and the purchase of IFSL,  offset by proceeds from the sale of equipment and the
net sale and maturity of marketable  securities.  Net cash provided by financing
activities  was $2.6 million and was the result of proceeds from the issuance of
common stock and stock option income tax benefits,  offset by the  repurchase of
common stock.
     The  Company's  capital  expenditures  were $14.3  million  in 1997,  $17.9
million  in 1996,  and $14.7  million in 1995.  The  Company's  primary  capital
equipment  expenditures  are for research  and  development,  demonstration  and
training  equipment  and  enhancements  to its internal  business  systems.  The
Company anticipates that it will acquire  approximately $18.0 million of capital
equipment in 1998.  During the first  quarter of 1998,  the Company  repurchased
$4.4 million of its common stock,  thereby  completing its previously  announced
$10 million stock repurchase  program.  The Company anticipates that its present
cash balances,  together with internally-generated  funds and credit lines, will
be  sufficient  to meet  its  working  capital  and  capital  expenditure  needs
throughout 1998.

                                 Other Matters

     Year 2000 The Company is assessing  the internal  readiness of its computer
systems  for  handling  the  year  2000.   The  Company   expects  to  implement
successfully the systems and programming  changes necessary to address year 2000
issues with respect to its  internal  systems and does not believe that the cost
of such actions will have a material  adverse effect on its financial  condition
or results of  operations.  Although  the  Company is not aware of any  material
operational  issues or costs  associated with preparing its internal systems for
the year 2000,  there can be no assurance  that there will not be a delay in, or
increased costs associated with, the implementation of the necessary systems and
changes  to  address  the year  2000  issues,  and the  Company's  inability  to
implement  such  systems  and  changes  could have an  adverse  effect on future
results of operations.

      Recent  Accounting   Pronouncements  In  1997,  SFAS  No.  130, "Reporting
Comprehensive  Income"  and SFAS No.  131,  "Disclosures  about  Segments  of an
Enterprise  and Related  Information,"  were issued and are effective for fiscal
years  beginning  after December 15, 1997. In October 1997, the AICPA issued SOP
97-2, "Software Revenue  Recognition," which supersedes SOP 91-1. The provisions
of SOP 97-2 are effective for fiscal years  beginning  after  December 15, 1997.
The Company is reviewing  the impact of these  pronouncements  on its  financial
statements.

     Environmental  Matters  The  Company is not aware of any issues  related to
environmental  matters  that have,  or are  expected  to  materially  affect its
business.

                                       21

<PAGE>

Management's  Discussion  and  Analysis of  Financial  Condition  and
Results of Operations

                             Certain Considerations

     This Annual Report contains  forward-looking  statements that involve risks
and  uncertainties,  including  those  discussed  below  and  in  the  Notes  to
Consolidated Financial Statements.  The actual results that the Company achieves
may  differ  materially  from  any  forward-looking  statements,  which  reflect
management's  opinions  only as of the date hereof.  The Company  undertakes  no
obligation  to revise or publicly  release the results of any revisions to these
forward-looking   statements.   Readers  should  carefully  review  the  factors
described  below and in other documents the Company files from time to time with
the Securities and Exchange Commission, including its Annual Report on Form 10-K
for 1997 and the  Quarterly  Reports on Form 10-Q to be filed by the  Company in
1998. Factors that may affect the Company's  business,  financial  condition and
results of operations include:

     Rapid  Technological  Change;   Product  Development  The  market  for  the
Company's  products  is  characterized  by  rapid  technological   developments,
evolving industry standards,  changes in customer  requirements and frequent new
product introductions and enhancements.  The Company's success will be dependent
upon its ability to enhance its existing products,  develop and introduce,  in a
timely manner, new products incorporating  technological advances and respond to
customer requirements.  Specifically, the Company has announced plans to deliver
a  new  range  of  desktop  software  products  providing   integrated  document
management  capability for existing and new users.  To the extent one or more of
the Company's  competitors  introduce  products that more fully address customer
requirements,  the Company's business could be adversely affected.  There can be
no assurance  that the Company will be successful  in  developing  and marketing
enhancements to its existing  products or new products on a timely basis or that
any new or enhanced  products will adequately  address the changing needs of the
market-place.  If the Company is unable to develop and introduce new products or
enhancements  to existing  products  in a timely  manner in response to changing
market conditions or customer  requirements,  the Company's business,  financial
condition or results of  operations  could be adversely  affected.  From time to
time, the Company or its competitors may announce new products,  capabilities or
technologies  that have the  potential  to replace or shorten the life cycles of
the  Company's  existing   products.   There  can  be  no  assurance  that  such
announcements  will not cause customers to delay their  purchasing  decisions in
anticipation  of such  products,  resulting in a material  adverse effect on the
Company's business, financial condition or results of operations.

     Uncertainty  of  Future  Operating   Results;   Fluctuations  in  Quarterly
Operating  Results  Future  operating  results  will depend  upon many  factors,
including  the demand  for the  Company's  products,  the  effectiveness  of the
Company's  efforts to continue to integrate various products it has developed or
acquired  through  acquisition  of others and to achieve the  desired  levels of
sales from such product integration, the level of product and price competition,
the length of the Company's  sales cycle,  seasonality  of  individual  customer
buying patterns,  the size and timing of individual  transactions,  the delay or
deferral  of  customer  implementations,  the  budget  cycles  of the  Company's
customers,  the timing of new product  introductions and product enhancements by
the Company and its  competitors,  the mix of sales by  products,  services  and
distribution   channels,   levels  of  international   sales,   acquisitions  by
competitors,  changes in foreign  currency  exchange  rates,  the ability of the
Company to develop  and market new  products  and  control  costs,  and  general
domestic and international economic and political conditions.  Accordingly,  the
Company's quarterly results are difficult to predict and revenues and net income
for any one quarter have in the past and may again fall  significantly  short of
anticipated  levels.  Additionally,  a large  percentage  of orders  for any one
quarter are usually  received from  customers very late in the quarter and, as a
result,  the  Company is not able to  identify  possible  revenue and net income
shortfalls to any significant extent until the end of the quarter.
     As a result  of these  factors,  revenues  and  operating  results  for any
quarter are subject to variation and are not  predictable  with any  significant
degree of  accuracy.  Therefore,  the  Company  believes  that  period-to-period
comparisons  of its results of operations  are not  necessarily  meaningful  and
should not be relied upon as indications of future performance.  Moreover,  such
factors  could cause the  Company's  operating  results in a given quarter to be
below the  expectations of public market analysts and investors and the price of
the Company's common stock could be materially adversely affected.

     Competition The document imaging,  workflow,  computer output to laser disk
and document management  software markets are highly competitive,  and there are
certain competitors of the Company with substantially greater sales,  marketing,
development and financial  resources.  The Company believes that the competitive
factors  affecting the market for its products and services  include  vendor and
product reputation;  product quality, performance and price; the availability of
products on multiple platforms;  product  scalability;  product integration with
other enterprise applications;  product functionality and features; product ease
of use; and the quality of customer support services and training.  The relative
importance of each of these factors depends upon the specific customer involved.
While the Company believes it competes  favorably in each of these areas,  there
can be no assurance  that it will  continue to do so.  Moreover,  the  Company's
present or future competitors may be able


                                       22
<PAGE>

to develop  products  comparable  or superior to those  offered by the  Company,
offer  lower  price  products  or adapt  more  quickly  than the  Company to new
technologies  or  evolving  customer  requirements.  Competition  is expected to
intensify.  In order to be successful in the future, the Company must respond to
technological  change,  customer  requirements and competitors' current products
and  innovations.  There can be no  assurance  that the Company  will be able to
continue to compete  effectively in its market or that future  competition  will
not have a material  adverse  effect on its  business,  financial  condition  or
results of  operations.  In addition,  current and  potential  competitors  have
established or may establish cooperative  relationships among themselves or with
third parties to increase the ability of their  products to address the needs of
the  markets  served  by the  Company.  Accordingly,  it is  possible  that  new
competitors  or  alliances  among  competitors  may emerge and  rapidly  acquire
significant market share.  Increased competition may result in price reductions,
reduced  gross  margins  and loss of market  share,  any of which  could  have a
material  adverse  effect on the  Company's  business,  financial  condition  or
results of operations.

     Intellectual  Property and Other  Proprietary  Rights The Company's success
depends,  in part,  on its  ability to  protect  its  proprietary  rights to the
technologies used in its principal products. The Company relies on a combination
of  copyrights,   trademarks,  trade  secrets,  confidentiality  procedures  and
contractual  provisions  to  protect  its  proprietary  rights.  There can be no
assurance that the Company's  existing or future copyrights,  trademarks,  trade
secrets or other  intellectual  property  rights will be of sufficient  scope or
strength  to  provide  meaningful  protection  or  commercial  advantage  to the
Company.  FileNET  has no  software  patents.  Also,  in selling  certain of its
products,  the Company  relies on "shrink wrap"  licenses that are not signed by
licensees  and,  therefore,  may be  unenforceable  under  the  laws of  certain
jurisdictions.  In addition,  the laws of some foreign  countries do not protect
the Company's proprietary rights to the same extent as do the laws of the United
States.  There can be no assurance  that such factors  would not have a material
adverse  effect on the  Company's  business,  financial  condition or results of
operations.  In addition,  the Company also relies on certain  software  that it
licenses  from  third  parties,  including  software  that  is  integrated  with
internally  developed  software  used in the  Company's  products to perform key
functions.  There can be no  assurance  that such third  parties  will remain in
business, that they will continue to support their products, that their products
are, or will be, year 2000  compliant,  or that their  products  will  otherwise
continue to be available to the Company on commercially  reasonable  terms.  The
loss or inability to maintain any of theses  software  licenses  could result in
delays or  reductions  in product  shipments  until  equivalent  software can be
developed,  identified,  licensed and  integrated,  any of which could adversely
affect the Company's business, financial condition or results of operations.
     The  Company  may,  from time to time,  be notified  that it is  infringing
certain  patent or  intellectual  property  rights of  others.  Combinations  of
technology  acquired  through  past or  future  acquisitions  and the  Company's
technology  will create new products and technology that may give rise to claims
of infringement. While no actions other than those discussed below are currently
pending  against  the Company for  infringement  of patent or other  proprietary
rights of third  parties,  there can be no assurance that third parties will not
initiate  infringement  actions against the Company in the future.  Infringement
actions can result in  substantial  cost to, and diversion of,  resources of the
Company.  If the Company  were found to infringe  upon the rights of others,  no
assurance can be given that licenses would be obtainable on acceptable  terms or
at all, that significant  damages for past infringement would not be assessed or
that further litigation  relative to any such licenses or usage would not occur.
The failure to successfully  defend any claims or obtain  necessary  licenses or
other rights, the ultimate disposition of any claims or the advent of litigation
arising out of any claims of infringement,  could have a material adverse effect
on the Company's business, financial condition or results of operations.
     In October 1994,  Wang  Laboratories,  Inc. (Wang) filed a complaint in the
United States District Court for the District of Massachusetts alleging that the
Company is infringing  five patents held by Wang (the FileNET Case). On June 23,
1995,  Wang amended its complaint to include an additional  related  patent.  On
July 2, 1996,  Wang filed a complaint in the same court  alleging that Watermark
Software  Inc.,  formerly a wholly  owned  subsidiary  that was merged  into the
Company,  is  infringing  three  of the same  patents  asserted  in the  initial
complaint (the Watermark  Case).  On October 9, 1996, Wang withdrew its claim in
the FileNET Case that one of the patents it  initially  asserted is infringed by
the Company's products that were commercialized before the initial complaint was
filed.  Wang  reserved  the right to assert  that patent  against the  Company's
products commercialized after that date in a separate lawsuit.
     In March 1997,  Eastman  Kodak Company  (Kodak)  purchased the Wang imaging
business unit that has  responsibility  for this litigation.  The patents in the
suit have been  transferred  to a Kodak  subsidiary,  Kodak  Limited of England,
which,  in turn,  has  exclusively  licensed them to another  Kodak  subsidiary,
Eastman  Software,  Inc. in the United States  (Eastman).  On July 30, 1997, the
Court  permitted  Eastman and Kodak Limited of England to be  substituted in the
litigation in place of Wang.
     FileNET has moved for summary  judgement on  noninfringement  as to each of
the five patents in the suit,  and for summary  judgment of invalidity as to one
of  the   patents.   Eastman   moved  for  summary   judgment  as  to  FileNET's
unenforceability defense on one of the patents. A trial date has not been set.
     If it should be determined  that the patents at issue in the litigation are
valid and are infringed by any of the Company's  products,  including  Watermark
products,  the Company will,  depending on the product,  redesign the infringing
products or seek to obtain a license to market the

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<PAGE>
Management's  Discussion  and  Analysis of  Financial  Condition  and Results of
Operations

products. There can be no assurance that the Company will be able to obtain such
a license on acceptable terms.  Based on the Company's analysis of these Eastman
patents and their  respective file histories,  the Company  believes that it has
meritorious defenses to Eastman's claims;  however, the ultimate outcome or any
resulting potential loss cannot be determined at this time.

     Dependence on Certain  Relationships  The Company has entered into a number
of   co-marketing   relationships   with  other   companies  such  as  Microsoft
Corporation,  Compaq Computer Corporation, SAP AG, HP and Sun Microsystems, Inc.
There can be no assurance  that these  companies  will not reduce or discontinue
their relationships with, or support of, the Company and its products.

     Dependence on Key Management and Technical  Personnel The Company's success
depends to a  significant  degree upon the  continued  contributions  of its key
management,  marketing,  technical and operational  personnel.  In general,  the
Company does not utilize employment  agreements for its key employees.  The loss
of the  services  of one or more key  employees  could have a  material  adverse
effect on the Company's operating results.  The Company also believes its future
success  will  depend in large  part upon its  ability  to  attract  and  retain
additional highly skilled management,  technical, marketing, product development
and  operational  personnel.   Competition  for  such  personnel,   particularly
engineers  and  other  technical  personnel,  is  intense,  and  there can be no
assurance  that the Company will be successful in attracting  and retaining such
personnel.  In addition, the Company may experience increased compensation costs
in order to attract and retain skilled personnel.

     International Sales Historically,  the Company has derived more than 30% of
its total revenues from  international  sales. Six percent of the Company's 1997
revenues were generated in the Asia-Pacific  region (including 4% in Australia).
International  business is subject to certain risks including  varying technical
standards,  tariffs and trade  barriers,  political  and  economic  instability,
reduced  protection  for  intellectual  property  rights in  certain  countries,
difficulties in staffing and  maintaining  foreign  operations,  difficulties in
managing foreign  distributors,  potentially adverse tax consequences,  currency
exchange  fluctuations,  the burden of complying  with a wide variety of complex
operations,  foreign laws,  regulations  and treaties,  and the  possibility  of
difficulties  in collecting  accounts  receivable.  In  particular,  the current
economic  crisis in the Asia Pacific  region may limit future  growth or cause a
decline in international  revenues.  There can be no assurance that any of these
factors  will not have a  material  adverse  effect on the  Company's  business,
financial condition or results of operations.

     Product  Liability  Products  as complex as those sold by the  Company  are
susceptible to errors or failures,  especially when first introduced or when new
versions are  released.  The  Company's  products are often  intended for use in
applications  that are  critical  to a  customer's  business.  As a result,  the
Company's  customers may rely on the effective  performance of the software to a
greater  extent than the market for  software  products  generally.  The Company
conducts  extensive  product  testing to ensure  that its  products  are free of
significant errors and defects. In addition, the Company has designed and tested
the most current  versions of its products to be year 2000  compliant.  However,
some of the Company's  customers are running earlier  product  versions that are
not  year  2000  compliant.  Although  the  Company  has been  encouraging  such
customers to migrate to current product versions, no assurance can be given that
all of them will do so in a timely  fashion,  if at all.  Moreover,  the Company
also relies on certain  software that it licenses from third parties,  including
software that is integrated  with internally  developed  software and is used in
the Company's products to perform key functions.  There can be no assurance that
such  third-party  software  will be free of errors and  defects or be year 2000
compliant  in a timely  fashion.  Although the Company has not  experienced  any
material product liability claims to date, there can be no assurance that errors
or defects,  whether associated with year 2000 functions or otherwise,  will not
result in product  liability  claims  against  the  Company in the  future.  The
Company's  license  agreements  with  customers   typically  contain  provisions
designed to limit the Company's  exposure to potential product liability claims;
however, it is possible that such limitation of liability pro-visions may not be
effective  under  the  laws of  certain  jurisdictions.  Defective  products  or
releases could result in loss of revenues,  increased service and warranty costs
and product  liability  claims,  and could adversely affect the Company's market
penetration and reputation, any of which could have a material adverse effect on
the Company's business, financial condition and results of operations.

     Stock Price Volatility The Company believes that a variety of factors could
cause  the  price of its  common  stock  to  fluctuate,  perhaps  substantially,
including quarter-to-quarter  variations in operating results;  announcements of
developments related to its business;  fluctuations in its order levels; general
conditions in the technology sector or the worldwide  economy;  announcements of
technological  innovations,  new products or product enhancements by the Company
or its  competitors;  key  management  changes;  changes in joint  marketing and
development  pro-grams;  developments  relating to patents or other intellectual
property rights or disputes;  and  developments  in the Company's  relationships
with its customers,  distributors and suppliers.  In addition,  in recent years,
the stock market in general, and the market for shares of high-technology stocks
in particular,  has experienced extreme price fluctuations which have often been
unrelated to the operating performance of affected companies.  Such fluctuations
could adversely affect the market price of the Company's common stock.


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