**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

----

**FORM 10-K**

**(Mark One)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934 

**Forthe fiscal year ended January 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934 

**Forthe transition period from                      to                      **

**Commissionfile number: 000-32377**

----

**OPSWARE INC.**

**(Exactname of registrant as specified in its charter)**

| **Delaware**                                                     | **94-3340178**                           |
|------------------------------------------------------------------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification Number) |

 

**599 N. Mathilda Avenue,Sunnyvale, California 94085**

**(Address, including zip code, ofRegistrant’s principal executive offices)**

**(408)744-7300**Registrant’stelephone number, including area code

----

**Securitiesregistered pursuant to Section 12(b) of the Act:None**

**Securitiesregistered pursuant to Section 12(g) of the Act:Common Stock, par value $0.001 per share**

----

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.YES o   NO x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act. YES o   NO x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. YES x   NO o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of the registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act.

o Large acceleratedfiler      x Accelerated filer      o Non-acceleratedfiler

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act). YES o   NO x

The aggregate market value of the voting stock held bynon-affiliates of the registrant, based upon the closing price as reported bythe NASDAQ National Market of the registrant’s Common Stock on July 31,2005, the last business day of the registrant’s most recently completed secondfiscal quarter, was approximately $388 million. Shares of voting stock held byeach officer and director and by each person who owns 5% or more of theoutstanding voting stock have been excluded in that such persons may be deemedto be affiliates. This determination of affiliate status is not necessarily aconclusive determination for other purposes.

As of April 1, 2006, 100,051,147 shares of theregistrant’s Common Stock were outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Part III of this Annual Report on Form 10-Kincorporates certain information by reference from the registrant’s definitiveproxy statement for the registrant’s Annual Meeting of Stockholders, scheduledfor June 20, 2006.

 

----

**TABLEOF CONTENTS**

| PART I       |   |                                                                                                                     |   |   |   |
|-------------------|--------|--------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
| ITEM 1.      |   | BUSINESS                                                                                                                 |   | 2      |   |
| ITEM 1A.     |   | RISK FACTORS                                                                                                             |   | 9      |   |
| ITEM 1B.     |   | UNRESOLVED STAFF  COMMENTS                                                                                               |   | 22     |   |
| ITEM  2.          |   | PROPERTIES                                                                                                               |   | 22     |   |
| ITEM  3.          |   | LEGAL PROCEEDINGS                                                                                                        |   | 22     |   |
| ITEM 4.           |   | SUBMISSION OF  MATTERS TO A VOTE OF SECURITY HOLDERS                                                                     |   | 22     |   |
| PART II      |   |                                                                                                                     |   |   |   |
| ITEM 5.           |   | MARKET FOR  REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES  OF EQUITY SECURITIES |   | 23     |   |
| ITEM 6.           |   | SELECTED  CONSOLIDATED FINANCIAL DATA                                                                                    |   | 24     |   |
| ITEM 7.           |   | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                              |   | 25     |   |
| ITEM 7A.     |   | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                         |   | 37     |   |
| ITEM 8.           |   | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                                             |   | 38     |   |
| ITEM 9.           |   | CHANGES IN AND  DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                               |   | 71     |   |
| ITEM 9A.     |   | CONTROLS AND  PROCEDURES                                                                                                 |   | 71     |   |
| ITEM 9B.          |   | OTHER INFORMATION                                                                                                        |   | 72     |   |
| PART III     |   |                                                                                                                     |   |   |   |
| ITEM 10.          |   | EXECUTIVE  OFFICERS AND DIRECTORS OF THE REGISTRANT                                                                      |   | 73     |   |
| ITEM 11.          |   | EXECUTIVE  COMPENSATION                                                                                                  |   | 77     |   |
| ITEM 12.          |   | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS                         |   | 77     |   |
| ITEM 13.          |   | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS                                                                          |   | 77     |   |
| ITEM 14.          |   | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                                  |   | 77     |   |
| PART IV      |   |                                                                                                                     |   |   |   |
| ITEM 15.     |   | EXHIBITS AND  FINANCIAL STATEMENT SCHEDULES                                                                              |   | 78     |   |
| POWER OF ATTORNEY |   | 80                                                                                                                       |   |

 

----

**CautionaryStatement Regarding Forward-Looking Statements**

This Annual Report on Form 10-K containsforward-looking statements within the meaning of the federal securities laws.These statements relate to our, and in some cases our customers’ or partners’, futureplans, objectives, expectations, intentions and financial performance and theassumptions that underlie these statements. These forward-looking statementsinclude, but are not limited to, statements regarding anticipated market trendsand uncertainties, expected financial and operating results, anticipatedcapital expenditures, expected revenue generated from the sale of our softwareproducts, including the impact of our license and maintenance agreement withEDS and our distribution arrangement with Cisco, the impact of the applicationof SFAS 123(R), the adequacy of our capital resources to fund our operations,the anticipated increase in customer expansion of our target markets, thetiming of new product releases, our expectations regarding ongoing developmentof our software products and other technical capabilities, formation ofstrategic partnerships and expansion in our direct and indirect salesorganizations.

These statements involve known and unknown risks,uncertainties and other factors that may cause industry trends or our actualresults, level of activity, performance or achievements to be materiallydifferent from the outcomes expressed or implied by these statements. Thesefactors include those listed under “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Risk Factors” and elsewhere inthis Annual Report on Form 10-K.

Although we believe that expectations reflected in theforward-looking statements are reasonable, we cannot guarantee future results,levels of activity, performance or achievements. We assume no obligation toupdate the information in this report after the date of this report, whether asa result of new information, future events or otherwise. You should not placeundue reliance on these forward-looking statements, which apply only as of thedate of this Annual Report on Form 10-K.

1

----

**PART I**

**ITEM 1.**                BUSINESS

**Overview**

Weare a provider of IT automation software products for enterprises, governmentagencies and service providers seeking to reduce the cost and improve thequality of IT operations. Our software products automate IT operations acrossservers, software, applications and network devices and discover and trackassets across the IT environment by automating formerly manual, time-consumingand error-prone tasks such as discovering, provisioning, changing, auditing,patching, reporting, configuring, scaling, securing and recovering of servers,software, business applications and network devices.

Oursoftware automation suite includes the Opsware Server Automation System (OSAS),the Opsware Network Automation System (ONAS) and the Opsware Asset ManagementSystem (OAMS). OSAS automates key server, software and application operations.ONAS automates network device operations for large data centers and remotelocations. OAMS enables IT organizations to discover IT hardware and software assets,track these assets on an ongoing basis and reduce costs of excess hardware andsoftware purchases, unnecessary maintenance renewals, and underutilization ofidle and redundant assets.

Ourproducts work across geographically disparate locations and heterogeneous ITenvironments consisting of UNIX, Linux and Windows servers and a wide range ofsoftware infrastructure and applications, as well as network devices includingswitches, routers, load balancers and firewalls. By using our IT automationsoftware, we believe customers can lower their IT operational costs, morequickly deploy new servers, applications and network infrastructure, speedoperations to respond faster to changing business needs, increase theefficiency of server and network administrators, achieve higher service qualityand security and improve tracking of IT assets.

Businessesand government agencies are increasingly turning to IT automation solutions toreduce operational costs, improve IT efficiencies, centralize and remotelymanage operations, ensure continuity of operations and reduce the costs ofdisaster recovery. Demand for our software is driven by the rapid growth ofservers and network devices across IT organizations that is resulting from themigration of client-server based applications to web-based applications, theincrease in the numbers of Windows servers, the rapid adoption of the Linuxplatform, the growth of Intel-based servers and the increase in the number ofnetwork devices within IT environments. Rapid server growth in data centers andat remote locations and increasing application complexity across the ITenvironment have resulted in a corresponding escalation in labor costs, adegradation in operations quality and a security crisis within ITorganizations. In addition, we believe that several other factors are drivingthe demand for our products, including the need to protect servers and networkinfrastructure from security vulnerabilities, to quickly and morecost-effectively deploy servers, applications and network infrastructure, totrack hardware and software assets and labor costs, to manage frequent changesacross servers and network devices and the need to ensure servers, networkdevices and applications comply with corporate and regulatory compliance policiessuch as the Sarbanes-Oxley Act, HIPAA, COSO and COBIT, as well as enableenforcement of best practices such as ITIL. Our products provide customers witha software solution that is reliable, secure, and scalable and allows them toreduce operational costs, increase IT efficiencies and improve operationsquality.

We were incorporated in September 1999 as aDelaware corporation. Prior to August 2002, we primarily provided managedInternet services for corporations and government agencies that operate mission-criticalInternet applications. We referred to this business as our Managed ServicesBusiness. On August 15, 2002, we sold our Managed Services Business toElectronic Data Systems Corporation (“EDS”). We developed our proprietaryOpsware automation technology for the Managed Services Business, and have sincedeveloped this technology into our stand-alone software products. In February 2004,we acquired Tangram Enterprise Solutions and in February 2005 we acquiredRendition Networks, each a software and services provider.

2

----

**Products andServices**

*Opsware Server AutomationSystem*

OSAS automates key server, software infrastructure andapplication operations in data centers and remote locations, includingdiscovering, provisioning, changing, patching, reporting, configuring, scaling,securing, recovering, auditing, and reallocating servers and businessapplications across geographically disparate locations and heterogeneous ITenvironments.

Some of the keycapabilities and benefits of OSAS are:

·       **Automated Provisioning.  **OSAS automates many of the tasksinvolved in provisioning new servers including provisioning UNIX, Linux andWindows operating systems, software infrastructure and applications tracking,which enables IT organizations to increase efficiencies and reduce the numberof IT staff required to perform these operations.

·       **Auto-Discovery.  **OSASautomatically discovers servers in an IT environment allowing devices to bequickly brought under management.

·       **Automated Change and Configuration Management.  **OSASautomates many of the tasks associated with managing system andapplication-level changes and configuration changes across operating systemsand software infrastructure tracking, which enables IT organizations toincrease efficiencies and reduce the costs associated with change andconfiguration management. 

·       **Automated Auditing and Compliance Management.  **OSASautomates the process of auditing and remediating servers and deployed softwarethereby allowing IT organizations to meet internal and regulatory compliancerequirements and policies. 

·       **Automated Patching and Security Administration.  **OSAS isdesigned to enable a high level of security for operational tasks fromprovisioning to patching to re-configuration and rollback. OSAS identifiespotentially vulnerable servers and software applications and enables rapiddistribution and installation of required patches to managed servers and theapplications that run on them. This enables IT organizations to protect serversagainst external vulnerabilities and maintain appropriate security patchlevels. OSAS is a highly secure system and supports fine-grained access controlfor operational functions so that only authorized personnel can make changes tosystems. 

·       **Disaster Recovery.  **OSAS Multimaster replicationfacilitates rapid disaster recovery by automatically maintaining an up-to-dateconfiguration database for all managed servers and using the informationcontained in this database to rapidly rebuild servers and applications in theevent of a disaster. This enables IT organizations to speed up and lower thecost of disaster recovery by allowing them to quickly recover and rebuild theunderlying server and application infrastructure of their IT environment in ageographically distinct data center or remote location. 

·       **Automated Reporting.  **OSAS includes a reporting systemthat provides customers with pre-defined and custom reports. OSAS reportingcapabilities include reports on all supported operational activities, assetreporting, security administration and compliance management. 

·       **Knowledge, Policy and Best Practices Encapsulation.  **OSASprovides built-in domain knowledge across a variety of operating systems andapplications including, for example, best practice installation andconfiguration information. In addition, OSAS incorporates operational policiesand best practices to deliver high quality operations and consistency acrossoperations. OSAS enables customers to capture their own best practices andoperational policies within the system. Knowledge encapsulation also enables ITorganizations to capture expertise in the system so that the knowledge can beleveraged and shared across all users of the system.

·       **System Extensibility.  **OSAS can be extended by ITorganizations, enabling the development of additional customer specificautomation modules. The system also integrates with other external IT 

3

----

systems such as incidentmanagement and performance management systems through application programminginterfaces. 

·       **Multi-location Operations.  **Opsware Multimaster andOpsware Satellite technologies enable multi-location operations and centralizedcontrol of systems located at remote locations. Opsware Satellite enablesautomated management of servers at remote locations regardless of location andnetwork bandwidth. All operations are conducted over OSAS’s securecommunication channel. 

*Opsware Network AutomationSystem*

In February 2005, we acquired Rendition Networks, Inc.,a software and services provider based in Redmond, Washington. As a result ofthe acquisition, we now offer our ONAS product.

ONAS automates key network device operations includingthe management of switches, routers, firewalls and load balancers in datacenters and remote locations. ONAS automates the full lifecycle of networkinfrastructure operations including discovering, provisioning, changing,auditing, patching, reporting, configuring, scaling, securing and recoveringnetwork devices across geographically disparate locations and heterogeneous ITenvironments.

Some of the keycapabilities and benefits of ONAS are:

·       **Auto-Discovery.  **ONAS automatically discovers networkdevices in an IT environment allowing devices to be quickly brought undermanagement.

·       **Automated Provisioning, Change and Configuration Management.  **ONASautomates many of the tasks involved in provisioning, updating, configuring andre-configuring switches, routers, load balancers and firewalls. Automatedprovisioning and change and configuration management are designed to increaseIT efficiency, increase network availability and reduce the number of networkengineering staff required to perform these operations. 

·       **Multi-Vendor Support.  **ONASsupports devices from a variety of network device vendors, such as CiscoSystems, Juniper/Netscreen, Nortel, 3Com, Extreme Networks, Check PointSoftware Technologies, F5 Networks, Foundry Networks, HP and others.

·       **Automated Auditing and Compliance Management.  **ONASautomates the process of auditing and remediating network devices to ensurethat they meet internal and regulatory compliance requirements and policies.ONAS provides a comprehensive compliance center thereby enabling customers toreduce the costs and time associated with compliance management and compliancereporting. 

·       **Automated Patching and Security Administration.  **ONAS isdesigned to enable a high level of security for operational tasks fromprovisioning to patching to re-configuration to auditing and change management.ONAS identifies potentially vulnerable network devices and enables rapiddistribution and installation of required patches to managed devices. ONAS alsoprovides a fine-grained access control mechanism so only authorizedadministrators can make changes to network devices and enables administratorsto lockdown devices to prevent tampering or unauthorized changes. 

·       **Process Automation.  **ONAS enables IT processes to beencapsulated in the system and those processes and operations workflows to beautomated. The automation of key IT processes improves quality and efficiencyof operations. 

·       **System Extensibility.  **ONAS provides an extensiblearchitecture that enables new network device types to be easily supported bythe system. The system extensibility enables customers to automate a wide rangeof network device types, manufacturers and models.

4

----

*The Opsware Network*

The Opsware Network is a subscription-based servicethat complements our software products. The Opsware Network provides criticalcontent for vulnerability management and new automation packs (content) on anongoing basis. The Opsware Network in combination with our products helps customersmaximize the benefits of their investment in IT automation by keeping customersup-to-date on technology support, vulnerabilities and automation capabilities.

*Opsware Asset ManagementSystem*

Our OAMS product enablesIT organizations to discover IT hardware and software assets, track assets onan ongoing basis and reduce the expense resulting from excess hardware andsoftware purchases, unnecessary maintenance renewals, and underutilization ofidle and redundant assets. OAMS also enables IT organizations to accuratelytrack and report on enterprise wide hardware and software asset deployment andutilization, and provides help desk staff with detailed visibility into currentand historical hardware and software configuration and usage information, aidingin rapid problem diagnosis, troubleshooting and problem resolution.

·       **Automated Discovery and Asset Tracking.  **OAMS discoversand tracks hardware and software assets across IT environments. OAMS can beused to discover and track a range of IT assets including desktops, servers,network devices and handheld devices. 

·       **Software Utilization.  **OAMS provides detailed informationon software usage and licensing, to reduce overbuys and detect potentiallicense violations. 

·       **Track Hardware and PDA Devices.  **OAMS manages hardwarePDA devices to minimize security breaches and reduce support requests, andprovides up-to-date information on asset usage to reduce maintenance andsupport costs. 

·       **License Tracking.  **OAMS supports a license trackingadd-on module that enables IT organizations to track and manage softwarelicenses and compliance contracts for the purpose of tracking license usage andrenewals. 

*Customer Support*

We believe that superior customer support is criticalto retaining our customer base. Our customer support organization providespost-sales support to customers via telephone, email and remote access. Ourmaintenance and support packages entitle customers to technical support andunspecified future maintenance releases and updates and upgrades to theversions of our products used by them, if and when commercially released. Fromtime to time, our customers request additional support services on a time andmaterials basis.

*Professional Services*

Our professional services organization providesproduct training, consulting and implementation services to assist customers inmaximizing the benefits of our software products.

**Customers**

We sell our suite of software automation products toenterprises, government agencies and service providers seeking to reduce costsand increase the quality of data center operations. Our customers are invarious vertical market segments, including the financial services, government,retail, media, industrial, telecommunication, service providers andhigh-technology sectors. For the fiscal year ended January 31, 2006, EDSaccounted for 35% of our net revenues. We expect that our operating resultswill be largely dependent on our relationship with EDS for the foreseeablefuture. The loss of EDS as a customer would have a material adverse effect uponour business and financial condition.

5

----

**IndustryRelationships**

*Cisco Systems.**  *In February 2006, we enteredinto a worldwide distribution agreement with Cisco to distribute our ONASproduct under the Cisco Systems brand name. This agreement represents asignificant expansion of our sales channel and market reach for our ONASproduct, and provides additional sales opportunities for other products in oursoftware automation suite, including our OSAS product.

*NEC Corporation.**  *Under our software distributionlicense agreement, NEC may use, market, sell, and support our software productsin Japan. NEC can sell our software products in connection with its VALUMOPlatform technology, as both a standalone product or integrated with otherVALUMO products that support mission critical systems. In January 2005, weentered into an amendment of our software distribution license agreement withNEC to enable NEC to utilize OSAS for its internal use.

*Nortel.*   Ourdistribution relationship with Nortel allows all resellers in their SelectProduct Program to purchase and resell ONAS.

We also have various strategic alliances with leadingsoftware, networking and services companies. Our strategy includes working closelywith these and other companies to promote industry advancement, accelerate newmarkets and add value for our customers by integrating our solutions with othersoftware and networking applications.

In addition, we have a number of relationships with resellersand system integrators to support our sales efforts and professional servicesobligations with our U.S. government customers.

**Research andDevelopment**

Our research and development organization designs,develops and tests the technologies that we offer to our customers as well asthe services that we use internally to streamline customer deployment andsupport processes. A primary goal of this organization is to bring new productsand new versions of existing products to market quickly in order to keep pacewith customer demands and remain competitive in the marketplace. In this way,our research and development organization is responsible for the extension ofour technology’s capabilities. During the fiscal years ended January 31,2006, 2005 and 2004, our research and development expenses were $22.0 million,$14.3 million and $8.7 million, respectively.

**Sales and Marketing**

We sell and market our services worldwide through adirect sales force and multiple indirect channels. During our 2006 fiscal year,we substantially increased the size of our direct sales force in order toenhance our geographic and vertical market segment coverage. We intend tocontinue to increase our sales force during fiscal 2007.

We also have agreements in place with corporate partners,such as distributors, value-added resellers, hardware providers and systemsintegrators. These agreements, subject to certain terms and conditions, enablethese companies to market and resell our products. We have expanded ourdistribution capabilities through new and enhanced partner and channelrelationships, including the Cisco distribution agreement described above.

For the fiscal year ended January 31, 2006, wegenerated approximately 11% of our net revenues from customers in the Europe,Middle East and Africa (“EMEA”) region and Asia Pacific (APAC) region. Weexpect international markets to provide increased opportunities for ourproducts and services in the future. Our current international efforts arefocused on strengthening our direct sales and marketing presence in EMEA andAPAC, and generating more revenues from these regions.

We focus our marketing efforts on sales forceenablement, increasing brand recognition, market awareness and lead generation.We intend to continue to invest in building our brand recognition and sales 

6

----

pipeline through leadgeneration programs, public relations programs, industry analysts, trade showsand industry and partner conferences.

**Competition**

Our competitors include large software, hardware andsystems companies as well as small, privately-held companies. The market forour technology is relatively new and therefore subject to rapid and significantchange. While we believe our technology is more comprehensive than and superiorto that of our competitors, we cannot assure you of the success of our strategygoing forward. Our competitors may succeed in developing technologies andproducts that are more effective than our software, which could render ourproducts obsolete and noncompetitive. Some of our competitors havesubstantially greater financial, technical and marketing resources, largercustomer bases, longer operating histories, more developed infrastructures,greater brand recognition, larger international presence and more establishedrelationships in the industry than we have, each of which may allow them togain greater market share. As a result, some of our competitors may be able todevelop and expand their technology offerings more rapidly, adapt to new oremerging technologies and changes in customer requirements more quickly, takeadvantage of acquisitions and other opportunities more readily, achieve greatereconomies of scale, devote greater resources to the marketing and sale of theirtechnology and adopt more aggressive pricing policies than we can. Some of ourcompetitors have lower priced offerings and offer point solutions that may be easierto sell and demonstrate to prospective customers. In addition, certain largecompetitors may be able to distribute their software products at minimal costor free of charge to customers. Furthermore, the open source community maydevelop competing software products which could erode our market share andforce us to lower our prices.

Although our market isrelatively new, it is intensely competitive. We believe that some of theprincipal competitive factors identified by customers in the IT data centerautomation market include:

·       breadthof technologies supported,

·       functionalityof product offerings,

·       qualityand extent of customer support and maintenance,

·       priceand demonstrable return on investment,

·       thevendor’s reputation, leadership team and financial stability,

·       performance,security, scalability, flexibility and reliability of the product offerings,and

·       easeof integration with existing applications and infrastructure.

Because some of our current competitors havepre-existing relationships with our current and potential customers, we mightnot be able to achieve sufficient market penetration to achieve or sustainprofitability. These existing relationships can also make it difficult for usto obtain additional customers due to the substantial investment that thesepotential customers might have already made based on our competitors’technology. Furthermore, our competitors may be able to devote substantialresources aimed at preventing us from establishing or enhancing our customerrelationships.

Our competitors and other companies may form strategicrelationships with each other to compete with us. These relationships may takethe form of strategic investments, joint-marketing agreements, licenses orother contractual arrangements, any of which may increase our competitors’ability to address customer needs with their product offerings. Our competitorsand other companies may consolidate with one another or acquire othertechnology providers, enabling them to offer a broader array of products andmore effectively compete with us. This consolidation could affect prices andother competitive factors in ways that could impede our ability to competesuccessfully and harm our business. In addition, to the extent that we seek toexpand our product lines, managerial and technical personnel skills andcapacity 

7

----

through acquisitions, thetrend in the software industry toward consolidation may result in ourencountering competition, and paying higher prices, for acquired businesses.

**IntellectualProperty**

We rely on a combination of patent, trademark, tradesecret, copyright and other laws and contractual restrictions to protect theproprietary aspects of our products and services. These legal provisions affordonly limited protection. It is difficult to monitor unauthorized use of ourtechnology, particularly in foreign countries where the laws may not protectour proprietary rights as fully as in the United States, and our competitorsmay independently develop technology similar to ours. We will continue toassess the necessity for additional intellectual property protections for thoseaspects of our technology that we believe constitute innovations providingsignificant competitive advantages.

We routinely require our employees, customers andpotential business partners to enter into confidentiality and nondisclosureagreements before we disclose any sensitive aspects of our technology, servicesor business plans to them. In addition, we require employees to agree to assignto us any proprietary information, inventions or other intellectual propertythey generate while employed by us. Despite our efforts to protect ourproprietary rights through confidentiality and license agreements, unauthorizedparties may attempt to copy or otherwise obtain and use our services ortechnology. These precautions may not prevent misappropriation or infringementof our intellectual property.

**Employees**

As of January 31, 2006, we had 336 full-timeemployees. We plan to hire additional personnel for the foreseeable future aswe continue to execute on our growth plan. Our future success will depend uponour ability to attract, integrate, retain and motivate highly qualifiedtechnical and management personnel, for whom competition can be intense. Noneof our employees is covered by a collective bargaining agreement. We believeour relations with our employees are good.

**AvailableInformation**

Our Internet website is located athttp://www.opsware.com. The information on our website is not a part of thisannual report. We make available free of charge on our website our annualreport on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K and amendments to those reports filed orfurnished pursuant to Section 13(a) or 15(d) of the SecuritiesExchange Act of 1934, as soon as reasonably practicable after we electronicallyfile such material with, or furnish it to, the Securities and ExchangeCommission.

Thepublic may also read and copy any materials we file with the Securities andExchange Commission at the Securities and Exchange Commission’s PublicReference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Thepublic may obtain information on the operation of the Public Reference Room bycalling the Securities and Exchange Commission at 1-800-SEC-0330.The Securities and Exchange Commission also maintains an Internet website thatcontains reports, proxy and information statements and other informationregarding issuers that file electronically with the Securities and ExchangeCommission. The Securities and Exchange Commission’s Internet website islocated at http://www.sec.gov.

8

----

**ITEM 1A.**     RISKFACTORS

Set forth below andelsewhere in this Annual Report on Form 10-K and in other documentswe file with the Securities and Exchange Commission are risks and uncertaintiesthat could cause actual results to differ materially from the resultscontemplated by the forward-looking statements contained in this Annual Reporton Form 10-K.

**We have relatively limited experience operating as asoftware company, which makes it difficult to evaluate our futureprospects.**

As a result of thesale of our Managed Services Business to EDS in fiscal 2003, our business modelhas shifted from providing managed Internet services to primarily licensing oursoftware products. We have relatively limited experience operating as asoftware company. As a result, we have limited ability to forecast futuredemand for our products and there is limited financial data upon which you mayevaluate our business and prospects. In addition, we have acquired existingbusinesses and a suite of software products from these businesses in order toaddress additional aspects of the IT automation market. We have limitedexperience operating these acquired businesses as well. Our potential forfuture profitability must be considered in light of the risks, uncertaintiesand difficulties frequently encountered by companies in their early stages ofdevelopment, particularly companies in new and rapidly evolving markets. Someof these risks relate to our potential inability to:

·       signcontracts with a sufficient number of customers in the time frame we anticipatein order to meet our financial goals, including our bookings targets;

·       providehigh levels of support for our products and support the deployment of a highervolume of our products;

·       developnew product offerings and extend the functionality of our existingtechnologies;

·       developand extend our software products to effectively support a wide range ofhardware, software and operating systems to meet the diverse needs ofcustomers;

·       integrateacquired businesses and technologies;

·       developeffective direct sales and indirect channels to sell our suite of softwareproducts;

·       developadditional strategic partnerships to facilitate our ability to market and sellour software products;

·       developthe capability that permits our software products to be integrated with thevariety of existing management systems that customers may already havedeployed; and

·       establishawareness of our brand.

If we do not successfullyaddress these risks, we may not realize sufficient revenue to reach or sustainprofitability.

**Our financialresults may fluctuate significantly, which could cause our stock price todecline.**

Our revenue andoperating results could vary significantly from period to period. Thesefluctuations could cause our stock price to fluctuate significantly or decline.Important factors that could cause our quarterly and annual financial resultsto fluctuate include:

·       ourability to obtain new customers and retain and generate expanded business fromour existing customers;

·       thetiming of signing contracts with customers;

9

----

·       thatfor the foreseeable future, whether we meet our sales targets will depend onclosing a small number of relatively large deals each quarter;

·       thetiming and magnitude of operating expenses and capital expenditures;

·       theeffect of any non-cash compensation charges in connection with the issuance,cancellation or modification of stock option awards;

·       thetiming of our satisfaction of revenue recognition criteria;

·       costsrelated to the various third-party technologies we may incorporate into ourtechnology and services;

·       changesin our pricing policies or those of our competitors;

·       anydownturn in our customers’ and potential customers’ businesses or in economicconditions generally;

·       thetiming of product releases or upgrades by us or by our competitors; and

·       changesin the mix of higher-margin software products versus lower-margin integrationand support services.

We are planning to increase our operating expenses andcapital expenditures in order to support our growth plans and based onestimates of future revenue. We believe that these expenditures are necessaryin order to position our company for growth, but there is no assurance thatthese investments will result in sales and revenue substantial enough to compensatefor these expenses. We may not be able to adjust spending in a timely manner tocompensate for any unexpected revenue shortfall, and any significant shortfallin revenue relative to planned expenditures could negatively impact ourbusiness and results of operations.

Our quarterly sales have historically reflected apattern in which a disproportionate percentage of a quarters’ total sales haveoccurred toward the end of that quarter. This makes predicting our revenue,earnings and cash flows for each financial period more difficult and increasesthe risk of unanticipated variations in our financial results. In addition,during our fiscal year 2006, the bulk of our license sales for the yearoccurred in the latter two fiscal quarters, and this pattern may continue infiscal 2007. This seasonality could make it more difficult to predict ourfinancial results, which could have an adverse impact on the trading price ofour common stock.

Due to these and otherfactors, period-to-period comparisons of our operating results may not bemeaningful. You should not rely on our results for any one period as anindication of our future performance. In future periods, our operating resultsmay fall below the expectations of public market analysts or investors. If thisoccurs, the market price of our common stock would likely decline.

**Our operating results are and will continue to behighly dependent upon our relationship with EDS and any deterioration of ourrelationship with EDS could adversely affect the success of our business.**

Our operating results are largely dependent on ourrelationship with EDS and will continue to be so for the foreseeable future. InAugust 2002, we entered into a three-year, $52.0 million license andmaintenance agreement with EDS. In August 2004, we entered into anamendment of our license and maintenance agreement with EDS whereby EDS agreedto extend the term of the agreement through March 2008 and committed topay minimum additional license and maintenance fees of approximately $50.0million over the term of the extended license. For the year ended January 31,2006, EDS accounted for 35% of our net revenue. If our relationship with EDSwere to deteriorate, or if EDS’s own financial position were to deteriorate,our business and results of operations would be adversely affected.

10

----

Although we extended ourlicense and maintenance agreement with EDS through March 2008, we cannotassure you that EDS will renew the license beyond the extended term or that ifEDS does renew the license beyond the extended term, it will do so on the termscontemplated in the agreement. Whether or not EDS continues to license oursoftware may depend, in large part, on its level of customer satisfaction andits own financial position. In addition, we cannot assure you that EDS willachieve the benefits they expect from our software products or that they willbe able to continue to deploy our software successfully or in the time framescontemplated by the license agreement. Each of these factors may affect EDS’willingness to renew the license. If EDS does not renew the license, ourbusiness and operating results may be adversely affected and this maynegatively impact our reputation and our ability to license our softwareproducts to other customers. In addition to these risks, the occurrence of anyof the adverse events discussed elsewhere in these Risk Factors couldnegatively impact our relationship with EDS and, consequently, our business.

**If we fail to maintain or achieve benefits from ourexisting distribution channels and develop additional channels in the future, ourfinancial results may suffer.**

We generate a portion of our revenue from sales of ourproducts and services through our network of indirect channel partners, such asdistributors, value-added resellers, systems integrators and OEM partners. Wemay not experience increased revenue from new channels and may see a decreasein revenue from our existing channels, which could harm our business. The lossof one or more of our channel partners, or any reduction or delay in theirsales of our products and services could result in reductions in our revenue infuture periods. In addition, our ability to increase our revenue in the futuredepends on our ability to expand our indirect distribution channels.

Our dependence onindirect distribution channels presents a number of risks, including:

·       ourchannel partners may cease marketing our products and services with limited orno notice and with little or no penalty;

·       ourchannel partners are generally not subject to minimum sales requirements or anyobligation to market our products to their customers;

·       wemay face conflicts between the activities of our indirect channels and ourdirect sales and marketing activities; and

·       ourchannel partners in some cases may not give priority to the marketing of ourproducts and services as compared to our competitors’ products or their ownproducts.

In particular, we entered into a distributionagreement in February 2006 with Cisco to distribute our ONAS product underthe Cisco Systems brand name. The initial term of this agreement is threeyears, although it may be terminated earlier in certain circumstances. We maynot fully realize the benefits anticipated under this agreement, such asadditional opportunities to cross-sell our OSAS product, and the amount andtiming of revenue recognized as a result of sales under this arrangement areuncertain. In addition, this agreement may displace some sales that mightotherwise occur through our direct sales force or other indirect sales channels.Accordingly, we would need to generate a higher volume of sales under thisagreement since our margins on sales under this agreement may be lower than onsales under our existing distribution arrangements.

In addition, we haveformed in the past, and intend to continue to form in the future, strategicrelationships with other technology companies in order to obtain a broaderreach for our products and services. We cannot guarantee that any new customerrelationships or revenue, or other anticipated benefits, will result from thesestrategic relationships. In addition, in the event that our strategic partnersexperience financial difficulties, we may not continue to realize existingbenefits from these relationships.

11

----

**The IT automation software market is relatively new,and our business will suffer if the market, or the technology standards withinthat market, do not develop as we expect.**

The market for our products and services is relativelynew and may not grow as we expect or be sustainable. Potential customers maychoose not to purchase IT automation software from a third-party provider dueto concerns about security, reliability, vendor stability and viability, costor system compatibility. It is possible that our products may never achievebroad market acceptance. We will incur operating expenses based to an extent onanticipated revenue trends that are difficult to predict given the recentemergence of the IT automation software market. If this market does notdevelop, or develops more slowly than we expect, we may not achieve significantmarket acceptance for our software, our rate of revenue growth may beconstrained and our operating results may suffer.

We have also joinedtogether with a number of other technology companies in connection with theestablishment of the data center mark-up language (“DCML”) standard within thedata center environment. We cannot assure you that the DCML standard willbecome widely accepted or result in any benefits to our business. If the DCMLstandard does not gain acceptance as we expect, we may not achieve significantmarket acceptance, our technology and products may need to be modified and ouroperating results may suffer.

**The market for our technology and services iscompetitive and we may not have the resources required to compete effectively.**

The market for our technology is relatively new andtherefore subject to rapid and significant change and we cannot assure you ofthe success of our strategy going forward. Our competitors may succeed indeveloping technologies and products that are more effective than our software,which could render our products obsolete and noncompetitive. Some of ourcompetitors have substantially greater financial, technical and marketingresources, larger customer bases, longer operating histories, more developedinfrastructures, greater brand recognition, international presence and moreestablished relationships in the industry than we have, each of which may allowthem to gain greater market share. As a result, some of our competitors may beable to develop and expand their technology offerings more rapidly, adapt tonew or emerging technologies and changes in customer requirements more quickly,take advantage of acquisitions and other opportunities more readily, achievegreater economies of scale, devote greater resources to the marketing and saleof their technology and adopt more aggressive pricing policies than we can.Some of our competitors have lower priced offerings and offer solutions thatmay be easier to sell and demonstrate to prospective customers. In addition,certain large competitors, including hardware manufacturers, may be able todistribute their software products at minimal cost or free of charge tocustomers. Furthermore, the open source community may develop competingsoftware products which could erode our market share and force us to lower ourprices. Our competitors include large software and systems companies as well assmall privately-held companies.

Because some of our current competitors havepre-existing relationships with our current and potential customers, we mightnot be able to achieve sufficient market penetration to achieve or sustainprofitability. These existing relationships can also make it difficult for usto obtain additional customers due to the substantial investment that thesepotential customers might have already made based on our competitors’technology. Furthermore, our competitors may be able to devote substantialresources aimed at preventing us from establishing or enhancing our customerrelationships.

Our competitors and othercompanies may form strategic relationships with each other to compete with us.These relationships may take the form of strategic investments, joint-marketingagreements, licenses or other contractual arrangements, any of which mayincrease our competitors’ ability to address customer needs with their productofferings. Our competitors and other companies may consolidate with one anotheror acquire other technology providers, enabling them to offer a broader array ofproducts and 

12

----

moreeffectively compete with us. This consolidation could affect prices and othercompetitive factors in ways that could impede our ability to competesuccessfully and harm our business. In addition, to the extent that we seek toexpand our product lines, managerial and technical personnel skills andcapacity through acquisitions, the trend in the software industry towardconsolidation may result in our encountering competition, and paying higherprices, for acquired businesses.

**The rates we charge our customers for our softwareproducts may decline or the terms of our customer contracts upon renewal maybe changed over time, either of which could reduce our revenue and affect ourfinancial results.**

As our business modelattracts the attention of competitors, we may experience pressure to decreasethe fees we charge for our software products, which could adversely affect ourrevenue and our gross margins. If we are unable to sell our software atacceptable prices, or if we fail to offer additional products with sufficientprofit margins, our revenue growth could slow, our margins may not improve andour business and financial results could suffer. In addition, we may choose toenter into new contracts with existing customers to better achieve our businessobjectives, and any new contracts could affect the manner in which we reportour results of operations as well as the historical accounting treatment forany such contracts.

**We must satisfy the criteria for revenue recognitionin order to recognize the fees generated under our license agreements asrevenue.**

In order to recognize thefees generated under our license agreements as revenue, we must demonstratethat the license arrangement satisfies the criteria for revenue recognitionincluding persuasive evidence that an arrangement exists, delivery hasoccurred, the fee is fixed or determinable and collectibility is probable. Ifwe are unable to satisfy the criteria for revenue recognition, our operatingresults may suffer or may fluctuate significantly from period to period. Inaddition, the timing of our recognition of revenue will depend upon the mix ofrevenue that is recognized in connection with multi-year licenses under theresidual method or ratably pursuant to the American Institute of CertifiedPublic Accountants (AICPA) SOP 97-2 and SOP 98-9, under thepercentage of completion or completed contract method of accounting, pursuantto SOP 81-1. In addition, if we are not able to maintain VSOE of fairvalue for maintenance and services for all product lines in the future, wecould be required, in certain circumstances, to recognize license, maintenanceand professional services revenues ratably over the maintenance period or deferall revenue recognition until professional services are delivered. Ourrevenue recognition requirement, and accordingly the length of time betweenexecution of a sales contract and recognition of revenue, varies among ourthree primary products. As a result, the mix of sales of particular productswill impact our recognition of revenues from these sales in future quarters.

**Our sales in anyquarter depend on a small number of relatively large transactions**

Our quarterly sales tocustomers other than EDS, and consequently the revenues that we recognize insubsequent quarters, are especially subject to fluctuation, because theynormally depend on the completion of a small number of relatively large licensetransactions. This dependence on large orders makes our net revenue andoperating results more likely to vary from quarter to quarter, and moredifficult to predict, because the loss or delay of any particular large orderis significant. As a result, our operating results could be adversely impactedif any large orders are delayed or canceled in any future period.

**Sales of our products generally involve lengthy salescycles, which may cause our financial results to suffer.**

We focus our salesefforts on enterprises, government agencies and service providers. Sales of ourproducts to these entities generally involve a long sales cycle. The length ofthe average sales cycle could 

13

----

makeit more difficult for us to predict revenue and plan expenditures accordingly.The sales cycle associated with the purchase of our products is subject to anumber of significant risks over which we have little or no control, such as:

·       customers’budget cycles, budgetary constraints and internal acceptance procedures;

·       thelimited experience and customer references we have from operating as a softwarecompany;

·       concernsabout the introduction or announcement of new products or enhancements by ourcustomers or us; and

·       potentialdownturns in the IT market and in economic conditions generally.

In addition, the time ittakes to demonstrate and deploy our software with these accounts may be longerthan a non-enterprise customer given the complexity of their operations, whichmay delay our ability to recognize revenue from sales to these accounts and mayaffect customer satisfaction.

**We may continue toincur significant operating losses and negative cash flow in future periods.**

We may be required to spend significant funds tocontinue developing our software products, and to expand our research anddevelopment and sales and marketing organizations to fit the needs of ourbusiness. We have incurred significant operating and net losses and negativecash flow in the past and have not achieved operating profitability. If ourrevenue grows more slowly than we anticipate or if our operating expensesincrease by more than we expect, our cash flow and operating results willsuffer. Consequently, it is possible that we will never achieve operatingprofitability. Even if we do achieve positive cash flow or profitability in anyone quarter, we may not sustain or increase positive cash flow or profitabilityon a quarterly or annual basis in the future.

In addition, any decisionto restructure our operations, to exit any activity or to eliminate any excesscapacity could result in significant accounting charges. Future businesscombinations may also result in restructuring or other accounting charges.These charges could result in greater net losses, could transform an otherwiseprofitable quarter into a net loss in future periods, or could materiallyimpair earnings should we achieve profitability in the future.

**Our revenue and operating results will be highlydependent upon our ability to provide high levels of customer satisfaction.**

Our products must integrate with many existingcomputer systems and software programs used by our customers. In addition,integration requires adaptation to each customer environment, both in terms ofinteroperability and to meet the particular goals and objectives of eachcustomer for our products. This integration can be complex, costly and timeconsuming, and can cause delays in the deployment of our products forcustomers. Customers could become dissatisfied with our products if deploymentswithin customer environments prove to be difficult, costly or time consuming,and this could negatively impact our ability to sell our products in thefuture.

We provide technicalsupport to our customers pursuant to contracts that are generally renewableannually. Our customers’ willingness to renew their maintenance and supportagreements, enter into new contracts for additional products and act as areference account will depend in large part on our ability to provide highlevels of customer service. If we fail to provide the level of support demandedby our customers or if the capabilities of our products do not match ourcustomers’ expectations, they may not renew their maintenance and supportagreements or enter into new contracts for additional products and may not actas a reference account, each of which could have a material adverse impact onour revenue and operating results.

14

----

**We may engage in additional acquisitions orinvestments, which may place a strain on our resources, cause dilution to ourstockholders and harm our operating results.**

From time to timewe may make acquisitions of or investments in other companies in an effort toincrease our customer base, broaden our product offerings or expand ourtechnology platform. For example, in February 2005, we acquired RenditionNetworks, a network device automation company located in Redmond, Washington.If we fail to evaluate and execute acquisitions or investments successfully,they may seriously harm our business. We may not realize anticipated benefitsfrom acquisitions if we are unable to do the following:

·       effectivelymarket and sell the newly acquired products, and capitalize on cross-sellingopportunities;

·       effectivelyprovide services to any newly acquired customers;

·       accuratelyforecast the financial impact of the transaction, including but not limited to,accounting charges related to the impairment of assets acquired and transactionexpenses;

·       managethe expenses of the acquired business;

·       integrateand retain personnel;

·       managegeographically dispersed operations; and

·       addressunforeseen liabilities or risks associated with the acquired company.

Integrating acquired businesses has been and willcontinue to be a complex, time consuming and expensive process. To integrateacquired businesses, we must implement our technology systems in the acquiredoperations and integrate and manage the personnel of the acquired operations.Our success in completing the integration of acquired businesses may impact themarket acceptance of such acquisitions, and our willingness to acquireadditional businesses in the future. Other challenges of integration includeour ability to incorporate acquired products and business technology into ourexisting product lines, including consolidating technology with duplicativefunctionality or designed on a different technological architecture, and ourability to sell the acquired products through our existing or acquired saleschannels. Further, the difficulties of integrating acquired businesses coulddisrupt our ongoing business, distract our management focus from otheropportunities and challenges, and increase our expenses and working capitalrequirements.

Future acquisitions by usmay result in entering into markets or acquiring technologies in areas in whichwe have little experience. Future acquisitions also may result in customerdissatisfaction, new competitors, performance problems with an acquired companyand its technology, dilutive issuances of equity securities, the use of asubstantial portion of our cash and investment balances, the incurrence ofadditional debt, large one-time write-offs and the creation of goodwill orother intangible assets that could result in significant impairment charges oramortization expense. Any of the foregoing and other factors could harm ourability to achieve anticipated levels of profitability from acquired businessesor to realize other anticipated benefits of acquisitions. Mergers andacquisitions of high technology companies are inherently risky, and noassurance can be given that our previous or future acquisitions will besuccessful and will not materially adversely affect our business, operatingresults, or financial condition.

**Our business is subject to changing regulation thathas increased both our costs and the risk of noncompliance.**

Our business, results of operations or financialcondition could be adversely affected if laws, regulations or standards relatingto us are implemented or changed.

15

----

In particular, we are subject to rules andregulations of federal, state and financial market exchange entities chargedwith the protection of investors and the oversight of companies whosesecurities are publicly traded. These entities, including the Public CompanyAccounting Oversight Board, the SEC and NASDAQ, have recently issued newrequirements and regulations and continue to develop additional regulations andrequirements in response to recent laws enacted by Congress, most notably theSarbanes-Oxley Act of 2002.

Our efforts to comply withthese new regulations have resulted in, and are likely to continue to resultin, increased general and administrative expenses and a diversion of managementtime and attention from revenue-generating activities to compliance activities.Any failure to comply with the reforms required by these new laws andregulations could significantly harm our business, operating results andfinancial condition. In particular, if we do not adequately manage and evolveour financial reporting and managerial systems and processes as necessary, ourability to manage and grow our business may be harmed.

**Unfavorable economic conditions and reductions ininformation technology spending could limit our ability to grow ourbusiness.**

Our business and operating results are subject to theeffects of changes in general economic conditions and changes in theinformation technology market. In addition, fears of global recession, war andacts of terrorism may impact global economies negatively. We believe that,during the past few years, poor U.S. economic conditions, as well as a declinein worldwide economic conditions, led to reduced IT spending. If theseconditions resurface, demand for our products may be reduced.

Our management is requiredto make forecasts with respect to economic trends and general businessconditions in order to develop budgets, plan research and developmentstrategies and perform a wide variety of general management functions. To theextent that our forecasts are incorrect, our performance may suffer because ofa failure to properly align our corporate strategy with economic conditions.

**If we do notdevelop our direct sales organization, we will have difficulty acquiringcustomers.**

Our products require asophisticated sales effort targeted at a limited number of key people withinour prospective customers’ organizations. Because the market for our technologyand services is new, many prospective customers are unfamiliar with theproducts we offer. As a result, our sales effort requires highly trained salespersonnel. During our 2006 fiscal year, we substantially increased the size ofour direct sales force in order to enhance our geographic and vertical marketsegment coverage, and we intend to continue to increase our sales force duringfiscal 2007. Our new sales personnel will require extensive training and timeto become productive, and there is no guarantee that they will produce at thelevels that we anticipate. In addition, competition for these individuals isintense, and we may not be able to hire and retain the type and number of salespersonnel we need. Moreover, even after we hire these individuals, they requireextensive training and time to become productive. If we decide, but are unable,to expand our direct sales force and train new sales personnel as rapidly asnecessary, we may not be able to increase market awareness and sales of ourproducts, which may prevent us from growing our revenue and achieving andmaintaining profitability.

**Future changes in accounting standards or ourinterpretation of current standards, particularly changes affecting revenuerecognition, could cause unexpected fluctuations in reported revenue.**

Future changes inaccounting standards or our interpretation of current standards, particularlythose affecting revenue recognition, could require us to change our accountingpolicies. These changes could cause deferral of revenue recognized in currentperiods to subsequent periods or accelerate recognition of deferred revenue tocurrent periods, each of which could impair our ability to meet securitiesanalysts’ and investors’ expectations, which could cause a decline in our stockprice.

16

----

**Changes in the accounting treatment of stock optionswill significantly impact our results of operations and could negatively impactour ability to attract and retain employees.**

Changes in the accounting treatment for stock optionswill require us to account for employee stock options as compensation expenseon our financial statements commencing February 1, 2006. We are currentlyevaluating option valuation methodologies and assumptions permitted by the FASBfor purposes of implementing the change in accounting treatment. This changewill significantly impact our reported results of operations and our timing toachieve profitability.

We have historically usedstock options and other forms of equity compensation as key components of ouremployee compensation program in order to align employees’ interests with theinterests of our stockholders, encourage employee retention, and providecompetitive compensation packages. The changing regulatory landscape could makeit more difficult and expensive for us to grant stock options to employees inthe future. In light of these changes, we may modify our equity compensationstrategy to emphasize equity incentives other than stock options, includingincreased use of certain performance-related features. If employees believethat the incentives that they would receive under a modified strategy are lessattractive, we may find it difficult to attract, retain and motivate employees.To the extent that new regulations make it more difficult or expensive to grantequity instruments to employees, we may incur increased compensation costs,further change our equity compensation strategy or find it increasinglydifficult to attract, retain and motivate employees, each of which couldmaterially and adversely affect our business, financial condition or results ofoperations.

**If we are unable tomanage rapid growth and change, our operating results could be adverselyaffected.**

We have, in the past, experienced significant growthand we believe this growth may continue. To successfully manage past growth andany future growth, we will need to continue to implement additional managementinformation systems, continue the development of our operating, administrative,financial and accounting systems and controls and maintain close coordinationamong our executive, engineering, finance, legal, marketing, sales andoperations organizations. Any failure by us to properly manage growth couldimpair our ability to attract and service customers and could cause us to incurhigher operating costs and experience delays in the execution of our businessplan.

In particular, we plan toincrease our international sales force and operations over the long term. Expandinginternationally requires significant management attention and financialresources, and we may not generate sufficient revenues to cover these expenses.In addition, our international business activities are subject to a variety ofrisks, including the adoption of or changes in laws, currency fluctuations andpolitical and economic conditions that could restrict or eliminate our abilityto conduct business in foreign jurisdictions.

**If we do not develop and maintain productiverelationships with systems integrators, our ability to deploy our software, generatesales leads and increase our revenue sources may be limited.**

We intend to developadditional relationships with a number of computing and systems integrationfirms to enhance our sales, support, service and marketing efforts,particularly with respect to the implementation and support of our products, aswell as to help generate sales leads and assist in the sales process. Many suchfirms have similar, and often more established, relationships with ourcompetitors. These systems integrators may not be able to provide the level andquality of service required to meet the needs of our customers. If we are unableto develop and maintain effective relationships with systems integrators, or ifthey fail to meet the needs of our customers, our business could be adverselyaffected.

17

----

**Because our success depends on our proprietarytechnology, if third parties infringe our intellectual property or if we areunable to rely upon the legal protections for our technology, we may be forcedto expend significant resources enforcing our rights or suffer competitiveinjury.**

Our success depends in large part on our proprietarytechnology. We have a number of issued patents and pending patent applications,and we currently rely on a combination of copyright, trademark, trade secretand other laws and restrictions on disclosure to protect our intellectualproperty rights. These legal protections afford only limited protection, andour means of protecting our proprietary rights may not be adequate.

Our intellectual property may be subject to even greaterrisk in foreign jurisdictions, as the laws of many countries do not protectproprietary rights to the same extent as the laws of the United States. If wecannot adequately protect our intellectual property, our competitive positionmay suffer.

We may be required tospend significant resources to monitor and police our intellectual propertyrights. We may not be able to detect infringement and may lose our competitiveposition in the market before we are able to ascertain any such infringement.In addition, competitors may design around our proprietary technology ordevelop competing technologies. Litigation may be necessary in the future toenforce our intellectual property rights, to protect our trade secrets, todetermine the validity and scope of the proprietary rights of others or todefend against claims of infringement. Any such litigation could result insignificant costs and diversion of resources, including the attention of seniormanagement.

**If our products infringe on the intellectual property rightsof others, we could face costly litigation, which could cause us to paysubstantial damages and ongoing royalties, and limit our ability to use ourtechnology or sell some or all of our products.**

Other companies,including our competitors, may obtain patents or other proprietary rights thatcould prevent, limit or interfere with our ability to make, use or sell ourproducts. As a result, we may be found to infringe on the proprietary rights ofothers. Intellectual property litigation or claims could force us to do one ormore of the following:

·       engagein costly litigation and pay substantial damages to third parties, andindemnify customers or commercial partners;

·       stoplicensing technologies that incorporate the challenged intellectual property;

·       terminateexisting contracts with customers or with channel partners;

·       contributeportions of our proprietary technology to the open source community;

·       obtaina license from the holder of the infringed intellectual property right, whichmay not be available on reasonable terms or at all; or

·       redesignour technology and products, if feasible.

If we are forced to take any of the foregoing actions,our business and financial condition may be seriously harmed. In addition, theoccurrence of any of these conditions could have the effect of increasing ourcosts and reducing our revenue. Our insurance for potential claims of this typemay not be adequate or available to indemnify us for all liability that may beimposed.

We use a limited amount ofwhat we believe to be open source software in our products and may use more ofthis software in the future. As a result, we could be subject to suits by thirdparties claiming ownership of what we believe to be open source software or wecould be found to be non-compliant with the terms and conditions of the opensource licenses that we use. Any non-compliance could result in litigation orloss of the right to use this software. In addition, potential customers maydelay or decline a 

18

----

purchaseof technology involving open source software, and open source license terms mayresult in unanticipated obligations for us or our customers.

**Our business will suffer if we do not enhance ourproducts or introduce new products and upgrades to meet changing customerrequirements.**

The market for our products and services ischaracterized by rapid technological change, uncertain product life cycles,changes in customer demands, evolving industry standards and increasedcomplexity and interdependence of our applications. Any delays in responding tothese changes and developing and releasing enhanced or new products andupgrades could hinder our ability to retain existing and obtain new customers.In particular, our technology is designed to support a variety of hardware andsoftware products that we believe to be proven and among the most widely used.We cannot be certain, however, that present and future customers will continueto use these products. Even if they do, new versions of these products arelikely to be released and we will need to adapt our technology to these newversions. We must, therefore, constantly modify and enhance our technology tokeep pace with changes made to our customers’ hardware and softwareconfigurations. If we fail to promptly modify or enhance our technology inresponse to evolving customer needs and demands, fail to introduce new productsand upgrades or fail to fully develop our new product offerings, our technologymay not achieve widespread acceptance and could become obsolete, which wouldsignificantly harm our business.

As we introduce newproducts or technologies into existing customer environments, we may experienceperformance and functionality problems associated with incompatibility amongdifferent versions of hardware, software and networking products. To the extentthat such problems occur, we may face adverse publicity, loss of sales, loss ofcustomer satisfaction and delay in market acceptance of our products orcustomer claims against us, any of which could harm our business.

**We rely on third-party software to develop and deliverour products to our customers, and the loss of access to this softwarecould harm our business.**

As part of our normaloperations in connection with the development and delivery of our software, welicense software from third-party commercial vendors. These products may notcontinue to be available on commercially reasonable terms, or at all. The lossof these products could result in delays in the sale of our software untilequivalent technology, if available, is identified, procured and integrated,and these delays could result in lost revenue. Further, to the extent that weincorporate these products into our software and the vendors from whom wepurchase these products increase their prices, our gross margins could be negativelyimpacted.

**Defects or security flaws in our products or claimsasserted against us could result in the loss of customers, a decrease inrevenue, unexpected expenses, loss of competitive market share and liabilityclaims.**

Our products dependon complex software, both internally developed and licensed from third parties.Also, our customers may use our products with other companies’ products thatalso contain complex software. If our software does not meet performancerequirements, our customer relationships will suffer. Complex software oftencontains errors and is susceptible to computer viruses and may contain securityvulnerabilities. Any failure or poor performance of our software or the thirdparty software with which it is integrated could result in:

·       delayedor diminished market acceptance of our software products;

·       delaysin product shipments;

·       unexpectedexpenses and diversion of resources to identify the source of errors or tocorrect errors;

19

----

·       damageto our reputation; or

·       liabilityclaims and loss of future revenue.

Although our agreementswith customers generally contain provisions designed to limit our exposure topotential liability claims, these provisions may not be effective to the extentwarranty exclusions or similar limitations of liability are unenforceable. Inaddition, the extent of these limitations may require negotiation. If any claimis made against us, we may be required to expend significant cash resources indefense and settlement of the claim.

**If we are unable to retain our executive officers orkey technical personnel, we may not be able to successfully manage ourbusiness or achieve our objectives.**

Our business andoperations are substantially dependent on the performance of our key employees,all of whom are employed on an at-will basis. If we lose the services of one ormore of our executive officers or key technical employees, in particular, MarcL. Andreessen, our Chairman, Benjamin A. Horowitz, our President and ChiefExecutive Officer, or Timothy A. Howes, our Chief Technical Officer, or if oneor more of them decides to join a competitor or otherwise compete directly orindirectly with us, we may not be able to successfully manage our business orachieve our business objectives.

**Our business willsuffer if we are unable to hire and retain highly qualified employees.**

Our future success depends on our ability to hire andretain highly qualified technical, sales and managerial personnel. Our failureto hire and retain qualified personnel could seriously disrupt our operationsand increase our costs by forcing us to use more expensive outside consultantsand by reducing the rate at which we can increase revenue. As our customer baseand revenue grow, we may need to hire additional qualified personnel.Competition for qualified personnel can be intense, and we may not be able toattract, train, integrate or retain a sufficient number of qualified personnelif we need to do so in the future.

Important components ofthe compensation of our personnel are stock options and restricted stock, whichtypically vest over a four-year period. We may face significant challenges inretaining our employees if the value of our stock declines. To retain ouremployees, we expect to continue to grant new options subject to vestingschedules, which will be dilutive to the investments of our existingstockholders. Some of our employees hold options with exercise prices that arehigher than the price at which our common stock is currently trading. If ourstock price does not increase in the future, we may need to exchange optionsfor new options or restricted stock, issue new options or grant additionalshares of stock to motivate and retain our employees. To the extent we issueadditional options or shares of restricted stock, existing stockholders willexperience dilution.

**Our stock price hasbeen volatile and could decline.**

The market price of our common stock has fluctuatedsignificantly in the past, will likely continue to fluctuate in the future andmay decline. The market for technology stocks has been extremely volatile, andhas from time to time experienced significant price and volume fluctuationsthat bear little relationship to the past or present operating performance ofthose companies. Furthermore, our common stock is relatively thinly traded,which contributes significantly to the volatility of our stock price. Due tothe low trading volume of our stock, stockholders may not be able to purchaseor sell shares, particularly large blocks of shares, as quickly and asinexpensively as if the trading volume were higher. This could result ingreater volatility in our stock price.

Among the factorsthat could affect our stock price are:

·       actualor anticipated variations in our quarter-to-quarter operating results;

20

----

·       theloss of any of our significant customers or our failure to obtain new customersor renew existing contracts;

·       announcementsby us or our competitors of significant contracts, new or enhanced products orservices, acquisitions, distribution partnerships, joint ventures or capitalcommitments;

·       changesin our financial estimates or investment recommendations by securities analystsfollowing our business;

·       oursale of common stock or other securities in the future;

·       changesin economic and capital market conditions for companies in our sector;

·       changesin the enterprise software markets;

·       changesin market valuations or earnings of our competitors;

·       changesin business or regulatory conditions;

·       interestrates and other factors affecting the capital markets;

·       fluctuationsin the trading volume of our common stock; and

·       theoccurrence of any of the adverse events discussed elsewhere in these RiskFactors.

In addition, if ourstockholders sell substantial amounts of our common stock in the public market,or if any of our officers or directors were to sell shares of our commons stockheld by them, the market price of our common stock could fall.

**We may require additional capital to fund ouroperations or may elect to raise additional capital if the market permits.**

We believe that ourcurrent cash balances, including cash and cash equivalents, and cash flow fromoperations will be sufficient to meet our working capital and capitalexpenditure requirements for at least the next 12 months. However, if ourlicensing revenue does not meet our expectations, if we encounter unforeseenexpenses or if our business plan changes, we may require additional equity ordebt financing. In addition, we may elect to raise additional capital if marketconditions permit in order to increase our cash balance and expand ourbusiness. If we elect to raise additional capital in the future, we cannot besure that we will be able to secure additional financing on acceptable terms,or at all. If we elect to raise additional capital through means of an equityfinancing, existing holders of our common stock will suffer dilution.Additionally, holders of any future debt instruments or preferred stock mayhave rights senior to those of the holders of our common stock. Any debtfinancing we raise could involve substantial restrictions on our ability toconduct our business and to take advantage of new opportunities.

**Insiders have substantial control over us and thiscould delay or prevent a change in control and could negatively affect yourinvestment.**

As of April 1, 2006,our officers and directors and their affiliates beneficially own, in theaggregate, approximately 25% of our outstanding common stock. Thesestockholders are able to exercise significant influence over all mattersrequiring stockholder approval, including the election of directors andapproval of significant corporate transactions, which could have the effect ofdelaying or preventing a third party from acquiring control over us and couldaffect the market price of our common stock. In addition, the interests ofcertain large stockholders may not always coincide with our interests or theinterests of other stockholders, and, accordingly, these stockholders couldapprove transactions or agreements that would not otherwise be approved by otherstockholders generally.

21

----

**We have implementedanti-takeover provisions that could make it more difficult to acquire us.**

Our certificate ofincorporation, our bylaws and Delaware law contain provisions that could makeit more difficult for a third party to acquire us without the consent of ourboard of directors, even if doing so would be beneficial to our stockholders.These provisions include:

·       classifyingour board of directors into three groups so that the directors in each groupwill serve staggered three-year terms, which would make it difficult for apotential acquirer to gain immediate control of our board of directors;

·       authorizingthe issuance of shares of undesignated preferred stock without a vote ofstockholders;

·       prohibitingstockholder action by written consent; and

·       limitations onstockholders’ ability to call special stockholder meetings.

**ITEM 1B.**    UNRESOLVEDSTAFF COMMENTS 

None.

**ITEM 2.**                PROPERTIES

Our corporate headquartersare located in Sunnyvale, California, where we rent approximately 75,000 squarefeet under a lease expiring in 2010, of which we sublease approximately 25,000square feet to EDS through August 2006. As a result of past acquisitionswe also occupy a facility in Cary, North Carolina, consisting of approximately13,000 square feet under a lease that terminates in May 2007 and afacility in Redmond, Washington, consisting of approximately 12,000 square feetunder a lease that terminates May 1, 2011. In addition, we have a numberof operating leases for field sales offices in various locations worldwide. Webelieve that our facilities are adequate to meet current requirements.

**ITEM 3.**                LEGALPROCEEDINGS 

We currently have nopending or threatened material litigation. In the future, we may be subject tolawsuits. Any litigation, even if not successful against us, could result insubstantial costs and divert management’s attention and other resources awayfrom the operation of our business.

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS 

None.

22

----

**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDERMATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES 

**Market for OurCommon Stock**

Our common stock is listedon the NASDAQ National Market under the symbol “OPSW”. The following table setsforth for each of the two preceding fiscal years the high and low sales pricesper share of our common stock as reported by the NASDAQ National Market foreach full quarterly period within the two most recent fiscal years.

| **Fiscal year ended January 31, 2005:** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------------------------------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter                                                    |       | $          | 9.47       |     | $          | 6.56    |       |
| Second Quarter                                                   |       | 8.65       |       | 5.59     |       |
| Third Quarter                                                    |       | 6.61       |       | 4.82     |       |
| Fourth Quarter                                                   |       | 7.45       |       | 5.41     |       |
|                                                                  |            |            |            |          |            |         |            |  |  |

 

| **Fiscal year ended January 31, 2006:** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------------------------------------|------------|------------|------------|----------|------------|---------|------------|
| First Quarter                                                    |       | $          | 6.07       |     | $          | 4.22    |       |
| Second Quarter                                                   |       | 6.00       |       | 3.90     |       |
| Third Quarter                                                    |       | 5.51       |       | 4.17     |       |
| Fourth Quarter                                                   |       | 7.55       |       | 4.91     |       |
|                                                                  |            |            |            |          |            |         |            |  |  |

 

We have never paid cashdividends and do not plan to do so in the foreseeable future. According to therecords of our transfer agent, at April 1, 2006, there were approximately581 stockholders of record of our common stock. Because many brokers and otherinstitutions hold stock on behalf of our stockholders, the total number ofbeneficial holders of our common stock is greater than that represented bythese record holders.

23

----

**ITEM 6.**                SELECTEDCONSOLIDATED FINANCIAL DATA 

The selected consolidated financial data below shouldbe read together with Item 7 “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and the consolidated financial statementsand related notes thereto in Item 8 “Financial Statements and SupplementaryData.”

Priorto August 2002 (fiscal year ending January 31, 2003), we primarilyprovided managed internet services, which we referred to as our ManagedServices Business. On August 15, 2002, we completed the sale of our ManagedServices Business to EDS. As a result, the historical financial informationrelating to the periods prior to August 15, 2002 is not related to ourcurrent software business and is not indicative of future actual results fromour current software business.

In addition, we acquired Rendition Networks inFebruary 2005 and Tangram Enterprise Solutions in February 2004, eachof which was accounted for as a purchase transaction. Accordingly, the resultsof the acquired companies’ operations are included in our consolidatedfinancial statements from their respective dates of acquisition.

| ** **                                                                          | ** ** | **Year Ended January 31,**                             | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                          | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **Consolidated Statement of  Operations Data:**                                     | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue                                                                         |       | $                                                                     | 61,077     |   | $ | 37,792 |   | $ | 18,050 |   | $ | 37,703 |   | $ | 56,012 |   |
| Restructuring  costs (recoveries), net                                              |       | (18                                                                   | )          | (1,085 | ) | 1,028 |   | 19,682 |   | 31,471 |   |
| Amortization  (reversal) of deferred stock compensation                             |       | 1,282                                                                 |       | (131 | ) | 606 |   | (14,303 | ) | 42,666 |   |
| Total costs and  expenses                                                           |       | 78,732                                                                |       | 49,718 |   | 32,277 |   | 99,008 |   | 263,346 |   |
| Loss from  operations                                                               |       | (17,655                                                               | )          | (11,926 | ) | (14,227 | ) | (61,305 | ) | (207,334 | ) |
| Gain from  retirement of senior discount notes                                      |       | —                                                                |       | — |   | — |   | 8,736 |   | — |   |
| Gain (loss) on  sale of assets and liabilities related to Managed Services Business |       | (69                                                                   | )          | 4,165 |   | 1,252 |   | 50,660 |   | — |   |
| Net loss                                                                            |       | $                                                                     | (14,751    | ) | $ | (7,246 | ) | $ | (8,409 | ) | $ | (3,247 | ) | $ | (210,675 | ) |
| Basic and diluted net  loss per share                                               |       | $                                                                     | (0.15      | ) | $ | (0.09 | ) | $ | (0.11 | ) | $ | (0.05 | ) | $ | (3.45 | ) |

 

Certainreclassifications have been made to prior fiscal year amounts in order toconform to the current fiscal year presentation.

| ** **                                                               | ** ** | **As of January 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                               | ** ** | **(in thousands)**              | ** ** |
| **Consolidated  Balance Sheet Data:**                                    | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash, cash  equivalents, short-term investments and restricted cash      |       | $                                    | 104,194    |   | $ | 121,355 |   | $ | 58,116 |   | $ | 66,983 |   | $ | 115,638 |   |
| Working capital                                                          |       | 83,199                               |       | 101,204 |   | 39,882 |   | 43,378 |   | 56,291 |   |
| Total assets                                                             |       | 169,752                              |       | 143,591 |   | 70,807 |   | 75,879 |   | 174,297 |   |
| Long-term  obligations and senior discount notes, net of current portion |       | 74                                   |       | — |   | — |   | 23 |   | 56,657 |   |
| Accrued  restructuring costs, net of current portion                     |       | 1,190                                |       | 1,466 |   | 2,154 |   | 7,840 |   | 7,363 |   |
| Stockholders’ equity                                                |       | 123,538                              |       | 116,662 |   | 47,225 |   | 46,138 |   | 57,476 |   |
|                                                                          |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

24

----

**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussionshould be read together with the financial statements and the related notesincluded in this Form 10-K. The following discussion containsforward-looking statements that involve risks and uncertainties, includingthose described in Item 1A “Risk Factors”. Our actual results may differmaterially from those projected in the forward-looking statements as a resultof these risks and uncertainties. See also “Cautionary Statement RegardingForward-Looking Statements.” The financial statement data contained hereinreflects our results as they existed for the periods presented.

**Overview**

We are a provider of IT automation software forenterprises, government agencies and service providers seeking to reduce thecost and improve the quality of IT operations. Our software automates IToperations across servers, software, applications and network devices anddiscover and track assets across the IT environment. Our software automationsuite includes the Opsware Server Automation System (OSAS), the Opsware NetworkAutomation System (ONAS) and the Opsware Asset Management System (OAMS). OSASautomates key server, software and application operations across geographicallydisparate locations and heterogeneous IT environments. ONAS automates networkdevice operations for data centers and remote locations. OAMS enables ITorganizations to discover IT hardware and software assets, track these assetson an ongoing basis and reduce costs of excess hardware and software purchases,unnecessary maintenance renewals and underutilization of idle and redundantassets. Our software products automate formerly manual, time-consuming anderror-prone tasks, including the provisioning, changing, auditing, patching,reporting, configuring, scaling, securing and recovering of servers, software,applications and network devices.

We derive a significant portion of our revenue fromsales of software licenses. We sell our products principally through our directsales force and, to a lesser extent, through indirect channels with corporatepartners, such as distributors, value-added resellers, hardware providers andsystems integrators. We intend to increase our sales efforts through indirectchannels in the future, in part due to our new distribution agreement withCisco Systems that is discussed below. We also derive revenue from sales ofitems that are complementary to our software automation suite, including annualsupport and maintenance agreements, professional services, training andsubscription-based products.

Our fiscal year ends on January 31. References tofiscal 2006, for example, refer to the fiscal year ended January 31, 2006.

In view of the rapidlychanging nature of our business, we believe that period-to-period comparisonsof revenues and operating results should not be unduly relied upon asindications of future performance, growth or financial results. Additionally,historical trends may not be indicative of future growth or financial results.

*StrategicRelationship with Cisco*

In February 2006, weentered into a worldwide distribution agreement with Cisco Systems todistribute our ONAS product under the Cisco Systems brand name. This agreementrepresents a significant expansion of our sales channel and market reach andprovides additional sales opportunities for other products in our softwareautomation suite, including our OSAS product. We do not expect to recognizesignificant revenue under this agreement during fiscal 2007, but expect thatthis agreement will contribute meaningfully to our fiscal 2008 revenue. Thethree year term of this agreement will commence in May 2006 and renewautomatically thereafter for one year terms, although it may be terminatedearlier in certain circumstances. There can be no assurance that we willrealize the benefits anticipated by this agreement.

25

----

*Relationship withEDS*

In August 2002, we sold our Managed ServicesBusiness to EDS for a total purchase price of $63.5 million in cash and enteredinto a separate agreement with EDS pursuant to which we granted EDS a licenseto use our software products. Under this license agreement, EDS agreed to payus a minimum license and maintenance fee of $52.0 million in the aggregate overa term of three years.

In August 2004, EDS agreed to extend the term ofthe agreement through March 2008 and committed to pay additional licenseand maintenance fees of approximately $50.0 million over the term of theextended license. These payments are in addition to the initial $52.0 millioncommitment. Pursuant to this amendment, (1) EDS is required to pay $2.0million per month from August 15, 2004 through August 14, 2005 and$1.6 million per month thereafter through March 2008, (2) EDS’monthly payments are no longer dependent upon the number of devices beingmanaged by our software products, (3) EDS receives rights to license allfuture products released by us, when and if available for commercial release,for no additional fee, (4) we agreed to provide certain third-partyequipment and software for EDS’ use in connection with our software products,and (5) dedicated Opsware support personnel will continue to be providedto EDS for the duration of the extended term. Following the extended term, theagreement will automatically renew at a fee of $1.6 million per month for fivesuccessive one-year terms unless terminated in advance by EDS. Revenue underthis arrangement will continue to be recognized ratably or, if earlier, whenmonthly payments become due over the extended term of the amended agreement.

For the fiscal years 2006,2005, and 2004, net revenues from our license and maintenance agreement withEDS were 35%, 54%, and 83%, respectively. Although the percentage of our netrevenues coming from customers other than EDS has increased in recent quarters,we expect that our operating results will continue to be significantlydependent on our relationship with EDS for the foreseeable future.

*PreviousAcquisitions*

In February 2005, we completed our acquisition ofRendition Networks, a provider of network device automation software located inRedmond, Washington. In this acquisition, we acquired our ONAS product. Thetransaction was valued at approximately $34.3 million, which included 2.53million shares of our common stock valued at $16.4 million, cash of $15.0million, assumed options and unvested restricted stock with a fair value of$2.2 million and approximately $0.7 million of direct acquisition costs. SeeNote 4, “Acquisitions” in the notes to the consolidated financial statementsfor a further description of this transaction.

In February 2004, we completed our acquisition ofTangram Enterprise Solutions to extend our product offerings and technologycapabilities, expand our customer base and increase research and developmentopportunities. The purchase price of the acquisition was $11.5 million,consisting of $10.0 million of our common stock, or approximately 1.1 millionshares, and approximately $1.5 million of direct acquisition costs.

26

----

**Results ofOperations**

Thefollowing table sets forth consolidated statement of operations data for theyears ended January 31, 2006, 2005 and 2004. The results for any oneperiod are not necessarily indicative of results for any future period.

| ** **                                                                              | ** ** | **Year Ended January 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                              | ** ** | **(in thousands)**                   | ** ** |
| **Consolidated Statement of  Operations Data:**                                         | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue:                                                                            |       |                                      |       |   |   |   |   |
| License revenue                                                                         |       | $                                         | 43,138     |   | $ | 26,699 |   | $ | 13,682 |   |
| Services revenue                                                                        |       | 17,939                                    |       | 11,093 |   | 4,368 |   |
| Net revenue                                                                             |       | 61,077                                    |       | 37,792 |   | 18,050 |   |
| Cost and expenses:                                                                      |       |                                      |       |   |   |   |   |
| Cost of license revenue                                                                 |       | 1,185                                     |       | 4,439 |   | 121 |   |
| Cost of services revenue*                                                               |       | 13,036                                    |       | 8,183 |   | 4,465 |   |
| Amortization of developed technology                                                    |       | 1,640                                     |       | 675 |   | — |   |
| Research and development*                                                               |       | 22,043                                    |       | 14,323 |   | 8,712 |   |
| Sales and marketing*                                                                    |       | 24,795                                    |       | 15,015 |   | 9,293 |   |
| General and administrative*                                                             |       | 12,277                                    |       | 7,092 |   | 8,052 |   |
| In-process research and development charges                                             |       | 1,190                                     |       | 610 |   | — |   |
| Restructuring costs (recoveries), net                                                   |       | (18                                       | )          | (1,085 | ) | 1,028 |   |
| Amortization of other acquisition related  intangibles                                  |       | 1,302                                     |       | 597 |   | — |   |
| Amortization (reversal) of deferred stock  compensation                                 |       | 1,282                                     |       | (131 | ) | 606 |   |
| Total cost and expenses                                                                 |       | 78,732                                    |       | 49,718 |   | 32,277 |   |
| Loss from  operations                                                                   |       | (17,655                                   | )          | (11,926 | ) | (14,227 | ) |
| Gain (loss) on sale of assets and liabilities from  Managed Services Business |       | (69                                       | )          | 4,165 |   | 1,252 |   |
| Interest and other income                                                               |       | 3,292                                     |       | 905 |   | 3,661 |   |
| Interest and other expense                                                              |       | (126                                      | )          | (2 | ) | (530 | ) |
| Loss before  income taxes                                                               |       | (14,558                                   | )          | (6,858 | ) | (9,844 | ) |
| Provision  (benefit) for income taxes                                                   |       | 193                                       |       | 388 |   | (1,435 | ) |
| Net loss                                                                                |       | $                                         | (14,751    | ) | $ | (7,246 | ) | $ | (8,409 | ) |

----

| *  Excludes  amortization (reversal) of deferred stock compensation of the following(1): |   |   |   |
|----------------------------------------------------------------------------------------------------|--------|--------|--------|
| Cost of services revenue                                                                           |   | $      | 8      |   | $ | (177 | ) | $ | 227 |   |
| Research and  development                                                                          |   | 1,106  |   | 15 |   | 224 |   |
| Sales and marketing                                                                                |   | 107    |   | 4 |   | 167 |   |
| General and  administrative                                                                        |   | 61     |   | 27 |   | (12 | ) |
| Total amortization  (reversal) of deferred stock compensation                                      |   | $      | 1,282  |   | $ | (131 | ) | $ | 606 |   |

(1)          Giventhe non-cash nature of the expense, we believe presenting amortization(reversal) of deferred stock compensation in a separate line item moreaccurately reflects the results of our individual operating expense categories.

**Net Revenue**

*Licenserevenue.**  *Licenserevenue consists of fees for term or perpetual licenses. License revenueincreased to $43.1 million in fiscal 2006 from $26.7 million in fiscal 2005.The increase was primarily due to the following factors: greater marketacceptance of our products, an increase in our customer base, increased salesto existing customers, sales of our ONAS product following our acquisition ofRendition 

27

----

Networks in February 2005and the establishment of VSOE of fair value for maintenance, which allowed usto recognize revenue using the residual method. Please see the section titled “CriticalAccounting Policies” for a description of our revenue recognition policy.License revenue from customers other than EDS increased approximately 148%during fiscal 2006 as compared to fiscal 2005.

License revenue increased to $26.7 million in fiscal2005 from $13.7 million in fiscal 2004. The increase was due to an increase inour customer base as well as an increase in revenue from EDS that resulted fromincreased minimum monthly fees under the amended license and maintenanceagreement.

Due to our revenue recognition policy, a substantialportion of the revenue that we recognize in a particular fiscal period may notbe based on, and therefore not necessarily indicative of, sales activity duringthat period, but instead may relate to sales executed in prior periods. Pleasesee the section titled “Critical Accounting Policies” for a description ofour revenue recognition policy.

*Services revenue.**  *Services revenue consists of feesfor annual support and maintenance and professional services. Services revenueincreased to $17.9 million in fiscal 2006 from $11.1 million in fiscal 2005.The increase was primarily due to the growth of our installed customer base,the renewal of support and maintenance contracts and an increase inprofessional services. Services revenue increased to $11.1 million in fiscal2005 from $4.4 million in fiscal 2004. The increase was due to increasedmaintenance revenue as our customer base increased as well as an increase inmaintenance revenue from EDS as the minimum monthly fees under the amendedagreement with EDS increased.

**Costs and Expenses**

*Cost of license revenue.**  *Cost of license revenue generallyconsists of royalties related to third-party technologies included in oursoftware.

| ** **                            | ** ** | **Year Ended January 31,** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                            | ** ** | **($ in thousands)**            | ** ** |
| Cost of license  revenue              |       | $                                         | 1,185      |   | $ | 4,439 |   | $ | 121 |   |
| Percentage of total  license revenues |       | 3%                                        |       | 17% |   | 1% |   |
|                                       |            |                                           |            |  |  |  |  |  |  |  |

 

The decrease in fiscal 2006 in absolute dollars and asa percentage of license revenue in comparison to the prior year was primarilydue to a $4.0 million one-time payment made to EDS in fiscal 2005, pursuant tothe terms of our amended license agreement effective August 2004, to fundEDS’ purchase of equipment required to support the deployment of our softwareproducts in its facilities.

The increase in fiscal 2005 in absolute dollars and asa percentage of license revenue in comparison to the prior year was primarilydue to the $4.0 million payment to EDS in fiscal 2005, as well as additionalroyalties due to increased sales.

*Cost of services revenue.**  *Cost of services revenue consistsprimarily of salaries and related personnel expenses of employees who provideimplementation, maintenance support, training and consulting services to ourcustomers, fees for outside consulting services, facility costs, travelexpenses and depreciation and amortization of capitalized equipment.

| ** **                            | ** ** | **Year Ended January 31,** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                            | ** ** | **($ in thousands)**            | ** ** |
| Cost of service  revenue              |       | $                                         | 13,036     |   | $ | 8,183 |   | $ | 4,465 |   |
| Percentage of total  service revenues |       | 73%                                       |       | 74% |   | 102% |   |
|                                       |            |                                           |            |  |  |  |  |  |  |  |

 

The increase from fiscal 2005 to fiscal 2006 inabsolute dollars was primarily due to increased salaries and related personnelexpenses due to an increase in services-related headcount from 42 on January 31,

28

----

2005 to 72 on January 31,2006, which resulted from additional hiring, and increased outsourcedcontractor fees, each to fulfill service obligations as a result of theincrease in our customer base.

The increase from fiscal 2004 to fiscal 2005 inabsolute dollars was primarily due to increased salaries and related personnelexpenses due to an increase in headcount from 19 on January 31, 2004 to 42on January 31, 2005, including the effect of the Tangram acquisition aswell as additional hiring necessary to meet the current needs of our business,and increased outsourced contractor fees to fulfill service obligations as aresult of the increase in our customer base. The decrease as a percentage ofservices revenue was primarily due to a greater increase in revenue relative toexpenses during fiscal 2004.

*Amortizationof developed technology.*   As a result of theacquisition of Rendition, we began amortizing purchased developed technologybeginning in the first quarter of fiscal 2006. The value assigned to developedtechnology was approximately $3.7 million, which is being amortized on a straight-linebasis over a four-year estimated life at a rate of approximately $233,000 perquarter. As a result of the acquisition of Tangram, we began amortizingpurchased developed technology beginning in the first quarter of fiscal 2005.The value assigned to this developed technology was approximately $2.9 million,which is being amortized on a straight-line basis over a four-year estimatedlife at a rate of approximately $179,000 per quarter.

*Research and development.**  *Research and development expensesconsist primarily of salaries and related personnel expenses, fees forconsulting services, facility costs and depreciation and amortization ofpurchased equipment and software.

| ** **                        | ** ** | **Year Ended January 31,** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                        | ** ** | **($ in thousands)**            | ** ** |
| Research and  development         |       | $                                         | 22,043     |   | $ | 14,323 |   | $8,712 |   |
| Percentage of total net  revenues |       | 36%                                       |       | 38% |   | 48% |   |
|                                   |            |                                           |            |  |  |  |  |  |  |

 

The increase from fiscal 2005 to fiscal 2006 inabsolute dollars was primarily due to increased salaries and related personnelexpenses resulting from an increase in headcount from 90 on January 31,2005 to 130 on January 31, 2006, which includes 19 employees assumed inconnection with our Rendition acquisition as well as additional hiringnecessary to meet the current needs of our business, while the decrease as apercentage of net revenue was primarily due to a greater increase in revenuerelative to the increase in expenses incurred during fiscal 2006.

The increase from fiscal 2004 to fiscal 2005 inabsolute dollars was primarily due to increased salaries and related personnelexpenses due to an increase in headcount from 46 on January 31, 2004 to 90on January 31, 2005, which includes the effect of the Tangram acquisitionas well as additional hiring necessary to meet the needs of our business, whilethe decrease as a percentage of net revenue was primarily due to a greaterincrease in revenue relative to the increase in expenses incurred during fiscal2005.

*Sales and marketing.**  *Sales and marketing expensesconsist primarily of salaries, commissions and related personnel expenses,travel expenses, advertising expenses, trade shows and other promotionalexpenses and facility costs.

| ** **                        | ** ** | **Year Ended January 31,** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                        | ** ** | **($ in thousands)**            | ** ** |
| Sales and  marketing              |       | $                                         | 24,795     |   | $ | 15,015 |   | $ | 9,293 |   |
| Percentage of total net  revenues |       | 41%                                       |       | 40% |   | 51% |   |
|                                   |            |                                           |            |  |  |  |  |  |  |  |

 

29

----

The increase from fiscal 2005 to fiscal 2006 inabsolute dollars was primarily due to increased salaries, commissions, andrelated personnel expenses, and to a lesser extent, increases in advertisingand promotional activities. Our sales and marketing department headcountincreased from 54 on January 31, 2005 to 92 on January 31, 2006, tomeet the current needs of our business.

The increase from fiscal 2004 to fiscal 2005 inabsolute dollars was primarily due to the same factors attributable to thegrowth in fiscal 2006. Our sales and marketing department headcount increasedfrom 27 on January 31, 2004 to 54 on January 31, 2005. The decreaseas a percentage of net revenue was primarily due to a greater increase inrevenue relative to the increase in expenses reported in fiscal 2005.

*General and administrative.**  *General and administrative expensesconsist primarily of salaries and related personnel expenses, fees for outsideprofessional services, non-cash compensation charges (recovery) for thecancellation and modification of executive stock option awards and facilitycosts.

| ** **                        | ** ** | **Year Ended January 31,** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                        | ** ** | **($ in thousands)**            | ** ** |
| General and  administrative       |       | $                                         | 12,277     |   | $ | 7,092 |   | $ | 8,052 |   |
| Percentage of total net  revenues |       | 20%                                       |       | 19% |   | 45% |   |
|                                   |            |                                           |            |  |  |  |  |  |  |  |

 

The increase from fiscal 2005 to fiscal 2006 inabsolute dollars was primarily due to increased salaries and related personnelexpenses and increased costs incurred related to Sarbanes-Oxley compliance. Generaland administrative headcount increased from 27 on January 31, 2005 to 42on January 31, 2006, to meet the current needs of our business. Theincrease as a percentage of total net revenues from fiscal 2005 to fiscal 2006was due in part to a non-cash compensation charge (recovery) related to equityawards, which resulted in a benefit of 2% of net revenues in fiscal 2005 and anexpense equal to 1% of net revenues in fiscal 2006. Other general andadministrative expenses decreased from 21% of net revenues in fiscal 2005 to19% of net revenues in fiscal 2006.

The decrease from fiscal 2004 to fiscal 2005 inabsolute dollars and as a percentage of net revenue was primarily due to anon-cash compensation charge (recovery) related to the revaluation of variablestock option awards and modification of stock option awards. This was offset byincreased salaries and related personnel expenses due to an increase inheadcount from 19 on January 31, 2004 to 27 on January 31, 2005,which increase resulted from additional hiring necessary to meet the currentneeds of our business, and increased costs incurred related to Sarbanes-Oxleycompliance.

*In-processresearch and development charges.*   We expensed$1.2 million in fiscal 2006 and $610,000 in fiscal 2005 of in-process researchand development (IPR&D) acquired in the purchase of Rendition Networks andTangram Enterprise Solutions, respectively. Products that qualify for IPR&Drepresent those that have not reached technical feasibility and for which noalternative future uses exist at the time of an acquisition. Accordingly, theseIPR&D amounts were expensed on the respective acquisition date of each ofthe acquired companies.

*Restructuringcosts (recoveries), net.**  *In fiscal 2003 we announced a restructuring programin connection with the sale of our Managed Services Business to EDS. Duringfiscal 2004, we recorded adjustments of $987,000 to the original restructuringcharge for a decrease in estimated sublease income, a recovery of property andequipment, and changes in the fair value of remaining lease paymentobligations. During fiscal 2005, we amended our agreement with our subtenantwith respect to our facility located in Sunnyvale, California. Pursuant to theamendment, the term of the sublease was increased, resulting in additionalprobable future sublease payments. As a result, we revised our estimates of thefair value (computed as the revised present value of the future net leasepayments on vacated leased facilities) of our restructuring liability,resulting in a reduction to the recorded restructuring liability and arestructuring recovery of approximately $436,000. In addition, we recorded arecovery for sublease payments received of 

30

----

approximately $313,000,and a recovery due to the settlement of a sublease agreement of approximately$190,000. The sublease payments were not included in the calculation of therestructuring charge due to the uncertainty of the financial condition of thesubtenant. In January 2005, we recorded a recovery of approximately$146,000 for property taxes, due to a change in estimate of future property taxpayments as property values have decreased. For a further discussion of ourrestructuring activities, please see Note 7, “Restructuring Costs,” in theaccompanying Notes to the Consolidated Financial Statements.

*Amortizationof other acquisition related intangibles.*   As aresult of the acquisition of Rendition, we began amortizing customerrelationships through operating expenses beginning in the first quarter offiscal 2006. The value assigned to Rendition customer relationships was $2.7million, which is being amortized on a straight-line basis over an estimatedfour-year life at a rate of approximately $169,000 per quarter. As a result ofthe acquisition of Tangram, we began amortizing customer relationships throughoperating expenses beginning in the first quarter of fiscal 2005. The valueassigned to Tangram customer relationships was $2.5 million, which is beingamortized on a straight-line basis over an estimated four-year life at a rateof approximately $158,000 per quarter.

*Amortization(reversal) of deferred* s*tock compensation, net.  *Stock-based compensationexpense (recovery) was $1.3 million in fiscal 2006 compared to $(131,000) infiscal 2005 and $606,000 in fiscal 2004. The expense in fiscal 2006 wasprimarily due to the amortization of deferred stock compensation related to theacquisition of Rendition. The expense in fiscal 2005 and 2004 was primarily aresult of equity awards to employees and amortized deferred stock compensationdue to our acquisition of Tangram. The expense in fiscal 2005 included a reversalof $234,000 of stock-based compensation expense upon the termination ofemployees because they had not vested in the underlying option shares givingrise to the expense. As a result, the difference between the expense recordedunder the graded vesting method and the expense that would have been recordedunder the straight-line vesting method was required to be reversed upontermination of these employees.

In accordance with the Statement of FinancialAccounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS123”), when we have granted stock options to employees and directors, we didnot record compensation expense in past fiscal years. Rather, we elected tocontinue to recognize stock-based compensation expense under Accounting PrinciplesBoard Opinion No. 25 (“APB 25”) and provide pro forma disclosures of theimpact on our operating results as if we had accounted for stock-basedcompensation under SFAS 123. See Note 1, “Summary of the Company andSignificant Accounting Policies,” in the notes to the consolidated financialstatements for a description of our policy with respect to our accountingtreatment for stock-based compensation in past fiscal years pursuant to SFAS123 and APB 25. However, effective for our fiscal quarter beginning February 1,2006, we will recognize compensation expense for equity awards to employees inaccordance with SFAS No. 123R, “Share-Based Payment.” For a furtherdiscussion of SFAS 123R, please see “Recent Accounting Pronouncements,” in Item7 of this Annual Report on Form 10-K.

*Gainon sale of assets and liabilities from Managed Services.*   InMay 2004, we entered into a settlement with Qwest following arbitration ofQwest’s claim that we breached agreements that we entered into with them infiscal 2002. Prior to this settlement, we accrued a liability related to ourManaged Services Business in the amount of $6.8 million in connection withQwest’s claim. As a result of the settlement, we reversed approximately $4.3million of previously accrued data center facility costs and recognized thegain as a component of the sale of assets and liabilities from the ManagedServices Business in the consolidated statements of operations in fiscal 2005.

*Interestand other income (expense), net.**  *Interest and other income(expense), net increased to income of $3.2 million in fiscal 2006 from incomeof approximately $900,000 in fiscal 2005, primarily due to an increase ininterest income during fiscal 2006 as a result of the $61.8 million net proceedsfrom the sale of our common stock in December 2004. Interest and otherincome (expense), net decreased to income of 

31

----

approximately $900,000 infiscal 2005 from income of $3.1 million in fiscal 2004. The interest and otherincome in fiscal 2004 was primarily due to proceeds received in the prior yearfrom a settlement with a former Managed Services Business customer ofapproximately $2.4 million and the recovery of $850,000 in connection with theresolution of certain liabilities related to the Managed Services Business,offset by our obligation to EDS for certain items of equipment retained by uspursuant to our asset purchase agreement with EDS.

*Provision for income taxes.**  *During fiscal 2006, we recorded astate tax provision of $64,000 and paid foreign withholding taxes of $129,000.During fiscal 2005, we recorded an income tax provision of $356,000 for foreignwithholding taxes paid in connection with the sale of a software license to oneof our customers, and a state tax provision of $32,000. In fiscal 2004 thetaxing authorities concluded a foreign jurisdictional tax examination coveringthe Managed Services Business sale that resulted in the reversal of an incometax provision of $1.5 million.

**Liquidity andCapital Resources**

Since inception, we have financedour operations primarily through customer revenue, the sale of our securities,the sale of our Managed Services Business, and, to a lesser extent, operatingequipment lease financing and capital equipment lease financing. As of January 31,2006, we had approximately $104.2 million in cash, cash equivalents andrestricted cash. On December 15, 2004, we received approximately $61.8million in net proceeds from the sale of 10 million shares of our common stock.

*Operating Activities*

Net cash used in operating activities for fiscal 2006of $2.7 million was primarily the result of our net operating loss of $14.8million, an increase in accounts receivable of $12.8 million, an increase inprepaid expenses, other current assets and other assets of $3.1 million, offsetby a net increase in advances from customers and deferred revenue of $12.4million, and an increase in accrued compensation of $4.6 million.

Net cash used in operating activities for fiscal 2005of $1.0 million was primarily the result of our net operating loss of $7.2million (including the $4.0 million one-time payment related to our amendedlicense and maintenance agreement with EDS and a $2.0 million payment to settlethe Qwest litigation), $933,000 decrease in our accrued restructuring liabilityin connection with an amendment to our leased facilities, and $521,000 increasein accounts receivable, offset by a $10.8 million net increase in deferredrevenue and advances from customers and $3.8 million of depreciation andamortization expense.

Net cash used in operatingactivities for fiscal 2004 of $13.8 million was primarily the result of our netoperating losses of $8.4 million, a decrease in accrued liabilities of $4.2million as we paid the remaining liabilities associated with our Managed ServicesBusiness and the payments in connection with the amendments to our leasedfacilities of $11.7 million, offset by depreciation and amortization of $2.8million, non-cash equity charges of $2.7 million and an increase in deferredrevenue and advances from customers of $7.6 million.

*Investing Activities*

Net cash used in investing activities for fiscal 2006of $16.8 million consisted of the cash paid to acquire Rendition Networks andrelated acquisition costs and $2.3 million of capital equipment purchases.

Net cash used in investing activities for fiscal 2005of $2.8 million consisted of purchases primarily of capital equipment and netdirect acquisition costs paid related to the acquisition of Tangram net of thecash acquired through the acquisition.

32

----

Net cash used in investingactivities for fiscal 2004 of $375,000 consisted of capital equipment purchasesand acquisition costs related to the acquisition of both Tangram and RenditionNetworks, offset by a reduction in restricted cash due to releases of ourletters of credits on certain facilities.

*Financing Activities*

Net cash provided by financing activities for fiscal2006 of $2.8 million was primarily attributable to proceeds received from theexercises of stock options.

Net cash provided by financing activities for fiscal2005 of $67.3 million was primarily attributable to net proceeds received fromthe issuance of 10 million shares of common stock as well as proceeds receivedfrom the exercise of stock options.

Net cash provided byfinancing activities for fiscal 2004 of $6.2 million was primarily attributableto proceeds received from the issuance of common stock in connection with theexercise of employee stock options.

*Commitments*

As of January 31,2006, our principal commitments consisted of obligations outstanding underoperating leases for facilities and capital leases. The following summarizesour contractual obligations at January 31, 2006 and the effect suchobligations are expected to have on our liquidity and cash flow in futureperiods (in thousands):

| ** **                          | ** ** | ** ** | ** ** | **Less**  | ** ** | ** **      | ** ** | ** ** | ** ** | **Greater** | ** ** |
|-------------------------------------|------------|------------|------------|-----------|------------|-----------------|------------|------------|------------|-------------|------------|
| ** **                          | ** ** | ** ** | ** ** | **than**  | ** ** | **1-3**         | ** ** | **4-5**    | ** ** | **than**    | ** ** |
| **Contractual Obligations**    | ** ** | ** ** | ** ** | **Total** | ** ** | **1 Year** | ** ** | **Years**  | ** ** | **Years**   | ** ** | **5 Years** | ** ** |
| Capital leases                      |       | $          | 143        |      | $          | 36              |       | $          | 72         |        | $          | 35 |   |   | $ | — |   |   |
| Operating leases,  net of subleases |       | 10,990     |       | 2,775     |       | 4,779           |       | 3,394      |       |        | 42         |   |   |
| Total contractual cash  obligations |       | $          | 11,133     |      | $          | 2,811           |       | $          | 4,851      |        | $          | 3,429 |   |   | $ | 42 |   |   |
|                                     |            |            |            |           |            |                 |            |            |            |             |            |  |  |  |  |  |  |  |  |  |

 

We do not have any other off balance sheetarrangements or contractual obligations.

We believe that ourcurrent cash balances, including cash and cash equivalents and cash flows fromoperations, will be sufficient to meet our working capital and capitalexpenditure requirements for at least the next 12 months. Nevertheless, we mayseek additional capital through the issuance of public and/or private equity ifthe market permits, equipment lease facilities, bank financings or arrangementswith strategic partners to expand our business. Capital requirements willdepend on many factors, including the rate of sales growth, market acceptanceof our products, costs of providing our products and services, the timing andextent of research and development projects and increases in our operatingexpenses or shortfalls in revenue. To the extent that existing cash and cashequivalents balances and any cashflows from operations are insufficient to fundour future activities, we may need to raise additional funds through public orprivate equity or debt financing. We cannot be sure that additional financingwill be available if necessary or available on reasonable terms. We may fromtime to time evaluate potential acquisitions of other businesses, services,products and technologies, which could increase our capital requirements.

**Critical AccountingPolicies and Estimates**

The methods, estimates and judgments we use inapplying our most critical accounting policies have a significant impact on theresults we report in our consolidated financial statements. Actual resultscould differ from these estimates. In addition, our estimates may change basedupon changed circumstances and as we reassess our underlying assumptions fromtime to time. The Securities and Exchange Commission has described the mostcritical accounting policies as the ones that are most important to theportrayal of 

33

----

our financial conditionand results, and require us to make our most difficult and subjectivejudgments, often as a result of the need to make estimates of matters that areinherently uncertain.

We believe the following are our critical accountingpolicies, which affect our more significant judgments and estimates used in thepreparation of our consolidated financial statements.

*RevenueRecognition.*   We recognize software revenue inaccordance with the American Institute of Certified Public Accountants’ (“AICPA”)Statement of Position No. 97-2 (“SOP 97-2”), “Software RevenueRecognition,” Statement of Position No. 98-9, “Modification of SOP 97-2with Respect to Certain Transactions” (“SOP 98-9”), EITF 00-21,Revenue Arrangements with Multiple Deliverables and Statement of Position No. 81-1,Accounting for Performance of Construction Type and Certain Production TypeContracts” (“SOP 81-1”). For each transaction, we determine whetherevidence of an arrangement exists, delivery has occurred, the fee is fixed ordeterminable, and collectibility of the fee is probable. If any of thesecriteria are not met, revenue recognition is deferred until such time as allcriteria are met. We consider all arrangements with payment terms extendingbeyond twelve months not to be fixed or determinable in which case revenue isrecognized no earlier than when payments become contractually due. Ifcollectibility is not considered probable, revenue is recognized when the feeis collected. No customer has a right of return privilege.

Most of our arrangements involve multiple elements(for example, license fees, maintenance and support, and professionalservices), and we allocate revenue to each component of the arrangement usingthe residual method based on our vendor specific objective evidence (VSOE) offair value of the undelivered elements, which is specific to us. This meansthat we defer revenue from the arrangement fee equivalent to the fair value ofthe undelivered elements. The residual arrangement fee is then allocated to thedelivered element or elements. VSOE of fair value for the ongoing maintenanceand support obligations (post contract support or PCS) within an arrangement isbased upon substantive renewal rates stated in the contracts, and in theabsence of stated renewal rates, upon separate sales of renewals to othercustomers. VSOE of fair value for professional services, such as consulting, isbased upon hourly or daily rates charged under separate sales of these servicesto other customers in standalone transactions.

License revenue consists of license fees charged forthe use of our products under perpetual or term license arrangements. Werecognize license revenue for perpetual licenses using the residual methodafter all elements other than PCS and professional services have beendelivered, provided that all of the criteria for revenue recognition, asdiscussed above, are met. Generally, these criteria are met at the time ofdelivery of the software to the customer. We recognize revenue under termlicenses on a straight line basis over the term of the arrangement oncecriteria for revenue recognition, as discussed above, have been met. If anarrangement includes an acceptance provision, revenue is deferred until theearlier of receipt of a written customer acceptance or expiration of theacceptance period.

Services revenue consists of revenue from maintenanceand support (PCS) and professional services agreements. PCS agreements includeongoing customer support and rights to product updates if and when available.Revenue under these arrangements is recognized ratably using the straight-linemethod over the period that the PCS is provided (generally one year). Professionalservice revenue consists of fees charged for product training and consultingservices. Consulting services are generally accounted for separately from thesoftware license because the services qualify for separate accounting asdefined in paragraph No. 65 of SOP 97-2. The more significantfactors considered in determining whether the services should be accounted forseparately include the nature of services (i.e., consideration of whether theservices are essential to the functionality of the licensed product), degree ofrisk, availability of services from other vendors, timing of payments andimpact of service milestones or acceptance criteria on the realizability of thesoftware license fee. Revenues for consulting services that qualify for separateaccounting are generally recognized as the services are performed. If servicesdo not qualify for separate accounting, the software license revenue isgenerally recognized together with the consulting services using contractaccounting 

34

----

(percentage of completionor the completed-contract method). Contract accounting is applied to anyarrangements: (1) that include milestones or customer specific acceptancecriteria that may affect collection of the software license fees; (2) whereservices include significant modification or customization of the software; or (3) wherethe software license payment is tied to the performance of consulting services.

We recognize revenue associated with software licensesand services sold to distributors, system integrators and value added resellers(collectively, “resellers”) upon satisfaction of all revenue recognitioncriteria unless we are aware that a reseller does not have a purchase order orother contractual agreement to purchase the software from an end user. Inconnection with sales to resellers, there is no right of return.

For all periods included in our consolidatedfinancials statements, in the case of OAMS and ONAS software, we recognizeperpetual license revenue using the residual method after all elements other thanmaintenance have been delivered, provided that all of the criteria for revenuerecognition discussed above are met. Generally, these criteria are met at thetime of delivery. For OSAS arrangements entered into prior to May 1, 2005,the date when we determined we had established VSOE of the fair value ofmaintenance and professional services for OSAS, we recognize both license andservices revenue from a transaction ratably over the remaining post-contractmaintenance and support period once deployment of our software had beencompleted and all other elements of the arrangement had been delivered. ForOSAS arrangements entered into on or after May 1, 2005, we recognizerevenue from perpetual licenses using the residual method. For term licenses,usually one year in duration, accompanied by PCS, the entire arrangement fee isrecognized ratably over the longer of the term of the license or PCS.

*Impairmentof Long-Lived Assets and Intangible Assets.*   Weperiodically review the carrying value of long-lived assets, including propertyand equipment and other identified intangible assets, to determine whetherthere are any indications of impairment. Some indicators of impairment includebut are not limited to, a decrease in the market price of a long-lived asset,an adverse change in the extent or manner in which a long-lived asset is beingused, a change in the business climate that could affect the value of along-lived asset, or a current-period operating or cash flow loss combined witha history of operating or cash flow losses. According to our accounting policy,when such indicators are present, if the undiscounted cash flows expected to begenerated from operations from those long-lived assets are less than thecarrying value of those long-lived assets, we compare the fair value of theassets (estimated using discounted future net cash flows to be generated fromthe lowest common level of operations utilizing the assets) to the carryingvalue of the long-lived assets to determine any impairment charges. We reducethe carrying value of the long-lived assets if the carrying value of thelong-lived assets is greater than their fair value. The new carrying value isthen depreciated over the remaining estimated useful lives of the assets. Thedetermination as to whether impairment exists involves significant judgment andthe assumptions supporting the estimated future cash flows reflects management’sbest estimates.

*Impairmentof Goodwill.*   We account for goodwill inaccordance with Statement of Financial Accounting Standards No. 142, “Goodwilland Intangible Assets” (“SFAS 142”). In accordance with SFAS 142, goodwill willnot be amortized, but instead will be tested for impairment at least annuallyand more frequently if certain indicators are present. Circumstances that couldtrigger an impairment test include, but are not limited to, a significantadverse change in the business climate or legal factors, unanticipatedcompetition and loss of key personnel. The assessment of impairment is made bycomparing the fair value of the reporting unit to which the goodwill has beenassigned by management to its carrying value. To the extent that an impairmentis indicated (fair value is less than carrying value), we must perform a secondtest to measure the amount of the impairment. The determination as to whether awrite down of goodwill is necessary involves significant judgment based on theshort-term and long-term projections of future performance. The assumptionssupporting the estimated future cash flows, including the discount rate usedand estimated terminal value, reflects management’s best estimates. In theevent we determine that goodwill has been impaired, we will incur an accountingcharge related to the impairment during the fiscal 

35

----

quarter in which suchimpairment determination is made. We review for indicators of potentialimpairment of goodwill annually.

Goodwill as of January 31, 2006 was $27.7million, which includes $24.1 million from our acquisition of RenditionNetworks, which occurred on February 3, 2005. As a result, if we arerequired to record a goodwill impairment charge in the future, any such chargemay have a material impact on our results of operations for that reportingperiod.

*Restructuring Costs.**  *During fiscal 2003 and 2002, werestructured our business under plans approved by the Board of Directors byreducing our headcount, consolidating our facilities and disposing of excessand obsolete property and equipment. As a result of these actions, we recordedrestructuring and other related charges consisting of cash severance paymentsfor severed employees and lease payments related to property abandoned as aresult of our facilities consolidation, net of estimated sublease income. As ofJanuary 31, 2006, all other restructuring liabilities have been paid outand only the lease obligations remain in the accrued restructuring balance. Ourestimates include the review of the financial condition of our existingsublessees as well as the state of the regional real estate markets. Eachreporting period, we review these estimates based on the status of execution ofour restructuring plan and, to the extent that these assumptions change due tochanges in market conditions and our business, the ultimate restructuringexpenses could vary by material amounts, and result in additional expenses orthe recovery of amounts previously recorded.

**Recent AccountingPronouncements**

In December 2004, theFASB issued Statement of Financial Accounting Standards No. 123R, “Share-BasedPayment” (“SFAS 123R”) which establishes standards for the accounting fortransactions in which an entity exchanges its equity instruments for goods orservices. A key provision of this statement is the requirement of a publicentity to measure the cost of employee services received in exchange for anaward of equity instruments (including stock options) based on the grant datefair value of the award and recognized over the vesting period. SFAS 123R willbe effective for our fiscal quarter beginning February 1, 2006, and wewill recognize stock-based compensation expense using the Modified Prospectiveapplication method. Under the Modified Prospective method, SFAS 123R is appliedto new awards and to awards granted prior to February 1, 2006 which aremodified, repurchased, or cancelled after the effective date. Compensation costfor the portion of awards for which service has not been rendered (such asunvested options) that are outstanding as of the date of adoption shall berecognized as the remaining services are rendered. We have not yet determinedwhether the adoption of SFAS 123R will result in amounts that are similar tothe current pro forma disclosures permitted under SFAS 123, as the full impactis dependent upon future uncertainties, including our future stock-basedcompensation strategy, stock price volatility, estimated stock optionforfeitures and employee stock option exercise behavior. We are evaluating therequirements under SFAS 123R and expect the adoption to have a significantimpact on our reported financial results.

36

----

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 

*InterestRate Risk.**  *Wehave limited exposure to financial market risks, including changes in interestrates. An increase or decrease in interest rates would not significantlyincrease or decrease interest expense on our debt obligations due to the fixednature of our debt obligations. Our interest income is sensitive to changes inthe general level of U.S. interest rates, particularly since we primarilyinvest in money market instruments. However, due to the short-term nature ofour investments, we believe that we are not subject to any material market riskexposure. A hypothetical 100 basis point increase in interest rates. wouldresult in less than a $100,000 decrease (less than 1%) in the fair value of ouravailable-for-sale securities.

*ForeignCurrency Risk.**  *Aswe expand into foreign markets, our financial results could be affected byfactors such as changes in foreign currency exchange rates or weak economicconditions in the foreign markets we plan to target. To date, our exposure toforeign currency risk has not been material. Most of our sales are currentlymade in U.S. dollars. Strengthening of the dollar could make our services lesscompetitive in the foreign markets we may target in the future.

37

----

**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

|                                                           | ** ** | **Page** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|
| Reports of Independent Registered Public Accounting  Firm |       |     | 39         |   |   |
| Consolidated  Balance Sheets                              |       |     | 41         |   |   |
| Consolidated Statements of Operations                     |       |     | 42         |   |   |
| Consolidated  Statements of Stockholders’ Equity     |       |     | 43         |   |   |
| Consolidated Statements of Cash Flows                     |       |     | 45         |   |   |
| Notes to Consolidated Financial Statements                |       |     | 46         |   |   |

 

38

----

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and Stockholders of OpswareInc.

We have audited the accompanying consolidated balancesheets of Opsware Inc. as of January 31, 2006 and 2005, and the relatedconsolidated statements of operations, stockholders’ equity, and cash flows foreach of the three years in the period ended January 31, 2006. Our auditsalso included the financial statement schedule listed in the Index at Item15(a). These financial statements and schedule are the responsibility of theCompany’s management. Our responsibility is to express an opinion on thesefinancial statements and schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Opsware Inc. at January 31, 2006 and 2005, and theconsolidated results of its operations, and its cash flows for each of thethree years in the period ended January 31, 2006, in conformity with U.S.generally accepted accounting principles. Also, in our opinion, the relatedfinancial statement schedule, when considered in relation to the basicfinancial statements taken as a whole, presents fairly in all material respectsthe information set forth therein.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Opsware Inc.’s internal control overfinancial reporting as of January 31, 2006, based on criteria establishedin Internal Control-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report dated April 12,2006 expressed an unqualified opinion thereon.

/s/ ERNST & YOUNG LLP

San Jose, CaliforniaApril 12, 2006

39

----

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVERFINANCIAL REPORTING**

The Board of Directors and Stockholders of OpswareInc.

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over FinancialReporting, that Opsware Inc. maintained effective internal control overfinancial reporting as of January 31, 2006, based on criteria establishedin Internal Control-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria). Opsware Inc.’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management’s assessment and an opinion on the effectiveness of the company’sinternal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that OpswareInc. maintained effective internal control over financial reporting as of January 31,2006, is fairly stated, in all material respects, based on the COSO criteria.Also, in our opinion, Opsware Inc. maintained, in all material respects,effective internal control over financial reporting as of January 31,2006, based on the COSO criteria**.**

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the 2006 consolidated financial statements and schedule ofOpsware Inc. and our report dated April 12, 2006 expressed an unqualifiedopinion thereon.

/s/ ERNST & YOUNG LLP

San Jose, CaliforniaApril 12, 2006

40

----

**OPSWARE INC.CONSOLIDATED BALANCE SHEETS(in thousands, except par value amounts)**

| ** **                                                                                                                                                                                     | ** ** | **As of January 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                                                     | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                                |       |                                 |       |   |   |
| Cash and cash equivalents                                                                                                                                                                      |       | $                                    | 101,898    |   | $ | 118,615 |   |
| Accounts receivable, net of allowance for doubtful accounts  of $219 and $125 at January 31, 2006 and 2005, respectively                                                        |       | 17,867                               |       | 3,895 |   |
| Prepaids and other current assets                                                                                                                                                              |       | 6,546                                |       | 3,506 |   |
| Total current assets                                                                                                                                                                           |       | 126,311                              |       | 126,016 |   |
| Property and  equipment, net                                                                                                                                                                   |       | 3,944                                |       | 4,113 |   |
| Restricted cash                                                                                                                                                                                |       | 2,296                                |       | 2,740 |   |
| Prepaid rent                                                                                                                                                                                   |       | 1,540                                |       | 2,185 |   |
| Other assets                                                                                                                                                                                   |       | 380                                  |       | 818 |   |
| Intangible assets,  net                                                                                                                                                                        |       | 7,613                                |       | 4,125 |   |
| Goodwill                                                                                                                                                                                       |       | 27,668                               |       | 3,594 |   |
| Total assets                                                                                                                                                                                   |       | $                                    | 169,752    |   | $ | 143,591 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                  | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                                           |       |                                 |       |   |   |
| Accounts payable                                                                                                                                                                               |       | $                                    | 1,217      |   | $ | 882 |   |
| Accrued compensation                                                                                                                                                                           |       | 6,895                                |       | 2,053 |   |
| Accrued data center facilities costs                                                                                                                                                           |       | 328                                  |       | 328 |   |
| Other accrued liabilities                                                                                                                                                                      |       | 4,166                                |       | 2,621 |   |
| Advances from customers                                                                                                                                                                        |       | 721                                  |       | 8,855 |   |
| Deferred revenue, current portion                                                                                                                                                              |       | 29,473                               |       | 9,840 |   |
| Accrued restructuring costs, current portion                                                                                                                                                   |       | 298                                  |       | 233 |   |
| Capital lease obligations, current portion                                                                                                                                                     |       | 14                                   |       | — |   |
| Total current liabilities                                                                                                                                                                      |       | 43,112                               |       | 24,812 |   |
| Capital Lease, net  of current portion                                                                                                                                                         |       | 74                                   |       | — |   |
| Deferred revenue,  net of current portion                                                                                                                                                      |       | 1,838                                |       | 651 |   |
| Accrued restructuring  costs, net of current portion                                                                                                                                           |       | 1,190                                |       | 1,466 |   |
| Commitments and  contingencies (See Note 6)                                                                                                                                                    |       |                                 |       |   |   |
| **Stockholders’  equity:**                                                                                                                                                                | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Preferred stock, $0.001 par value, 15,000 shares  authorized at January 31, 2006 and 2005, no shares issued or outstandin                                                                 |       | —                               |       | — |   |
| Common stock, $0.001 par value, 200,000 shares  authorized at January 31, 2006 and 2005; 99,596 and 95,254 shares issued  and outstanding at January 31, 2006 and 2005, respectively |       | 100                                  |       | 95 |   |
| Additional paid-in  capital                                                                                                                                                                    |       | 609,455                              |       | 585,204 |   |
| Notes receivable  from stockholders                                                                                                                                                            |       | —                               |       | (1 | ) |
| Deferred stock  compensation                                                                                                                                                                   |       | (2,606                               | )          | (106 | ) |
| Accumulated  deficit                                                                                                                                                                           |       | (483,270                             | )          | (468,519 | ) |
| Accumulated other  comprehensive loss                                                                                                                                                          |       | (141                                 | )          | (11 | ) |
| Total stockholders’ equity                                                                                                                                                                |       | 123,538                              |       | 116,662 |   |
| Total liabilities  and stockholders’ equity                                                                                                                                               |       | $                                    | 169,752    |   | $ | 143,591 |   |

 

See accompanying notes.

41

----

**OPSWARE INC.CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share amounts)**

| ** **                                                                              | ** ** | **Year Ended January 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net revenue:                                                                            |       |                                      |       |   |   |   |   |
| License revenue                                                                         |       | $                                         | 43,138     |   | $ | 26,699 |   | $ | 13,682 |   |
| Services revenue                                                                        |       | 17,939                                    |       | 11,093 |   | 4,368 |   |
| Net revenue                                                                             |       | 61,077                                    |       | 37,792 |   | 18,050 |   |
| Cost and  expenses:                                                                     |       |                                      |       |   |   |   |   |
| Cost of license revenue                                                                 |       | 1,185                                     |       | 4,439 |   | 121 |   |
| Cost of services revenue*                                                               |       | 13,036                                    |       | 8,183 |   | 4,465 |   |
| Amortization of developed technology                                                    |       | 1,640                                     |       | 675 |   | — |   |
| Research and development*                                                               |       | 22,043                                    |       | 14,323 |   | 8,712 |   |
| Sales and marketing*                                                                    |       | 24,795                                    |       | 15,015 |   | 9,293 |   |
| General and administrative*                                                             |       | 12,277                                    |       | 7,092 |   | 8,052 |   |
| In-process research and development charges                                             |       | 1,190                                     |       | 610 |   | — |   |
| Restructuring costs (recoveries), net                                                   |       | (18                                       | )          | (1,085 | ) | 1,028 |   |
| Amortization of other acquisition related  intangibles                                  |       | 1,302                                     |       | 597 |   | — |   |
| Amortization (reversal) of deferred stock  compensation, net                            |       | 1,282                                     |       | (131 | ) | 606 |   |
| Total cost and expenses                                                                 |       | 78,732                                    |       | 49,718 |   | 32,277 |   |
| Loss from operations                                                                    |       | (17,655                                   | )          | (11,926 | ) | (14,227 | ) |
| Gain (loss) on sale of assets and liabilities from  Managed Services Business |       | (69                                       | )          | 4,165 |   | 1,252 |   |
| Interest and other income                                                               |       | 3,292                                     |       | 905 |   | 3,661 |   |
| Interest and other expense                                                              |       | (126                                      | )          | (2 | ) | (530 | ) |
| Loss before  income taxes                                                               |       | (14,558                                   | )          | (6,858 | ) | (9,844 | ) |
| Provision  (benefit) for income                                                         |       | 193                                       |       | 388 |   | (1,435 | ) |
| Net loss                                                                                |       | $                                         | (14,751    | ) | $ | (7,246 | ) | $ | (8,409 | ) |
| Basic and diluted  net loss per share                                                   |       | $                                         | (0.15      | ) | $ | (0.09 | ) | $ | (0.11 | ) |
| Shares used in  computing basic and diluted net loss per share                          |       | 98,115                                    |       | 84,733 |   | 78,617 |   |

----

| *  Excludes  amortization (reversal) of deferred stock compensation of the following (1): |   |   |   |
|-----------------------------------------------------------------------------------------------------|--------|--------|--------|
| Cost of services revenue                                                                            |   | $      | 8      |   | $ | (177 | ) | $ | 227 |   |
| Research and  development                                                                           |   | 1,106  |   | 15 |   | 224 |   |
| Sales and marketing                                                                                 |   | 107    |   | 4 |   | 167 |   |
| General and  administrative                                                                         |   | 61     |   | 27 |   | (12 | ) |
| Total amortization  (reversal) of deferred stock compensation, net                                  |   | $      | 1,282  |   | $ | (131 | ) | $ | 606 |   |

(1)          Given the non cashnature of the expense, we believe presenting amortization (reversal) ofdeferred stock compensation in a separate line item more accurately reflectsthe results of our individual operating expense categories.

See accompanying notes.

42

----

**OPSWARE INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (in thousands)**

| ** **                                                                                               | ** ** | **Common Stock** | ** ** | **Additional  Paid-In ** | ** ** | **Notes  Receivable  from** | ** ** | **Deferred  Stock** | ** ** | **Accumulated**  | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Stockholders’ ** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------------|------------|-----------------------------|------------|---------------------|------------|------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                               | ** ** | **Shares**            | ** ** | **Amount**                    | ** ** | **Capital**                 | ** ** | **Stockholders**    | ** ** | **Compensation** | ** ** | **Deficit**                           | ** ** | **Income (Loss)**              | ** ** | **Equity** | ** ** |
| Balance at  January 31, 2003                                                                        |       |                  | 78,611     |                          |       |                        | 79         |                |       |             | 500,976    |                                  |       |                                | (793       | ) |   |   | (1,665 | ) |   |   | (452,863 | ) |   |   | 404 |   |   |   | 46,138 |   |   |
| Exercise of stock options  by employees, net of repurchases                                              |       |                  | 2,326      |                          |       |                        | 3          |                |       |             | 5,299      |                                  |       |                                | 42         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 5,344 |   |   |
| Issuance of common stock  in connection with the Employee Stock Purchase Program                         |       |                  | 447        |                          |       |                        | —     |                |       |             | 465        |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 465 |   |   |
| Repayment of note  receivable                                                                            |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                | 423        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 423 |   |   |
| Amortization of deferred  stock compensation                                                             |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                |       |   |   |   | 1,425 |   |   |   |   |   |   |   |   |   |   |   | 1,425 |   |   |
| Reversal of deferred  compensation based on straight line vs. graded                                     |       |                  |       |                          |       |                        |       |                |       |             | (819       | )                                     |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (819 | ) |   |
| Reversal related to  unamortized portion of deferred stock compensation related to terminated  employees |       |                  |       |                          |       |                        |       |                |       |             | (130       | )                                     |       |                                |       |   |   |   | 130 |   |   |   |   |   |   |   |   |   |   |   | — |   |   |
| Impact of variable  accounting related to replacement stock option                                       |       |                  | —     |                          |       |                        |       |                |       |             | 2,160      |                                  |       |                                |       |   |   |   |   |   |   |   | — |   |   |   |   |   |   |   | 2,160 |   |   |
| Issuance of restricted  stock option award                                                               |       |                  | 105        |                          |       |                        |       |                |       |             | 588        |                                  |       |                                |       |   |   |   | (352 | ) |   |   |   |   |   |   |   |   |   |   | 236 |   |   |
| Stock option  modifications                                                                              |       |                  |       |                          |       |                        |       |                |       |             | 292        |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 292 |   |   |
| Exercise of stock warrant                                                                                |       |                  | 48         |                          |       |                        |       |                |       |             | 373        |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 373 |   |   |
| Repurchase of common  stock                                                                              |       |                  | —     |                          |       |                        |       |                |       |             | (2         | )                                     |       |                                |       |   |   |   |   |   |   |   | (1 | ) |   |   |   |   |   |   | (3 | ) |   |
| Components of comprehensive loss                                                                         |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                                 |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                |       |   |   |   |   |   |   |   | (8,409 | ) |   |   |   |   |   |   | (8,409 | ) |   |
| Translation  adjustment                                                                                  |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   | (400 | ) |   |   | (400 | ) |   |
| Total comprehensive loss                                                                                 |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   | (8,809 | ) |   |
| Balance at  January 31, 2004                                                                        |       |                  | 81,537     |                          |       |                        | 82         |                |       |             | 509,202    |                                  |       |                                | (328       | ) |   |   | (462 | ) |   |   | (461,273 | ) |   |   | 4 |   |   |   | 47,225 |   |   |
| Exercise of stock options  by employees, net of repurchases                                              |       |                  | 1,903      |                          |       |                        | 2          |                |       |             | 4,136      |                                  |       |                                | 13         |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 4,151 |   |   |
| Issuance of common stock  in connection with the Employee Stock Purchase Program                         |       |                  | 713        |                          |       |                        | —     |                |       |             | 1,080      |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 1,080 |   |   |
| Secondary offering of  common stock in December 2004 (less issuance costs of $2,200)                |       |                  | 10,000     |                          |       |                        | 10         |                |       |             | 61,791     |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 61,801 |   |   |
| Repayment of note  receivable                                                                            |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                | 314        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 314 |   |   |
| Charge for accelerated  vesting of options to terminated employees                                       |       |                  |       |                          |       |                        |       |                |       |             | 3          |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 3 |   |   |
| Amortization of deferred  stock compensation                                                             |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                |       |   |   |   | 103 |   |   |   |   |   |   |   |   |   |   |   | 103 |   |   |
| Reversal of deferred  compensation based on straight line vs. graded                                     |       |                  |       |                          |       |                        |       |                |       |             | (234       | )                                     |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (234 | ) |   |
| Common Stock issued in  connection with Tangram acquisition                                              |       |                  | 1,121      |                          |       |                        | 1          |                |       |             | 10,000     |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 10,001 |   |   |
| Reversal related to  unamortized portion of deferred stock compensation related to terminated  employees |       |                  |       |                          |       |                        |       |                |       |             | (7         | )                                     |       |                                |       |   |   |   | 7 |   |   |   |   |   |   |   |   |   |   |   | — |   |   |
| Impact of variable  accounting related to replacement stock option                                       |       |                  |       |                          |       |                        |       |                |       |             | (730       | )                                     |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (730 | ) |   |
| Issuance of restricted  stock option award                                                               |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                |       |   |   |   | 246 |   |   |   |   |   |   |   |   |   |   |   | 246 |   |   |
| Repurchase of common  stock                                                                              |       |                  | (17        | )                             |       |                        |       |                |       |             | (14        | )                                     |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (14 | ) |   |
| Retirement of common stock                                                                               |       |                  | (3         | )                             |       |                        |       |                |       |             | (23        | )                                     |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (23 | ) |   |
| Components of comprehensive loss                                                                         |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | — |   |   |
| Net loss                                                                                                 |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                |       |   |   |   |   |   |   |   | (7,246 | ) |   |   |   |   |   |   | (7,246 | ) |   |
| Translation  adjustment                                                                                  |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   | (15 | ) |   |   | (15 | ) |   |
| Total comprehensive loss                                                                                 |       |                  |       |                          |       |                        |       |                |       |             |       |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   | (7,261 | ) |   |
| Balance at January 31, 2005                                                                         |       |                  | 95,254     |                          |       |                        | 95         |                |       |             | 585,204    |                                  |       |                                | (1         | ) |   |   | (106 | ) |   |   | (468,519 | ) |   |   | (11 | ) |   |   | 116,662 |   |   |

 

See accompanying notes.

43

----

**OPSWARE INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY—(Continued) (in thousands)**

 

| ** **                                                                                               | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Notes  Receivable  from** | ** ** | **Deferred  Stock** | ** ** | **Accumulated**  | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-----------------------------|------------|---------------------|------------|------------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                               | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**                 | ** ** | **Stockholders**    | ** ** | **Compensation** | ** ** | **Deficit**                           | ** ** | **Income (Loss)**        | ** ** | **Equity** | ** ** |
| Balance at  January 31, 2005                                                                        |       |                  | 95,254     |                    |       |                        | $          | 95                  |       |             |       | $                                     | 585,204    |                          |       |   | $ | (1 | ) |   |   | $ | (106 | ) |   |   | $ | (468,519 | ) |   |   | $ | (11 | ) |   |   | $ | 116,662 |   |   |
| Exercise of stock  options by employees, net of repurchases                                              |       |                  | 886        |                    |       |                        | 1          |                |       |             | 1,050      |                                  |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,051 |   |   |
| Issuance of common  stock in connection with the Employee Stock Purchase Program                         |       |                  | 524        |                    |       |                        | 1          |                |       |             | 1,538      |                                  |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,539 |   |   |
| Repayment of notes  receivable                                                                           |       |                  | —     |                    |       |                        | —     |                |       |             | (1         | )                                     |       |                          | 1          |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Charge for  accelerated vesting of options to terminated employees                                       |       |                  | —     |                    |       |                        | —     |                |       |             | 12         |                                  |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 12 |   |   |
| Amortization of  deferred stock compensation                                                             |       |                  | —     |                    |       |                        | —     |                |       |             |       |                                  |       |                          | —     |   |   |   | 1,320 |   |   |   | — |   |   |   | — |   |   |   | 1,320 |   |   |
| Reversal of  deferred compensation based on straight line vs. graded                                     |       |                  | —     |                    |       |                        | —     |                |       |             | (40        | )                                     |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (40 | ) |   |
| Common Stock  issued in connection with Rendition acquisition                                            |       |                  | 2,532      |                    |       |                        | 3          |                |       |             | 18,559     |                                  |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 18,562 |   |   |
| Deferred Compensation  related to Rendition acquisition                                                  |       |                  | —     |                    |       |                        | —     |                |       |             | —     |                                  |       |                          | —     |   |   |   | (1,505 | ) |   |   | — |   |   |   | — |   |   |   | (1,505 | ) |   |
| Reversal related  to unamortized portion of deferred stock compensation related to terminated  employees |       |                  | —     |                    |       |                        | —     |                |       |             | (74        | )                                     |       |                          | —     |   |   |   | 74 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Impact of variable  accounting related to replacement stock option                                       |       |                  | —     |                    |       |                        | —     |                |       |             | 395        |                                  |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 395 |   |   |
| Issuance of  restricted stock option award                                                               |       |                  | 400        |                    |       |                        |       |                |       |             | 2,812      |                                  |       |                          |       |   |   |   | (2,389 | ) |   |   | — |   |   |   | — |   |   |   | 423 |   |   |
| Components of  comprehensive loss                                                                        |       |                  |       |                    |       |                        |       |                |       |             |       |                                  |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                                 |       |                  | —     |                    |       |                        | —     |                |       |             | —     |                                  |       |                          | —     |   |   |   | — |   |   |   | (14,751 | ) |   |   | — |   |   |   | (14,751 | ) |   |
| Translation  adjustment                                                                                  |       |                  | —     |                    |       |                        | —     |                |       |             | —     |                                  |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | (130 | ) |   |   | (130 | ) |   |
| Total  comprehensive loss                                                                                |       |                  | —     |                    |       |                        | —     |                |       |             | —     |                                  |       |                          | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | (14,881 | ) |   |
| Balance at  January 31, 2006                                                                        |       |                  | 99,596     |                    |       |                        | $          | 100                 |       |             |       | $                                     | 609,455    |                          |       |   | $ | — |   |   |   | $ | (2,606 | ) |   |   | $ | (483,270 | ) |   |   | $ | (141 | ) |   |   | $ | 123,538 |   |   |

 

See accompanying notes.

44

----

**OPSWARE INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)**

| ** **                                                                                             | ** ** | **Year ended January 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Operating activities:                                                                                  |       |                                      |       |   |   |   |   |
| Net loss                                                                                               |       | $                                         | (14,751    | ) | $ | (7,246 | ) | $ | (8,409 | ) |
| Adjustments to reconcile loss to net cash used in  operating activities:                               |       |                                      |       |   |   |   |   |
| Depreciation                                                                                           |       | 2,666                                     |       | 2,577 |   | 2,791 |   |
| Amortization of  intangibles                                                                           |       | 2,942                                     |       | 1,272 |   | — |   |
| Charge (benefit) related  to stock-based compensation agreements                                       |       | 698                                       |       | (496 | ) | 2,661 |   |
| Amortization (reversal)  of deferred stock compensation                                                |       | 1,282                                     |       | (131 | ) | 606 |   |
| Recovery on disposal of  property and equipment                                                        |       | (4                                        | )          | (6 | ) | (152 | ) |
| In-process research and  development charges                                                           |       | 1,190                                     |       | 610 |   | — |   |
| Foreign Income taxes                                                                                   |       | —                                    |       | — |   | (1,500 | ) |
| Changes in operating assets and liabilities:                                                           |       |                                      |       |   |   |   |   |
| Accounts receivable, net                                                                               |       | (12,819                                   | )          | (521 | ) | (1,687 | ) |
| Prepaid expenses, other  current assets and other assets                                               |       | (3,073                                    | )          | 195 |   | (461 | ) |
| Prepaid rent                                                                                           |       | 645                                       |       | 816 |   | (3,001 | ) |
| Accounts payable                                                                                       |       | 335                                       |       | 229 |   | (163 | ) |
| Accrued compensation                                                                                   |       | 4,561                                     |       | 393 |   | 341 |   |
| Accrued data center  facilities costs                                                                  |       | —                                    |       | (6,522 | ) | (993 | ) |
| Other accrued liabilities                                                                              |       | 1,413                                     |       | (107 | ) | (4,196 | ) |
| Advances from customers                                                                                |       | (8,134                                    | )          | 4,620 |   | 1,696 |   |
| Deferred revenue                                                                                       |       | 20,579                                    |       | 4,208 |   | 5,918 |   |
| Accrued restructuring  costs                                                                           |       | (211                                      | )          | (933 | ) | (7,219 | ) |
| Net cash used in  operating activities                                                                 |       | (2,681                                    | )          | (1,042 | ) | (13,768 | ) |
| **Investing activities:**                                                                              | ** ** | ** **                                | ** ** |   |   | ** ** | ** ** |
| Purchases of property and  equipment                                                                   |       | (2,278                                    | )          | (2,843 | ) | (886 | ) |
| Restricted cash                                                                                        |       | 444                                       |       | 171 |   | 910 |   |
| Proceeds from sale of  assets                                                                          |       | —                                    |       | 6 |   | 20 |   |
| Direct acquisition costs  paid                                                                         |       | (14,984                                   | )          | (1,123 | ) | (419 | ) |
| Cash acquired (overdraft)  in acquisition of businesses                                                |       | (22                                       | )          | 954 |   | — |   |
| Net cash used in  investing activities                                                                 |       | (16,840                                   | )          | (2,835 | ) | (375 | ) |
| **Financing activities:**                                                                              | ** ** | ** **                                | ** ** |   |   | ** ** | ** ** |
| Proceeds from issuance of  common stock, net of repurchases                                            |       | 2,715                                     |       | 67,019 |   | 5,809 |   |
| Receipt of (principal  payments on) capital lease obligations                                          |       | 88                                        |       | (23 | ) | (43 | ) |
| Proceeds from repayment  of notes receivable                                                           |       | 1                                         |       | 314 |   | 423 |   |
| Repurchase of common  stock, net                                                                       |       | —                                    |       | (23 | ) | (3 | ) |
| Net cash provided by  financing activities                                                             |       | 2,804                                     |       | 67,287 |   | 6,186 |   |
| Net increase (decrease)  in cash and cash equivalents                                                  |       | (16,717                                   | )          | 63,410 |   | (7,957 | ) |
| Cash and cash equivalents  at beginning of period                                                      |       | 118,615                                   |       | 55,205 |   | 63,162 |   |
| Cash and cash equivalents  at end of period                                                            |       | $                                         | 101,898    |   | $ | 118,615 |   | $ | 55,205 |   |
| **Supplemental schedule of non-cash investing and  financing activities:**                             | ** ** | ** **                                | ** ** |   |   | ** ** | ** ** |
| Reversal of unamortized  portion of deferred stock compensation related to terminated employees        |       | $                                         | 75         |   | $ | 7 |   | $ | 130 |   |
| Equipment purchased under  capital lease                                                               |       | 98                                        |       | — |   | — |   |
| Cancellation of stockholder  notes receivable for terminated employees related to unvested awards |       | —                                    |       | 13 |   | 42 |   |
| Common stock issued in  connection with the acquisition of Tangram                                     |       | —                                    |       | 10,000 |   | — |   |
| Common stock issued in  connection with the acquisition of Rendition                                   |       | 18,562                                    |       | — |   | — |   |
| **Supplemental disclosures:**                                                                          | ** ** | ** **                                | ** ** |   |   | ** ** | ** ** |
| Cash paid for interest                                                                                 |       | $                                         | 20         |   | $ | — |   | $ | 6 |   |
| Cash paid for taxes                                                                                    |       | 161                                       |       | 29 |   | — |   |

 

See accompanying notes.

45

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.**   Summaryof the Company and Significant Accounting Policies

*Nature of Operations*

Opsware Inc. (“Opsware,” or “the Company,”), wasincorporated on September 9, 1999 in the state of Delaware. The Companysells its IT automation software suite which includes the Opsware ServerAutomation System (OSAS), Opsware Network Automation System (ONAS) and OpswareAsset Management System (OAMS), to enterprises, government agencies and serviceproviders seeking to reduce costs and increase the quality of data center operations.The Company refers to this business as its Software Business. The Company’ssoftware products automate key network, server and software operations in datacenters, including provisioning, changing, patching, reporting, configuring,scaling, securing, recovering, auditing, and reallocating servers, networkdevices and applications. The Company’s products work across geographicallydisparate locations and heterogeneous IT environments consisting of UNIX, Linuxand Windows servers and a wide range of software infrastructure andapplications, as well as network devices including switches, routers, loadbalancers and firewalls.

Prior to August 15,2002, the Company primarily provided managed Internet services for corporationsand government agencies that operate mission-critical Internet applications.The Company referred to this business as its Managed Services Business. On August 15,2002, the Company completed the sale of its Managed Services Business toElectronic Data Systems Corporation (“EDS”). The Company used its proprietaryOpsware automation technology in the Managed Services Business, and has sinceintegrated this technology into its software products. As a result, theoperations and cash flows of the Managed Services Business could not clearly bedistinguished from its Software Business, either operationally or for financialreporting purposes. Therefore, the sale of the Managed Services Business wasnot considered a discontinued operation.

*Basis of Presentation*

The consolidated financialstatements include accounts of the Company and its wholly owned subsidiaries.All intercompany balances have been eliminated.

*Use of Estimates and Reclassifications*

The preparation ofconsolidated financial statements in conformity with U.S. generally acceptedaccounting principles requires management to make estimates and assumptionsthat materially affect the amounts reported in the consolidated financialstatements. Actual results could differ materially from these estimates. Themethods, estimates and judgments the Company uses in applying its most criticalaccounting policies have a significant impact on the results reported in itsfinancial statements.

*Significant Accounting Policies*

*Revenue Recognition*

The Company recognizes software revenue in accordancewith the American Institute of Certified Public Accountants’ (“AICPA”)Statement of Position No. 97-2 (“SOP 97-2”), “Software RevenueRecognition,” Statement of Position No. 98-9, “Modification of SOP 97-2with Respect to Certain Transactions” (“SOP 98-9”), EITF 00-21,Revenue Arrangements with Multiple Deliverables and Statement of Position No. 81-1,Accounting for Performance of Construction Type and Certain Production TypeContracts” (“SOP 81-1”). For each transaction, the Company determineswhether evidence of an 

46

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

arrangement exists,delivery has occurred, the fee is fixed or determinable, and collectibility ofthe fee is probable. If any of these criteria are not met, revenue recognitionis deferred until such time as all criteria are met. The Company considers allarrangements with payment terms extending beyond twelve months not to be fixedor determinable in which case revenue is recognized  when the fee is collected. No customer has aright of return privilege.

Most of the Company’s arrangements involve multipleelements (for example, license fees, maintenance and support, and professionalservices), and the Company allocates revenue to each component of thearrangement using the residual method based on the Company’s vendor specificobjective evidence (VSOE) of fair value of the undelivered elements, which isspecific to the Company. This means that the Company defers revenue from thearrangement fee equivalent to the fair value of the undelivered elements. Theresidual arrangement fee is then allocated to the delivered element or elements.VSOE of fair value for the ongoing maintenance and support obligations (postcontract support or PCS) within an arrangement is based upon substantiverenewal rates stated in the contracts, and in the absence of stated renewalrates, upon separate sales of renewals to other customers. VSOE of fair valuefor professional services, such as consulting, is based upon hourly or dailyrates charged under separate sales of these services to other customers instandalone transactions

License revenue consists of license fees charged forthe use of the Company’s products under perpetual or term license arrangements.The Company recognizes license revenue for perpetual licenses using theresidual method after all elements other than PCS and professional serviceshave been delivered, provided that all of the criteria for revenue recognition,as discussed above, are met. Generally, these criteria are met at the time ofdelivery of the software to the customer. The Company recognizes revenue underterm licenses on a straight-line basis over the term of the arrangement oncecriteria for revenue recognition, as discussed above, have been met. If anarrangement includes an acceptance provision, revenue is deferred until theearlier of receipt of a written customer acceptance or expiration of theacceptance period.

Services revenue consists of revenue from maintenanceand support (PCS) and professional services agreements. PCS agreements includeongoing customer support and rights to product updates if and when available.Revenue under these arrangements is recognized ratably using the straight-linemethod over the period that the PCS is provided (generally one year).Professional service revenue consists of fees charged for product training andconsulting services. Consulting services are generally accounted for separatelyfrom the software license because the services qualify for separate accountingas defined in paragraph No. 65 of SOP 97-2. The more significantfactors considered in determining whether the services should be accounted forseparately include the nature of services (i.e., consideration of whether theservices are essential to the functionality of the licensed product), degree ofrisk, availability of services from other vendors, timing of payments andimpact of service milestones or acceptance criteria on the realizability of thesoftware license fee. Revenues for consulting services that qualify forseparate accounting are generally recognized as the services are performed. Ifservices do not qualify for separate accounting, the software license revenueis generally recognized together with the consulting services using contractaccounting (percentage of completion or the completed-contract method).Contract accounting is applied to any arrangements: (1) that includemilestones or customer specific acceptance criteria that may affect collectionof the software license fees; (2) where services include significantmodification or customization of the software; or (3) where the softwarelicense payment is tied to the performance of consulting services.

47

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

The Company recognizes revenue associated withsoftware licenses and services sold to distributors, system integrators andvalue added resellers (collectively, “resellers”) upon satisfaction of allrevenue recognition criteria unless it is aware that a reseller does not have apurchase order or other contractual agreement to purchase the software from anend user. In connection with sales to resellers, there is no right of return.

For all periods includedin the Company’s consolidated financials statements, in the case of OAMS andONAS software, the Company recognizes perpetual license revenue using theresidual method after all elements other than maintenance have been delivered,provided that all of the criteria for revenue recognition discussed above aremet. Generally, these criteria are met at the time of delivery. For OSASarrangements entered into prior to May 1, 2005, the date when the Companydetermined it had established VSOE of the fair value of maintenance andprofessional services for OSAS, the Company recognizes both license andservices revenue from a transaction ratably over the remaining post-contractmaintenance and support period once deployment of the Company’s software hadbeen completed and all other elements of the arrangement had been delivered.For OSAS arrangements entered into on or after May 1, 2005, the Companyrecognized revenue from perpetual licenses using the residual method. For termlicenses, usually one year in duration, accompanied by PCS, the entirearrangement fee is recognized ratably over the longer of the term of thelicense or PCS.

*Impairment of Long-Lived Assets and Intangible Assets*

The Company periodically reviews the carrying value oflong-lived assets, including property and equipment and other identifiedintangible assets, to determine whether there are any indicators of impairment.Some indicators of impairment include but are not limited to, a decrease in themarket price of a long-lived asset, an adverse change in the extent or mannerin which a long-lived asset is being used, a change in the business climatethat could affect the value of a long-lived asset or a current-period operatingor cash flow loss combined with a history of operating or cash flow losses.According to the Company’s accounting policy, when such indicators are present,if the undiscounted cash flows expected to be generated from operations fromthose long-lived assets are less than the carrying value of those long-livedassets, the Company compares the fair value of the assets (estimated usingdiscounted future net cash flows to be generated from the lowest common levelof operations utilizing the assets) to the carrying value of the long-livedassets to determine any impairment charges. The Company reduces the carryingvalue of the long-lived assets if the carrying value of the long-lived assetsis greater than their fair value. The new carrying value is then depreciatedover the remaining estimated useful lives of the assets. The determination asto whether impairment exists involves significant judgment and the assumptionssupporting the estimated future cash flows reflects management’s bestestimates. There were no impairment charges recorded through January 31,2006.

As part of the Company’sacquisition of Tangram Enterprise Solutions in February 2004,approximately $5.4 million of the purchase price was allocated to identifiedintangible assets, including approximately $2.5 million for customerrelationships and approximately $2.9 million for developed technology. As partof the acquisition of Rendition Networks in February 2005, approximately$6.4 million of the purchase price was allocated to identified intangibleassets, including approximately $2.7 million for customer relationships andapproximately $3.7 million for developed technology. The Company is amortizingthese intangible assets on a straight-line basis over an average estimated lifeof four years.

48

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

*Impairment of Goodwill*

The Company accounts for goodwill in accordance withStatement of Financial Accounting Standards No. 142, “Goodwill andIntangible Assets” (“SFAS 142”). In accordance with SFAS 142, goodwill is notamortized, but instead will be tested for impairment at least annually and morefrequently if certain indicators are present. Circumstances that could triggeran impairment test include, but are not limited to, a significant adversechange in the business climate or legal factors, unanticipated competition andloss of key personnel. The assessment of impairment is made by comparing thefair value of the reporting unit to which the goodwill has been assigned bymanagement to its carrying value. To the extent that an impairment is indicated(fair value is less than carrying value), the Company must perform a secondtest to measure the amount of the impairment. The Company operates as a singlesegment for reporting purposes. The determination as to whether a write down ofgoodwill is necessary involves significant judgment based on the short-term andlong-term projections of future performance. The assumptions supporting theestimated future cash flows, including the discount rate used and estimatedterminal value, reflects the Company’s best estimates. In the event the Companydetermines that goodwill has been impaired, the Company will incur anaccounting charge related to the impairment during the reporting period inwhich such impairment determination is made. The Company reviews for indicatorsof potential impairment of goodwill at least annually. No goodwill impairmentcharges have been recorded through January 31, 2006.

Goodwill as of January 31,2006 was $27.7 million, which includes $24.1 million from the Company’sacquisition of Rendition Networks, which occurred on February 3, 2005.

*Contingency Accruals*

The Company evaluatescontingent liabilities including threatened or pending litigation in accordancewith Statement of Financial Accounting Standards No. 5 (“SFAS 5”), “Accountingfor Contingencies”. If the potential loss from any claim or legal proceedingsis considered probable and the amount can be estimated, the Company accrues aliability for the estimated loss. Because of uncertainties related to thesematters, accruals are based upon management’s judgment and the best informationavailable to management at the time. As additional information becomesavailable, the Company reassesses the potential liability related to itspending claims and litigation and may revise its estimates.

*Restructuring Costs*

During fiscal 2002 and2003, the Company restructured its business under plans approved by the Boardof Directors by reducing its headcount, consolidating its facilities anddisposing of excess and obsolete property and equipment. As a result of theseactions, the Company recorded restructuring and other related chargesconsisting of cash severance payments to be made to severed employees and leasepayments related to property vacated as a result of its consolidation offacilities, net of estimated sublease income. The Company’s estimates includethe review of the financial condition of its existing sublessees as well as thestate of the regional real estate markets. Each reporting period, the Companyreviews these estimates based on the status of execution of its restructuringplan and, to the extent that these assumptions change due to changes in marketconditions and its business, the Company revises the estimated fair value ofits restructuring liabilities in accordance with SFAS 146, “Accounting forCosts Associated with Exit or Disposal Activities.”

49

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

*Cash, Cash Equivalents and Short-term Investments*

The Company considers all highly liquid investmentsecurities with a maturity date from the date of purchase of three months orless to be cash equivalents and investment securities with a maturity date fromthe date of purchase of more than three months, but less than twelve months, tobe short-term investments.

Management determines theappropriate classification of debt and equity securities at the time ofpurchase and evaluates such designation as of each balance sheet date. To date,all debt securities have been classified as available-for-sale and are carriedat fair value with unrealized gains and losses, if any, included instockholders’ equity. Interest and dividends on all securities are included ininterest income.

*Concentrations of Credit Risk and SignificantCustomers*

Financial instruments that potentially subject theCompany to concentrations of credit risk consist principally of cash, cashequivalents, restricted cash and accounts receivable. The Company places all ofits cash, cash equivalents and restricted cash with high-credit qualityissuers. Carrying amounts of financial instruments held by the Company, whichinclude cash equivalents, restricted cash and accounts receivable, approximatefair value due to their short duration. The Company performs ongoing creditevaluations, as warranted, and maintains allowances for potential losses onaccounts receivable.

For the fiscal year ended January 31,2006, EDS accounted for 35% of the Company’s net revenues. For the fiscal yearended January 31, 2005, EDS and NTT Communications accounted for 54% and11% of the Company’s net revenues, respectively. For the fiscal year ended January 31,2004, EDS accounted for 83% of the Company’s net revenues. As of January 31,2006, the General Electric Company and Royal Bank of Scotland accounted for 15%and 11% of the Company’s accounts receivable balance, respectively. EDSaccounted for 53%, and 83% of the Company’s accounts receivable balance as of January 31,2005, and January 31, 2004, respectively. Additions (credits) to theallowance for doubtful accounts were 131,000, 131,000, and (7,000) for theyears ended January 31, 2006, 2005, and 2004, respectively. Deductionsagainst the allowance were 37,000, 59,000, and 8,000 for the years ended January 21,2006, 2005, and 2004, respectively.

*Fair Value of Financial Instruments*

The carrying amounts ofthe Company’s financial instruments, which include cash and cash equivalents,restricted cash, accounts receivable, accounts payable, and other accrued liabilities,approximate their fair values due to their short maturities.

*Allowance for Doubtful Accounts*

The Company maintains anallowance for doubtful accounts for estimated losses resulting from the inabilityof its customers to make required payments. The allowance for doubtful accountsis based on specifically identified customers and as a percentage of accountsreceivable based on historical write-offs for the Company. If the financialcondition of the Company’s customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired. In addition, under the Company’s accounting policy, it continuallyassesses the balance of its allowance for doubtful accounts based on, amongother things, its customers’ payment history and financial condition, includinga review of the customers’ balance sheets, statements of operations, statementsof cash flows and credit reports. If actual write-offs were greater than theCompany’s estimates, it would increase its allowance for doubtful accounts,which would increase its bad debt expense.

50

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

*Accounting for Stock-Based Compensation*

TheCompany grants stock options and stock purchase rights for a fixed number ofshares to employees and directors with an exercise price equal to the fairvalue of the shares at the date of grant. As permitted under the FinancialAccounting Standards Board (“FASB”) Statement of Financial Accounting StandardsNo. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as amendedby Statement of Financial Accounting Standards No. 148, “Accounting forStock-Based Compensation—Transition and Disclosure” (“SFAS 148”), the Companyaccounts for stock option grants and stock purchase rights to employees anddirectors in accordance with Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” (“APB Opinion No. 25”) and, accordingly,recognizes no compensation expense for stock option grants or stock purchaserights with an exercise price equal to or greater than the fair value of theshares at the date of grant. If compensation expense for the Company’sstock-based compensation plans had been determined in accordance with SFAS 123,the Company’s net loss and net loss per share would have resulted in the proforma GAAP amounts indicated below (in thousands, except per share amounts):

| ** **                                                                                                          | ** ** | **Year Ended January 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| As reported net  loss                                                                                               |       | $                                         | (14,751    | ) | $ | (7,246 | ) | $ | (8,409 | ) |
| Stock-based  compensation expense (reversal) included in reported net loss                                     |       | 2,097                                     |       | (615 | ) | 3,294 |   |
| Total stock-based  employee compenstation expense determined under the fair value based  method for all awards |       | (14,033                                   | )          | (10,251 | ) | (7,700 | ) |
| Pro forma net  loss                                                                                                 |       | $                                         | (26,687    | ) | $ | (18,112 | ) | $ | (12,815 | ) |
| Earnings (loss) per share:                                                                                          |       |                                      |       |   |   |   |   |
| As reported net  loss per share—basic and diluted                                                              |       | $                                         | (0.15      | ) | $ | (0.09 | ) | $ | (0.11 | ) |
| Pro forma net loss per share—basic and diluted                                                                 |       | $                                         | (0.27      | ) | $ | (0.21 | ) | $ | (0.16 | ) |

 

Forpurposes of this disclosure, the estimated fair value of the stock options andstock purchase rights is amortized to expense over the stock purchase rightsand options’ vesting periods. The fair value of stock options is measured usingan expected four year life and the fair value of employee stock purchase rightsis measured using an expected two year life. The fair value of options grantedand stock purchase rights during all periods was estimated at the date of theoption grant using the Black-Scholes option pricing model with the followingassumptions:

| ** **                | ** ** | **Stock Awards**                     | ** ** | **Employee Stock Purchase Plan** | ** ** |
|---------------------------|------------|-------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                | ** ** | **Year Ended January 31,** | ** ** | **Year Ended January 31,**       | ** ** |
| ** **                | ** ** | **2006**                                  | ** ** | **2005**                                        | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Risk-free  interest yield |       |                                      | 4.0        | %                                               |       |   | 3.6 | % |   |   | 2.9 | % |   |   | 3.5 | % |   |   | 1.9 | % |   |   | 1.8 | % |   |
| Expected life  (years)    |       |                                      | 4.0        |                                            |       |   | 4.0 |   |   |   | 4.0 |   |   |   | 2.0 |   |   |   | 2.0 |   |   |   | 2.0 |   |   |
| Volatility                |       |                                      | 73         | %                                               |       |   | 81 | % |   |   | 96 | % |   |   | 68 | % |   |   | 112 | % |   |   | 124 | % |   |
| Dividend yield            |       |                                      | 0          | %                                               |       |   | 0 | % |   |   | 0 | % |   |   | 0 | % |   |   | 0 | % |   |   | 0 | % |   |

 

The weighted average fairvalue was $3.40, $4.47 and $3.00 per share, for stock options granted in theyears ended January 31, 2006, 2005 and 2004, respectively. The weightedaverage fair value was $2.19, 

51

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

$1.69and $1.05 per share, for stock purchase rights granted in the years ended January 31,2006, 2005 and 2004, respectively.

*Property and Equipment*

Property and equipment isstated at cost, net of accumulated depreciation. Depreciation is calculatedusing the straight-line method over the estimated useful lives of the assets,or two years for software, three years for computer and office equipment andfive years for furniture and fixtures. The Company amortizes capital leases andleasehold improvements using the straight-line method over the lesser of theasset’s estimated useful lives or remaining lease terms (typically three tofive years).

*Advertising Expenses*

All advertising expensesare expensed as incurred. Advertising expenses were $239,000, $186,000, and$171,000 for the fiscal years ended January 31, 2006, 2005, and 2004,respectively.

*Research and Development Costs*

Research and developmentexpenditures are charged to operations as incurred. Statement of FinancialAccounting Standards No. 86, “Accounting for the Costs of ComputerSoftware to Be Sold, Leased or Otherwise Marketed,” (“SFAS 86”) requires thecapitalization of certain software development costs subsequent to theestablishment of technological feasibility. Based on the Company’s productdevelopment process, technological feasibility is established upon thecompletion of a working model. Costs incurred by the Company between thecompletion of the working model and the point at which the product is ready forgeneral release have been insignificant. Accordingly, the Company has chargedall such costs to research and development expense in the accompanyingstatements of operations. As a result, research and development expendituresare not reflected in the accompanying balance sheets of the Company.

*Guarantees and Indemnifications*

Financial Accounting Standards Board Interpretation No. 45,“Guarantor’s Accounting and Disclosure Requirements for Guarantees, IncludingIndirect Guarantees of Indebtedness of Others” (“FIN 45”), requires that theCompany recognize and record the fair value of guarantee and indemnificationarrangements issued or modified by the Company after December 31, 2002, ifthese arrangements are within the scope of FIN 45. In addition, the Companymust continue to monitor the conditions that are subject to the guarantees andindemnifications, as required under previously existing generally acceptedaccounting principles, in order to identify if a loss has occurred. If theCompany determines it is probable that a loss has occurred then any suchestimable loss would be recognized under those guarantees and indemnifications.

In some cases, the Companymay provide warranties or indemnification with respect to its softwareproducts. Consistent with FIN 45, the Company will accrue for known warranty orindemnification claims if a loss is probable and can be reasonably estimatedand will accrue for estimated but unidentified warranty or indemnificationclaims based on historical activity. To date, the Company has had no warrantyclaims. As a result, the Company has not recorded a warranty accrual. Inaddition, there has been no history of indemnification claims related to theCompany’s software and the Company has not recorded an indemnification accrual.

52

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

*Comprehensive Income (Loss)*

Under Statement ofFinancial Accounting Standards No. 130, “Reporting Comprehensive Income”(“SFAS 130”), the Company is required to display comprehensive income (loss)and its components as part of the financial statements. Other comprehensiveincome (loss) includes foreign currency translation adjustments and unrealizedgains/losses on available-for-sale securities that are excluded from net income(loss) and is reported in the accompanying consolidated statement of stockholders’equity.

*Income Taxes*

The Company accounts forincome taxes using the liability method under which deferred tax assets andliabilities are determined based on differences between financial reporting andtax bases of assets and liabilities and are measured using the enacted taxrates and laws that will be in effect when the differences are expected toreverse. A valuation allowance is recorded to reduce the carrying amounts ofdeferred tax assets if it is more likely than not that those assets will not berealized.

*Recent Accounting Pronouncements*

In December 2004, theFASB issued Statement of Financial Accounting Standards No. 123R, “Share-BasedPayment” (“SFAS 123R”), which establishes standards for the accounting fortransactions in which an entity exchanges its equity instruments for goods orservices. A key provision of this statement is the requirement of a publicentity to measure the cost of employee services received in exchange for anaward of equity instruments (including stock options) based on the grant datefair value of the award and recognized over the vesting period. SFAS 123R willbe effective for the Company’s fiscal quarter beginning February 1, 2006,and the Company will recognize stock-based compensation expense using theModified Prospective application method. Under the Modified Prospective method,SFAS 123R is applied to new awards and to awards modified, repurchased, orcancelled after the effective date. Compensation cost already measured underSFAS 123 for the portion of awards for which service has not been rendered(such as unvested options) that are outstanding as of the date of adoptionshall be recognized as the remaining services are rendered. Although theCompany has not yet determined the impact of the adoption of SFAS 123R onits consolidated financial statements it expects the adoption to have asignificant adverse impact on its reported financial results.

**2.**   Cashand cash equivalents.

Thefollowing table summarizes the estimated fair value of financial instruments atthe dates indicated (in thousands):

| ** **                   | ** ** | **Year Ended January 31,** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                  | ** ** | **2005** | ** ** |
| Cash and money  market funds |       | $ 104,194                            |       | $ 121,355 |   |
| Reported as:                 |       |                                      |       |   |   |
| Cash and  equivalents        |       | $ 101,898                            |       | $ 118,615 |   |
| Restricted cash              |       | 2,296                                     |       | 2,740 |   |
|                         |       | $ 104,194                            |       | $ 121,355 |   |

 

53

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

Realized gains and lossesfrom the sale of financial instruments were not material for fiscal 2006 and2005. See Note 5 for discussion on restricted cash.

**3.**   Propertyand Equipment

Propertyand equipment consist of the following (in thousands): 

| ** **                                                        | ** ** | **Year Ended January 31,** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                        | ** ** | **2006**                                  | ** ** | **2005** | ** ** |
| Computer and  other related equipment                             |       | $   8,358                  |       | $ 11,942 |   |
| Office equipment,  leasehold improvements, furniture and fixtures |       | 10,417                                    |       | 9,742 |   |
| Software                                                          |       | 10,506                                    |       | 10,188 |   |
|                                                              |       | 29,281                                    |       | 31,872 |   |
| Less accumulated  depreciation and amortization                   |       | (25,337                                   | )          | (27,759 | ) |
| Property and  equipment, net                                      |       | $   3,944                  |       | $   4,113 |   |

 

Depreciation andamortization expense amounted to $2.7 million, $2.6 million, and $2.8 millionfor the years ended January 31, 2006, 2005, and 2004, respectively. As of January 31,2006 and 2005 property and equipment under capital leases totaled $104,000 and$6,000 with related accumulated amortization of $23,000 and $5,000,respectively.

**4.**   IntangibleAssets

Intangibleassets consist of the following (in thousands):

| ** **                     | ** ** | **Year Ended January 31,** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                  | ** ** | **2005** | ** ** |
| Developed  technology          |       | $ 6,592                              |       | $ 2,862 |   |
| Customer  relationships        |       | 5,235                                     |       | 2,535 |   |
| Less accumulated  amortization |       | 11,827                                    |       | 5,397 |   |
| Intangible  assets, net        |       | (4,214                                    | )          | (1,272 | ) |
|                           |       | $ 7,613                              |       | $ 4,125 |   |

 

Theaggregate estimated annual intangible amortization expense through January 31,2010 is as follows (in thousands):

| **Fiscal Year** | ** ** | ** ** | ** **   | **Amortization** | ** ** |
|----------------------|------------|------------|--------------|------------------|------------|
| 2007                 |       |       | 2,957        |             |       |
| 2008                 |       |       | 2,957        |             |       |
| 2009                 |       |       | 1,685        |             |       |
| 2010                 |       |       | 14           |             |       |
|                 |       |       | $ 7,613 |             |       |

 

54

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

**5.**   Acquisitions

*Rendition Networks, Inc.*

On February 3, 2005, the Company acquiredRendition Networks. This acquisition enables the Company to automate networkinfrastructure, which allows customers to manage multiple aspects of their ITinfrastructure. The transaction was valued at approximately $34.3 million, whichincluded 2.53 million shares of Company common stock valued at $16.4 million,cash of $15.0 million, assumed options and unvested restricted stock with afair value of $2.2 million and approximately $0.7 million of direct acquisitioncosts. The transaction was accounted for using the purchase method. The commonstock issued in the acquisition was valued using the average closing price ofthe Company’s common stock for the two consecutive trading days before, the dayof, and two days after the announcement of the acquisition, which was $6.97 pershare. Approximately $6.0 million of the cash paid to the Rendition Networksstockholders was withheld in escrow as security for the satisfaction ofindemnification claims by the Company under the merger agreement. Approximatelyone-half of the escrowed amount was released to the Rendition Networksshareholders on February 3, 2006, less aggregate indemnifiable damagespaid to the Company of approximately $318,000. Assuming no further indemnityclaims are made, the remaining escrowed amount will be released to certain ofthe Rendition Networks stockholders following August 3, 2006.

The results of operations of Rendition Networks wereincluded in the Company’s consolidated financial statements beginning on theeffective date of the acquisition, February 3, 2005.

In accordance with SFAS No. 141 “BusinessCombinations” (“SFAS 141”), the Company allocated the purchase price of theacquisition to the liabilities and tangible and intangible assets acquired,including in-process research and development (“IPR&D”), based on theirestimated fair values. The excess purchase price over those fair values wasrecorded as goodwill. The fair value assigned to intangible assets acquired wasbased on several factors, including valuations, estimates and assumptionsprovided by the Company. The purchase price allocation for purchase accountingpurposes is not final and may be adjusted for a period of one year from thetransaction close date based on higher than expected acquisition costs orunforeseen pre-acquisition liabilities.

Asummary of the total purchase price is as follows (in thousands):

| Common stock                                                          |   | $ 16,398 |   |
|-----------------------------------------------------------------------|--------|---------------|--------|
| Assumption of  Rendition vested options and unvested restricted stock |   | 2,162         |   |
| Cash  consideration                                                   |   | 14,831        |   |
| Direct costs of  the acquisition                                      |   | 704           |   |
| Total purchase price                                                  |   | $ 34,095 |   |

 

55

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

Thetotal purchase price has been allocated as follows (in thousands):

| Accounts  receivable, net            |   | $ 1,153  |   |
|--------------------------------------|--------|---------------|--------|
| Other current  assets                |   | 78            |   |
| Property and  equipment, net         |   | 215           |   |
| Amortizable intangible  assets:      |   |          |   |
| Customer Relationships               |   | 2,700         |   |
| Developed Technology                 |   | 3,730         |   |
| In-Process  Research and Development |   | 1,190         |   |
| Goodwill                             |   | 24,074        |   |
| Deferred stock  compensation         |   | 1,505         |   |
| Accounts payable                     |   | (22           | )      |
| Other accrued  liabilities           |   | (287          | )      |
| Deferred revenue                     |   | (241          | )      |
| Total purchase price                 |   | $ 34,095 |   |

 

*Goodwill*

Goodwill represents theexcess of the purchase price over the estimated fair value of the underlyingnet tangible and intangible assets acquired.

*Purchased identified intangible assets*

TheCompany is amortizing the intangible assets on a straight-line basis over anaverage estimated life of four years. Amortization expense for these intangibleassets was $1.6 million for the year ended January 31, 2006. Totalintangible assets subject to amortization are as follows (in thousands):

| ** **                         | ** ** | **January 31,** | ** **   |
|------------------------------------|------------|----------------------|--------------|
| ** **                         | ** ** | **2006**             | ** **   |
| Customer  relationships            |       |                 | $ 2,700 |   |   |
| Developed  technology              |       |                 | 3,730        |   |   |
| Gross intangible  assets           |       |                 | 6,430        |   |   |
| Less accumulated  amortization     |       |                 | (1,593       | ) |   |
| Identified  intangible assets, net |       |                 | $ 4,837 |   |   |

 

Theaggregate estimated annual intangible amortization expense through January 31,2010 is as follows (in thousands):

| **Fiscal Year** | ** ** | ** ** | ** **   | **Amortization** | ** ** |
|----------------------|------------|------------|--------------|------------------|------------|
| 2007                 |       |       | 1,608        |             |       |
| 2008                 |       |       | 1,608        |             |       |
| 2009                 |       |       | 1,607        |             |       |
| 2010                 |       |       | 14           |             |       |
|                 |       |       | $ 4,837 |             |       |

 

56

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

*In-process research and development*

Of the total purchaseprice, $1.2 million was allocated to IPR&D. Projects that qualify asIPR&D represent those that have not yet reached technological feasibilityand for which no future alternative uses exist. The charge of $1.2 million forIPR&D was expensed in the Company’s operating results for the year ended January 31,2006.

*Deferred revenue*

Of the total purchaseprice, approximately $200,000 was allocated to deferred revenue. Deferredrevenue represents the fair value, based on the present value of estimatedfuture cash flows, of fulfilling maintenance obligations under customercontracts assumed in the Rendition Networks acquisition.

*Pro forma results*

The unaudited pro forma financial information belowpresents the combined results of operations of the Company and RenditionNetworks as if the acquisition had occurred as of the beginning of the earliestperiod presented. Rendition Networks’ operating results have been included inthe Company’s operating results since the date of acquisition, February 3,2005. The operating results for the period of February 1, 2005 to February 2,2005 were not included in the pro forma results for the year ended January 31,2006 because they are not materially different than the Company’s reportedhistorical consolidated operating results for the same periods. The unauditedpro forma financial information for the year ended January 31, 2005 wasderived from the Company’s condensed consolidated statements of operations forthe year ended January 31, 2005 and Rendition Networks’ unauditedstatements of operations for the year ended December 31, 2004. Theunaudited pro forma basic and diluted net loss per share computations are basedupon the weighted average outstanding common stock of the Company during the periodspresented, plus the number of shares of the Company’s common stock issued tocomplete the acquisition of Rendition Networks as if the acquisition hadoccurred as of the beginning of the earliest period presented. The pro formafinancial information excludes charges for acquired IPR&D. The unauditedpro forma financial information is not intended to represent or be indicativeof the consolidated results of operations or financial condition that theCompany would have reported had the acquisition been completed as of the datespresented and should not be taken as representative of the future consolidatedresults of operations.

Unauditedpro forma financial information is as follows (in thousands, except per shareamounts):

| ** **                                     | ** ** | **Year ended January 31,** | ** **               |
|------------------------------------------------|------------|-------------------------------------------|--------------------------|
| ** **                                     | ** ** | **2005**                                  | ** **               |
| Net revenue                                    |       |                                      | $ 39,633            |   |   |
| Net income (loss)                              |       |                                      | $ (17,366           | ) |   |
| Basic and diluted  net income (loss) per share |       |                                      | $   (0.20 | ) |   |

 

**6.**   Commitments

Rent expense, net of sublease income, was $2.7million, $2.3 million and $1.0 million for the years ended January 31,2006, 2005, and 2004, respectively. The Company leases approximately 75,000square feet in Sunnyvale, California for its corporate headquarters, under alease expiring in 2010, of which it is subleasing approximately 25,000 squarefeet to EDS through August 2006. A portion of the lease was restructuredin the August 2002 restructuring. The Company issued a letter of credit inconnection with this lease, which requires the Company to hold approximately$2.3 million of restricted cash with the issuer 

57

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

of the letter of credit ofcash on deposit. Accordingly, this amount is included in restricted cash, along-term asset, on the accompanying consolidated balance sheets.

Futurepayments under all noncancelable leases entered into as of January 31,2006 are as follows (in thousands):

| **Years ending January 31,** | ** ** | ** ** | ** ** | **Capital  Leases** | ** ** | **Operating  Leases** | ** **    |
|---------------------------------------------|------------|------------|------------|---------------------|------------|-----------------------|---------------|
| 2007                                        |       |       | $ 36  |                |       |                  | $ 2,775  |   |   |
| 2008                                        |       |       | 36         |                |       |                  | 2,440         |   |   |
| 2009                                        |       |       | 36         |                |       |                  | 2,339         |   |   |
| 2010                                        |       |       | 35         |                |       |                  | 2,290         |   |   |
| 2011                                        |       |       | —     |                |       |                  | 1,104         |   |   |
| Thereafter                                  |       |       | —     |                |       |                  | 42            |   |   |
| Total minimum payments                      |       |       | $ 143 |                |       |                  | $ 10,990 |   |   |
| Amount representing interest                |       |       | (55        | )                   |       |                  |          |   |   |
| Present value of minimum payments           |       |       | 88         |                |       |                  |          |   |   |
| Less current portion                        |       |       | (14        | )                   |       |                  |          |   |   |
| Long term portion                           |       |       | $ 74  |                |       |                  |          |   |   |

 

Future payments underoperating leases are shown net of approximately $222,000 due to the Companyunder noncancelable subleases through August 2006.

**7.**   RestructuringCosts

In August 2002, the Company announced arestructuring program in connection with the closing of the sale of its ManagedServices Business to EDS. The restructuring program was accounted for under theprovisions of Statement of Financial Accounting Standards No. 146, “Accountingfor Costs Associated with Exit or Disposal Activities,” (“SFAS 146”). Therestructuring program included a provision for the resulting excess facilitieslocated in Sunnyvale, California, and a provision for excess and obsoleteproperty and equipment. The lease payments on excess facilities were based onmanagement’s estimates of its ability to sublease excess facilities based onknown prevailing real estate market conditions at that time. As a result, theCompany recorded restructuring costs of $13.3 million in the quarter ended October 31,2002.

In August 2003, the Company entered into anagreement to amend the facility lease of its corporate headquarters, portionsof which were idle and included in the August 2002 restructuring program.Pursuant to the agreement, the Company renegotiated its lease payments and paidthe lessor approximately $7.4 million. This resulted in a reduction of itsrestructuring liability related to the sale of its Managed Services Business ofapproximately $2.2 million and a recovery of approximately $145,000 resultingfrom the adjustment to the present value of the remaining payments included inthe original restructuring charge. The remainder of the payment was accountedfor as prepaid rent and will be amortized to operating expense through May 2010,the end of the lease term.

In May 2004, the Company amended its agreementwith its subtenant with respect to the Company’s facility located in Sunnyvale,California. Pursuant to the amendment, the term of the sublease was 

58

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

extended to August 2006,resulting in additional probable future sublease payments. As a result, theCompany revised its estimates of the fair value (computed as the revisedpresent value of the future net lease payments on vacated leased facilities) ofits restructuring liability, resulting in a reduction to the recordedrestructuring liability of approximately $436,000. In addition, the Company recordeda recovery for excess facilities of approximately $313,000 during the fiscalyear ended January 31, 2005 due to sublease payments received. The Companyalso recorded a recovery due to the settlement of a sublease agreement ofapproximately $190,000. The sublease payments were not included in thecalculation of the original 2002 restructuring charge due to the uncertainty ofthe financial condition of the subtenant. The Company also recorded a recoveryof approximately $146,000 for property taxes, due to a change in estimate offuture property tax payments as property values had decreased. Property taxeshad been included in the original restructuring calculation.

Asummary of the restructuring charges is outlined as follows (in millions):

| ** **                            | ** ** | **Facilities** | ** **  | **Disposal of  Property and  Equipment** | ** ** | **Total** | ** **          |
|---------------------------------------|------------|----------------|-------------|----------------------------------------------------|------------|-----------|---------------------|
| Total Charge                          |       |           | $ 12.1 |                                               |       |      | $ 1.2          |   |   | $ 13.3 |   |
| Noncash Charges                       |       |           | —      |                                               |       |      | (1.2                | ) |   | (1.2 | ) |
| Cash Payments, net of sublease income |       |           | (3.2        | )                                                  |       |      | —              |   |   | (3.2 | ) |
| Balance at January 31, 2003      |       |           | 8.9         |                                               |       |      | —              |   |   | 8.9 |   |
| Adjustments                           |       |           | 1.1         |                                               |       |      | (0.1                | ) |   | 1.0 |   |
| Noncash Charges                       |       |           | —      |                                               |       |      | 0.1                 |   |   | 0.1 |   |
| Cash Payments, net of sublease income |       |           | (7.4        | )                                                  |       |      | —              |   |   | (7.4 | ) |
| Balance at January 31, 2004      |       |           | 2.6         |                                               |       |      | —              |   |   | 2.6 |   |
| Adjustments                           |       |           | (0.9        | )                                                  |       |      | —              |   |   | (0.9 | ) |
| Noncash Charges                       |       |           | 0.4         |                                               |       |      | —              |   |   | 0.4 |   |
| Cash Payments, net of sublease income |       |           | (0.4        | )                                                  |       |      | —              |   |   | (0.4 | ) |
| Balance at January 31, 2005      |       |           | 1.7         |                                               |       |      | —              |   |   | 1.7 |   |
| Cash Payments, net of sublease income |       |           | (0.2        | )                                                  |       |      | —              |   |   | (0.2 | ) |
| Balance at January 31, 2006      |       |           | $ 1.5  |                                               |       |      | $  — |   |   | $ 1.5 |   |

 

Amounts related to theremaining accrual for excess facilities will be paid over the respective leaseterms through 2010.

**8.**   Transactionswith EDS

*Managed Services Business*

On August 15, 2002, the Company received $63.5million in cash proceeds from the sale of its Managed Services Business to EDS.The sale included the disposal of $31.6 million of assets, including $19.6million of property and equipment, $10.3 million of accounts receivable, $1.7million of other current assets and $0.05 million of other assets, and$21.4 million of liabilities, including $2.6 million of accounts payable, $5.7million of accrued liabilities, $11.2 million of deferred revenue and $1.9million of capital leases. In addition, the Company incurred transaction costsof $2.3 million and recorded a deferred gain of $333,000 for the maintenance ofsoftware for customers transferred to EDS. The Company recognized a 

59

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

gain on the sale of theassets and liabilities of its Managed Services Business in the amount of $50.7million in the three-month period ended October 31, 2002.

The Company used its proprietary Opsware automationtechnology in the Managed Services Business, and has since integrated thistechnology into its software products. As a result, the operations and cashflows of the Managed Services Business could not clearly be distinguished fromthe Software Business, either operationally or for financial reportingpurposes. Therefore, the Managed Services Business was not considered adiscontinued operation in accordance with Statement of Financial AccountingStandard No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets” (“SFAS 144”). The Company has accounted for the sale of assets andliabilities related to the Managed Services Business as a nonoperating gain inthe Statement of Operations. The Company retained title to all of itsproprietary software products.

As part of the purchaseprice, the Company granted EDS a license to use its software products toservice those customers that were transferred to EDS, and agreed to providecertain maintenance services with respect to the license, including desktopsupport and software updates and enhancements on an if and when availablebasis. The Company recorded a deferred gain of $388,000 for the maintenance ofsoftware for customers transferred to EDS, all of which was recognized as ofthe fiscal year ended January 31, 2004.

*Original Software License and Maintenance Agreement*

At the time that it entered into the asset purchaseagreement, the Company also entered into a separate software license andmaintenance agreement with EDS (“the EDS License”) pursuant to which theCompany granted EDS a license to use the Company’s software products. Under theEDS License, EDS agreed to pay the Company a minimum aggregate license andmaintenance fee of $52.0 million over a term of three years beginning in August 2002.EDS’ payment obligation was subject to the Company’s development and deliveryof specified software product features and functions, which the Companydelivered to EDS and for which the Company received acceptance from EDS in April 2003.

At the time the EDSLicense was signed, the Company determined it had sufficient objective andreliable evidence of fair value for both the value of the Managed ServicesBusiness sold to EDS and the separate EDS license and maintenance agreementbased upon the renewal rates stated in the EDS License. The Company furtherdetermined that the $52.0 million EDS License entailed a separate earningsprocess and therefore did not affect the quality of use or the $63.5 millionvalue paid by EDS for the Managed Services Business. Because the EDS Licensecontained extended payment terms and the Company had not established VSOE offair value for its maintenance, the Company has been recognizing the relatedlicense fees when the monthly minimum commitments become due, but only afterthe Company delivered all specified features and functions in April 2003.Payments received prior to delivery of the specified features and functions arebeing amortized as revenue by the Company on a straight-line basis over theremaining term of the contract. The Company has allocated 20% of the totallicense fees under the EDS License to maintenance revenue. The allocation isconsistent with the pricing of license and maintenance agreements with othercustomers. The payments from EDS License were equal to the greater of themonthly minimum commitment or the actual monthly fees, based upon a definedlicense fee per device per month. Under the EDS License, EDS was required topay the Company monthly minimum commitment fees of $333,000 for the first sixmonths of the initial term (which commenced on August 16, 2002), $1.3million for the next twelve months, $1.7 million for the following six months,and $2.0 million per month thereafter until the completion of the initialthree-year term which occurred in August 2005.

60

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

*Amendments to the EDS License*

In August 2004, the Company entered into anamendment to the EDS License. Pursuant to the amendment, (1) the term ofthe original license and maintenance agreement was extended throughMarch 2008, (2) EDS paid the Company $2.0 million per month fromAugust 15, 2004 through August 14, 2005 and is required to pay $1.6million per month thereafter through March 2008, (3) EDS’ monthlypayments are no longer dependent upon the number of devices being managed bythe software products, (4) EDS receives rights to license all futureproducts released by the Company, including ONAS and OAMS, when and ifavailable for commercial release, for no additional fee, (5) the Companyagreed to provide certain third-party equipment and software for EDS’ use inconnection with the software products, and (6) dedicated Opsware supportpersonnel will continue to be provided to EDS for the duration of the extendedterm. Following the extended term, the agreement will automatically renew at afee of $1.6 million per month for five successive one-year terms unlessterminated in advance by EDS. Revenue under the amended arrangement willcontinue to be recognized ratably, which is the lesser of ratable or whenmonthly payments become due over the extended term of the amended agreement.

In October 2004, theCompany entered into another amendment of the EDS License pursuant to which theCompany provided EDS with $4.0 million for the purchase of computer equipmentrequired to support the planned deployment of the software products within EDS’facilities. As a result of this amendment, the Company was released from anyfurther obligation to provide any equipment to EDS. Accordingly, the amountspaid to EDS pursuant to the amendment have been charged to cost of sales as acontract acquisition cost.

**9.**   Stockholders’Equity

*Preferred Stock*

The Company is authorizedto issue up to 15 million shares of undesignated preferred stock, none of whichhas been issued as of January 31, 2006.

*Common Stock*

On December 15, 2004,the Company completed the sale of 10 million shares of its common stock at aprice of $6.40 per share to institutional investors for net proceeds of $61.8million. The shares were registered pursuant to a shelf registration statementthat was declared effective by the Securities and Exchange Commission on June 8,2004.

*Common Stock Repurchases*

In November 2002, theCompany’s Board of Directors approved the repurchase of up to $5.0 millionworth of the Company’s common stock. The term of the repurchase program expiredon December 31, 2005. Pursuant to the repurchase program, the Companyrepurchased 52,000 shares at prices ranging from $1.77 to $1.98, for anaggregate price of $98,000, in the open market pursuant to the repurchaseprogram. An additional 16,000 shares at prices ranging from $0.74 to $1.78, foran aggregate of $20,000, were repurchased from employees due to default oftheir stockholder notes during the period ended January 31, 2003.Repurchases during fiscal years 2004, and 2005 were not material. There were norepurchases during fiscal year 2006.

61

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

*Stock Option Plan*

The Company’s 2000 Incentive Stock Plan provides forthe grant of incentive stock options to the Company’s employees andnon-qualified stock options and stock purchase rights to its employees,directors and consultants. A total of 12.5 million shares of the Company’scommon stock plus any unissued but reserved shares under the 2000 IncentiveStock Plan as of the effective date of the initial public offering and anyshares returned to such plans were initially reserved for issuance under the2000 Incentive Stock Plan. The shares may be authorized, but unissued, orreacquired common stock.

The number of shares reserved for issuance under theCompany’s 2000 Incentive Stock Plan provides for annual increases on the firstday of the Company’s fiscal year beginning in 2003 by an amount equal to thelesser of: (i) 8% of the outstanding shares of the Company’s common stockon the first day of the year; such percentage decreasing to 6% of the outstandingshares of the Company’s common stock beginning after 2007, (ii) 9.0million shares or (iii) an amount determined by the Company’s Board ofDirectors. In 2006, 2005 and 2004, an additional 4.0 million, 3.8 million and3.3 million shares, respectively, were made available pursuant to the annualincrease provisions.

The Director OptionProgram is part of the Company’s 2000 Incentive Stock Plan and provides forformulaic and periodic grants of non-qualified stock options to the Company’snon-employee directors.

*2000 Employee Stock Purchase Plan*

Under the 2000 Employee Stock Purchase Plan (thePurchase Plan) a total of 1.5 million shares of the Company’s common stock wereinitially made available for sale. In addition, the Purchase Plan provides forannual increases in the number of shares available for issuance under thePurchase Plan on the first day of the Company’s fiscal year beginning in 2003in an amount equal to the lesser of: (i) 5.0 million shares, (ii) 2%of the outstanding shares of the Company’s common stock on that date, or (iii) anamount determined by the Company’s Board of Directors. In 2006, 2005, and 2004,an additional 1.0 million, 1.0 million and 1.6 million shares, respectively,were made available pursuant to the annual increase provisions. The Company’sBoard of Directors or a committee of its Board administers the Purchase Plan.

The Purchase Plan contains consecutive, overlapping 24-monthoffering periods. Each offering period includes four six-month purchaseperiods.

The price of common stockthat may be purchased under the Purchase Plan is 85% of the lower of the fairmarket value of the Company’s common stock at the beginning of an offeringperiod or after a purchase period ends. If the fair market value at the end ofa purchase period is less than the fair market value at the beginning of theoffering period, participants will be withdrawn from the current offeringperiod following their purchase of shares on the purchase date and will bere-enrolled in the immediately following offering period. The Company hadissued 2.9 million shares under the Purchase Plan as of January 31, 2006.As of January 31, 2006, the Company had 4.8 million shares reserved forfuture issuance under the Purchase Plan.

*Stock-Based Compensation*

Under the Company’s stock option plans, options orstock purchase rights for common stock may be granted to eligible participants,pursuant to actions by the Board of Directors. Options granted are eitherincentive stock options or non-qualified stock options and are exercisablewithin the times or upon the events determined by the Board of Directors asspecified in each agreement. Options and stock purchase 

62

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

rights vest over a periodof time as determined by the Board of Directors and have a maximum term of tenyears. Options and stock purchase rights generally vest with respect to 25% ofthe shares one year after the option or stock purchase right grant date and theremainder ratably over the following three years.

Thefollowing table summarizes all stock option plan activity:

| ** **                               | ** ** | ** **    | ** ** | **Options and Stock** | ** ** |
|------------------------------------------|------------|---------------|------------|---------------------------------|------------|
| ** **                               | ** ** | ** **    | ** ** | **Purchase Rights**        | ** ** |
| ** **                               | ** ** | ** **    | ** ** | **Outstanding**                 | ** ** |
| ** **                               | ** ** | ** **    | ** ** | ** **                      | ** ** | **Weighted** | ** ** |
| ** **                               | ** ** | ** **    | ** ** | ** **                      | ** ** | **Average** | ** ** |
| ** **                               | ** ** | **Shares**    | ** ** | ** **                      | ** ** | **Exercise** | ** ** |
| ** **                               | ** ** | **Available** | ** ** | **Shares**                      | ** ** | **Price** | ** ** |
| Balance at  January 31, 2003        |       | 9,801,723     |       | 13,529,597                      |       |   | $ | 2.86 |   |   |
| Shares authorized                        |       | 3,930,558     |       | —                          |       |   | — |   |   |
| Granted                                  |       | (2,391,020    | )          | 2,391,020                       |       |   | 4.52 |   |   |
| Exercised                                |       | —        |       | (2,378,522                      | )          |   | 2.25 |   |   |
| Restricted stock awards                  |       | (105,000      | )          | —                          |       |   | 0.001 |   |   |
| Repurchases                              |       | 52,576        |       | —                          |       |   | 0.52 |   |   |
| Cancellations                            |       | 1,564,858     |       | (1,564,858                      | )          |   | 5.13 |   |   |
| Balance at January 31, 2004         |       | 12,853,695    |       | 11,977,237                      |       |   | 3.05 |   |   |
| Shares authorized                        |       | 3,261,468     |       | —                          |       |   | — |   |   |
| Granted                                  |       | (4,718,025    | )          | 4,718,025                       |       |   | 7.30 |   |   |
| Exercised                                |       | —        |       | (1,902,734                      | )          |   | 2.17 |   |   |
| Repurchases                              |       | 16,980        |       | —                          |       |   | 0.80 |   |   |
| Cancellations                            |       | 922,791       |       | (922,791                        | )          |   | 3.80 |   |   |
| Balance at January 31, 2005         |       | 12,336,909    |       | 13,869,737                      |       |   | 4.57 |   |   |
| Shares authorized                        |       | 3,810,157     |       | —                          |       |   | — |   |   |
| Options assummed in Rendtion acquisition |       | —        |       | 137,089                         |       |   | 1.29 |   |   |
| Granted                                  |       | (4,545,778    | )          | 4,545,778                       |       |   | 5.42 |   |   |
| Exercised                                |       | —        |       | (887,183                        | )          |   | 1.33 |   |   |
| Restricted stock awards                  |       | (400,000      | )          | —                          |       |   | 0.001 |   |   |
| Cancellations                            |       | 729,323       |       | (748,110                        | )          |   | 6.13 |   |   |
| Balance at January 31, 2006         |       | 11,930,611    |       | 16,917,311                      |       |   | 4.88 |   |   |
| Exercisable at end of period             |       | —        |       | 9,305,495                       |       |   | $ | 4.22 |   |   |

 

In December 2005, the Company issued awards of200,000 shares of restricted stock to each of two executive officers. Theissuance resulted in an aggregate non-cash compensation charge of approximately$2.8 million. The expense is being amortized equally to research anddevelopment and sales and marketing over the four-year vesting period of thestock awards. The Company recognized approximately $328,000 of stockcompensation expense using the graded vesting method in connection with theseawards during the fiscal year ended January 31, 2006.

In August 2003, the Company issued an award of105,000 shares of restricted stock to an executive officer. The issuanceresulted in a non-cash compensation charge of approximately $0.6 million. Theexpense is being amortized to sales and marketing over the three-year vestingperiod of the stock award. 

63

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

The Company recognizedapproximately $93,000, $246,000 and $236,000 of stock compensation expenseusing the graded vesting method in the fiscal years ended January 31,2006, 2005 and 2004, respectively, with respect to this award.

In June 2002, at the request of its President andChief Executive Officer, the Company cancelled an option held by him topurchase 500,000 shares of the Company’s common stock at an exercise price of$18.00 per share. The cancellation of this option resulted in variableaccounting expense with respect to the issuance of another option to purchase500,000 shares with an exercise price of $3.68 held by him. Variable accountingrequires recognition of compensation expense, adjusted for increases ordecreases in intrinsic value, until the options are exercised, forfeited orexpire. The Company recognized approximately $395,000, ($730,000) and $2.2million of stock compensation expense (recovery) with respect to this optionduring the fiscal years ended January 31, 2006, 2005, and 2004,respectively.

During the fiscal year ended January 31, 2004,the Company extended the exercise period from 90 days to 1 year for stockoptions held by certain terminated employees. The modification of the optionsresulted in the recognition of compensation expense upon termination,calculated as the difference between the intrinsic value on the date ofmodification and the exercise price at the date of termination. The Companyrecognized approximately $292,000 of stock compensation expense with respect tothese modifications during the fiscal year ended January 31, 2004.

Thefollowing table summarizes significant ranges of outstanding and exercisableoptions at January 31, 2006:

| ** **                   | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                   | ** ** | ** **                   | ** ** | ** **                   | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                   | ** ** | ** **                   | ** ** | **Weighted Average**    | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Ranges of**           | ** ** | **Number**                   | ** ** | **Remaining**                | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Prices**     | ** ** | **of Shares**           | ** ** | **Contractual Life**    | ** ** | **Price** | ** ** | **of Shares** | ** ** | **Price** | ** ** |
| 0.26 –   1.49 |       | 2,060,813                    |       |                         | 6.39       |   |   |   | $ | 0.95 |   |   | 1,685,761 |   |   | $ | 1.02 |   |   |
| 1.60 –   3.60 |       | 2,335,458                    |       |                         | 6.42       |   |   |   | 2.16 |   |   | 1,972,561 |   |   | 2.18 |   |   |
| 3.68 –   4.56 |       | 2,312,356                    |       |                         | 6.14       |   |   |   | 3.77 |   |   | 2,098,441 |   |   | 3.72 |   |   |
| 4.66 –   5.15 |       | 2,208,495                    |       |                         | 9.20       |   |   |   | 4.98 |   |   | 169,786 |   |   | 5.04 |   |   |
| 5.16 –   5.86 |       | 2,356,363                    |       |                         | 8.86       |   |   |   | 5.67 |   |   | 648,389 |   |   | 5.66 |   |   |
| 5.92 –   7.73 |       | 2,864,744                    |       |                         | 7.93       |   |   |   | 6.69 |   |   | 1,307,569 |   |   | 6.50 |   |   |
| 7.79 – 18.00            |       | 2,779,082                    |       |                         | 7.85       |   |   |   | 8.38 |   |   | 1,422,988 |   |   | 8.64 |   |   |
|                         |       | 16,917,311                   |       |                         | 7.57       |   |   |   | $ | 4.88 |   |   | 9,305,495 |   |   | $ | 4.22 |   |   |

 

There were approximately 699,000 unvested shares ofcommon stock subject to repurchase as of January 31, 2006. Common stock issubject to repurchase upon termination of the employment of the holder of thestock if the underlying purchase right has not yet vested. Such shares aresubject to repurchase at their original issuance prices.

As discussed in Note 1,the Company applies APB 25 and related interpretations in accounting forstock-based awards issued under the Company’s option plans. As of January 31,2006, the Company has $2.6 million recorded in deferred compensation for stockpurchase rights and stock options to purchase common stock granted at exerciseprices deemed to be below the fair value of common stock. Stock-basedcompensation expense (recovery), net of $1.3 million, ($131,000), and $606,000was recognized using the graded vesting method for the years ended January 31,2006, 2005, and 2004, respectively. The Company reversed approximately $38,000,$234,000, and $819,000 from stock compensation expense related to 

64

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

employeesthat were terminated during fiscal years ended January 31, 2006, 2005, and2004, respectively. The reversals reflected previously recognized expense onstock awards for which the terminated employees had not vested in theunderlying shares. As a result, the difference between the expense initiallyrecorded under the graded vesting method and the expense that would have beenrecorded under the straight-line vesting method was required to be reversedupon termination of these employees. The Company’s policy is to use the gradedvesting method for recognizing compensation cost for fixed awards with pro ratavesting. The Company amortizes the deferred stock-based compensation on thegraded vesting method over the vesting period of the applicable stock purchaserights and stock options, generally four years. The Company recordedapproximately $1.3 million, $103,000 and $1.4 million in amortization expenseduring fiscal years ended January 31, 2006, 2005, and 2004, respectively.The graded vesting method provides for vesting of portions of the overallawards at interim dates and results in greater vesting in earlier years thanthe straight-line method. In addition, the Company reversed approximately$74,000, $7,000, and $130,000 of unamortized deferred stock compensationrelated to the terminated employees during the fiscal period ended January 31,2006, 2005, and 2004, respectively.

**10. SegmentInformation**

Statement of Financial Accounting Standards No. 131,“Disclosures about Segments of an Enterprise and Related Information,”establishes standards for reporting information about operating segments in theCompany’s financial statements. Operating segments are defined as components ofan enterprise about which separate financial information is available that isevaluated regularly by the chief operating decision maker (CODM), or decisionmaking group, in deciding how to allocate resources and in assessingperformance. The Company’s CODM is the Chief Executive Officer of the Company.During the periods ended January 31, 2006, 2005, and 2004, the Company hadonly one operating segment. However, the Company’s CODM regularly reviewsinformation about revenues by geographic region for purposes of makingoperating decisions and assessing financial performance. The Company isorganized into three geographic regions:  North America, the Europe,Middle East and Africa (EMEA) region and Asia Pacific (APAC) region. Netrevenue by customers’ geographic location is as follows (in thousands):

Netrevenues by geographic location are as follows (in thousands):

| ** **                               | ** ** | **Year Ended January 31,** | ** ** |
|------------------------------------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues  generated in the North America |       | $                                         | 54,371     |   | $ | 33,173 |   | $ | 18,050 |   |
| Revenues  generated in EMEA              |       | 2,924                                     |       | 378 |   | — |   |
| Revenues  generated in APAC              |       | 3,782                                     |       | 4,241 |   | — |   |
| Revenues as  reported (1)                |       | $                                         | 61,077     |   | $ | 37,792 |   | $ | 18,050 |   |

----

(1)          For the year endedJanuary 31, 2006, EDS accounted for 35% of the Company’s net revenues. Forthe year ended January 31, 2005, EDS and NTT Communications accounted for54% and 11% of the Company’s net revenues, respectively. For the year endedJanuary 31, 2004, EDS accounted for 83% of the Company’s net revenues. 

65

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

Long-livedassets and total assets by geographic location were as follows (in thousands):

| ** **    | ** ** | **Year Ended  January 31,** | ** ** |
|---------------|------------|---------------------------------------|------------|
| ** **    | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| North America |       | $                                     | 3,885      |   | $ | 4,076 |   |
| EMEA          |       | 57                                    |       | 33 |   |
| APAC          |       | 2                                     |       | 4 |   |
| Total         |       | $                                     | 3,944      |   | $ | 4,113 |   |

 

**11. Income Taxes**

Theprovision (benefit) for income taxes consists of the following (in thousands):

| ** **                            | ** ** | **January 31,** | ** ** |
|---------------------------------------|------------|----------------------|------------|
| ** **                            | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current:                              |       |                 |       |   |   |   |   |
| Federal                               |       | —               |       | — |   | — |   |
| State                                 |       | $                    | 64         |   | $ | 32 |   | — |   |
| Foreign                               |       | 129                  |       | 356 |   | $ | (1,435 | ) |
|                                  |       | $                    | 193        |   | $ | 388 |   | $ | (1,435 | ) |
| Deferred:                             |       |                 |       |   |   |   |   |
| Federal                               |       | —               |       | — |   | — |   |
| State                                 |       | —               |       | — |   | — |   |
| Foreign                               |       | —               |       | — |   | — |   |
|                                  |       | —               |       | — |   | — |   |
| Provision (benefit) for  income taxes |       | $                    | 193        |   | $ | 388 |   | $ | (1,435 | ) |

 

TheCompany’s provision for income taxes differs from the amount computed byapplying the federal statutory rate to income before taxes as follows (inthousands):

| ** **                                        | ** ** | **January 31,** | ** ** |
|---------------------------------------------------|------------|----------------------|------------|
| ** **                                        | ** ** | **2006**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Federal statutory  rate                           |       | $                    | (4,819     | ) | $ | (1,639 | ) | $ | (3,290 | ) |
| Unbenefited net  operating losses                 |       | 4,819                |       | 1,639 |   | 3,290 |   |
| State taxes                                       |       | 64                   |       | 32 |   | — |   |
| Foreign tax on  sale of Managed Services Business |       | —               |       | — |   | (1,500 | ) |
| Foreign taxes                                     |       | 129                  |       | 356 |   | 65 |   |
| Provision  (benefit) for income taxes             |       | $                    | 193        |   | $ | 388 |   | $ | (1,435 | ) |

 

Foreign pretax income was insignificant for the yearsended January 31, 2006, 2005, and 2004. In the year ended January 31,2004, the Company concluded a foreign jurisdictional tax examination coveringthe Managed Services Business sale that resulted in the reversal of an incometax provision of $1.5 million.

66

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

Deferredincome taxes reflect the net tax effects of net operating losses and tax creditcarryovers and temporary differences between the carrying amounts of assets andliabilities for financial reporting purposes and the amounts used for incometax purposes. Significant components of the Company’s deferred tax assets areas follows (in thousands):

| ** **                           | ** ** | **Year Ended January 31,** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                  | ** ** | **2005** | ** ** |
| Deferred tax  assets                 |       |                                      |       |   |   |
| Net operating loss carryforwards     |       | $                                         | 136,800    |   | $ | 115,643 |   |
| Deferred revenue                     |       | 736                                       |       | 4,197 |   |
| Non-deductible reserves and accruals |       | 2,668                                     |       | 3,763 |   |
| Other                                |       | 4,612                                     |       | 4,695 |   |
| Total deferred tax assets            |       | 144,816                                   |       | 128,298 |   |
| Valuation allowance                  |       | (141,771                                  | )          | (126,648 | ) |
| Deferred tax liability:              |       |                                      |       |   |   |
| Purchased intangibles                |       | (3,045                                    | )          | (1,650 | ) |
| Net deferred tax  assets             |       | $                                         | —     |   | $ | — |   |

 

Realization of deferred tax assets is dependent uponfuture earnings, if any, the timing and amount of which are uncertain.Accordingly, the net deferred tax assets have been fully offset by a valuationallowance. The valuation allowance increased by approximately $15.1 millionduring the year ended January 31, 2006.

As of January 31, 2006, the Company had netoperating loss carryforwards for federal income tax purposes of approximately$364.5 million, which expire in the years 2006 through 2026, and federalresearch and development tax credits of approximately $1.5 million, whichexpire in the years 2019 through 2026. In addition, the Company had state netoperating loss carryforwards of approximately $214.8 million, which expire inthe years 2006 through 2016, and state research and development credits ofapproximately $1.6 million, which do not expire.

Utilization of the Company’snet operating loss and tax credit carryforwards may be subject to a substantialannual limitation due to the ownership change limitations provided by theInternal Revenue Code and similar state provisions. Such an annual limitationmay result in the expiration of the net operating loss and tax creditcarryforwards before utilization.

67

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

**12. Net Loss PerShare**

TheCompany follows the provisions of Statement of Financial Accounting Standards No. 128,“Earnings Per Share” (“SFAS 128”). Basic and diluted net loss per share iscomputed using the weighted average number of common shares outstanding duringthe period less shares subject to repurchase. Shares subject to repurchase arenot included in the computation of basic consolidated net loss per share untilthe time-based vesting restrictions have lapsed and are not included in thecomputation of diluted net loss per share because their effect would beantidilutive. Diluted net loss per share excludes potential common sharesoutstanding as their effect is antidilutive, and also excludes shares subjectto repurchase shares. The following table presents the calculation of basic anddiluted net loss per share (in thousands, except per share amounts):

| ** **                                          | ** ** | **Year Ended January 31,** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator:                                          |       |                                      |       |   |   |   |   |
| Net loss                                            |       | $                                         | (14,751    | ) | $ | (7,246 | ) | $ | (8,409 | ) |
| Denominator:                                        |       |                                      |       |   |   |   |   |
| Weighted average common shares outstanding          |       | 98,629                                    |       | 85,404 |   | 80,027 |   |
| Less weighted average shares subject to repurchase  |       | (514                                      | )          | (671 | ) | (1,410 | ) |
| Shares used in basic and diluted net loss per share |       | 98,115                                    |       | 84,733 |   | 78,617 |   |
| Basic and diluted net loss per share                |       | $                                         | (0.15      | ) | $ | (0.09 | ) | $ | (0.11 | ) |

 

For the years ended January 31,2006, 2005, and 2004, the Company excluded 7.3 million, 12.8 million, and 11.5million shares of common stock, respectively, in the computation of diluted netloss per share. The Company has excluded the impact of all shares of common stocksubject to repurchase, and stock options from the calculation of historicaldiluted consolidated net loss per common share because all such securities areantidilutive for these periods.

**13. Guarantees andIndemnifications**

The Company from time to time in the ordinary courseof its business enters into contractual arrangements with third parties underwhich the Company has agreed to defend, indemnify and hold the third partyharmless from and against certain losses. These arrangements may limit the timewithin which an indemnification claim can be made, the type of the claim andthe total amount that the Company can be required to pay in connection with theindemnification obligation. For example, the Company has entered into certainreal estate leases that require it to indemnify property owners against certainenvironmental claims. However, the Company only engages in the development,marketing and distribution of software, and has never been subject to anyenvironmental related claim. The Company is also responsible for certain costsof restoring leased premises to their original condition. In addition, theCompany has entered into indemnification agreements with its directors andofficers, and the Company’s bylaws contain indemnification obligations in favorof the Company’s directors, officers and agents.

68

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

**14. Settlements**

In May 2004, the Company and Qwest entered into asettlement of the arbitration of Qwest’s claim that the Company breached theamended and restated ethernet collocation internet access service agreement,amended and restated reseller agreement and confidentiality agreement that theCompany entered into with Qwest in fiscal 2002. Prior to this settlement, theCompany accrued a liability related to its Managed Services Business in theamount of $6.8 million in connection with Qwest’s claim. In connection with thesettlement, the Company paid $2.0 million to Qwest and transferred ownership ofcertain items of equipment to Qwest, with an aggregate fair market value ofapproximately $170,000. In addition, the Company and Qwest reserved from the settlementany claims either party may have under the guaranteed term agreement betweenthe parties, up to an aggregate maximum of $300,000. As a result of thesettlement, the Company reversed approximately $4.3 million of previouslyaccrued data center facility costs and recognized a gain on sale of assets andliabilities from the Managed Services Business in the consolidated statementsof operations for the year ended January 31, 2005.

During the year ended January 31, 2004, theCompany reached final resolution with a former Managed Services Business vendorrelated to certain liabilities associated with the Managed Services Business.These liabilities had been previously accrued by the Company and the resolutionof such liabilities resulted in an additional gain on the sale of the assetsand liabilities of the Managed Services Business to EDS of approximately $1.1million.

Additionally, during the year ended January 31,2004, the Company reached final resolution related to certain liabilitiesassociated with the Managed Services Business. These liabilities had beenpreviously accrued for by the Company and the resolution of such liabilitiesresulted in a recovery to other income (expense) of approximately $850,000during the year ended January 31, 2004.

Also, during the yearended January 31, 2004, the Company entered into a settlement agreementwith Atriax, a former Managed Services Business customer, pursuant to whichAtriax paid the Company $2.4 million. The Company recognized this settlementpayment as other income during the year ended January 31, 2004.

**15. Legal Proceedings**

The Company is notcurrently involved in any material legal proceedings. In the future, theCompany may be subject to legal proceedings. Any litigation, even if notsuccessful against the Company, could result in substantial costs and divertmanagement’s attention and other resources away from the operation of itsbusiness.

**16. Subsequent Event**

**In February 2006,the Company entered into a worldwide distribution agreement with Cisco  to distribute the Company’s ONAS productunder the Cisco Systems brand name. The Company does not expect to recognizesignificant revenue under this agreement during fiscal 2007, but expects thatthis agreement will contribute meaningfully to its fiscal 2008 revenue. Thethree year term of this agreement will commence in May 2006 and renewsautomatically thereafter for one year terms, although it may be terminatedearlier in certain circumstances.**

69

----

**OPSWARE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)**

**17. Quarterly Results(Unaudited)**

Thetable below sets forth selected supplementary unaudited financial data for eachquarter of the last two years. (in thousands, except per share amounts)

| ** **                                                                               | ** ** | **First**               | ** ** | **Second**    | ** ** | **Third**     | ** ** | **Fourth**    | ** ** |
|------------------------------------------------------------------------------------------|------------|-------------------------|------------|---------------|------------|---------------|------------|---------------|------------|
| ** **                                                                               | ** ** | **Quarter**             | ** ** | **Quarter**   | ** ** | **Quarter**   | ** ** | **Quarter**   | ** ** |
| **Year  ended January 31, 2006**                                                    | ** ** | ** **              | ** ** | ** **    | ** ** | ** **    | ** ** | ** **    | ** ** |
| Net revenues                                                                             |       | $ 12,615           |       | $ 14,123 |       | $ 15,747 |       | $ 18,592 |       |
| Cost of revenues                                                                         |       | 3,019                   |       | 3,480         |       | 3,534         |       | 4,188         |       |
| Restructuring  charges, net                                                              |       | (18                     | )          | —        |       | —        |       | —        |       |
| Amortization of  deferred stock compensation                                             |       | 415                     |       | 324           |       | 267           |       | 276           |       |
| Loss from  operations                                                                    |       | (5,740                  | )          | (4,589        | )          | (3,225        | )          | (4,101        | )          |
| Loss on sale of  assets and liabilities related to Managed Services Business             |       | (33                     | )          | (11           | )          | (12           | )          | (13           | )          |
| Net loss                                                                                 |       | (5,129                  | )          | (3,924        | )          | (2,380        | )          | (3,318        | )          |
| Basic and diluted  net loss per share                                                    |       | $ (0.05            | )          | $ (0.04  | )          | $ (0.02  | )          | $ (0.03  | )          |
| **Year ended January 31, 2005**                                                     |       |                    |       |          |       |          |       |          |       |
| Net revenues                                                                             |       | $ 7,338            |       | $ 8,641  |       | $ 10,230 |       | $ 11,583 |       |
| Cost of revenues                                                                         |       | 1,713                   |       | 2,049         |       | 6,312         | (1)        | 2,548         |       |
| Restructuring  charges, net                                                              |       | (150                    | )          | (854          | )          | (54           | )          | (27           | )          |
| Amortization  (reversal) of deferred stock compensation                                  |       | (122                    | )          | (10           | )          | 1             |       | —        |       |
| Loss from  operations                                                                    |       | (2,023                  | )          | (991          | )          | (6,507        | )          | (2,405        | )          |
| Gain (loss) on  sale of assets and liabilities related to Managed Services Business |       | 4,280                   | (2)        | 58            |       | —        |       | (173          | )          |
| Net income (loss)                                                                        |       | 2,017                   |       | (813          | )          | (6,315        | )          | (2,135        | )          |
| Basic and diluted  net income (loss) per share                                           |       | $   0.02 |       | $ (0.01  | )          | $ (0.08  | )          | $ (0.02  | )          |

----

(1)          This amount includes a$4.0 million one-time payment made to EDS in October 2004, pursuant to theterms of our amended license and maintenance agreement effective August 2004,to fund EDS’ purchase of equipment required to support the deployment of oursoftware products in its facilities.

(2)          This amount includes a$4.3 million reversal of previously accrued data center facility costs relatingto the Company’s Managed Services Business in connection with the Company’ssettlement of litigation with Qwest Communications.

Basic and diluted net loss per share are computedindependently for each of the quarters presented. Therefore, the sum of thequarters may not be equal to the full year net loss per share amounts.

70

----

**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 

None.

**ITEM 9A.**        CONTROLSAND PROCEDURES 

*ConclusionsRegarding Disclosure Controls and Procedures.**  *Disclosure controls and proceduresare controls and other procedures designed to ensure that information requiredto be disclosed in our reports filed under the Securities Exchange Act of 1934is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms and that such information isaccumulated and communicated to our management, including our chief executiveofficer and chief financial officer, as appropriate to allow timely decisionsregarding required disclosure.

Under the supervision and with the participation ofour management, including our chief executive officer and chief financialofficer, we conducted an evaluation of the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934). Based on thisevaluation, our chief executive officer and chief financial officer, as of January 31,2006, concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934) are effectiveto provide reasonable assurance that the objectives for which they are designedwill be achieved.

*Management’sReport on Internal Control Over Financial Reporting.**  *Our management is responsible forestablishing and maintaining adequate internal control over financial reportingto provide reasonable assurance regarding the reliability of our financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. Internal control overfinancial reporting includes those policies and procedures that (i) pertainto the maintenance of records that in reasonable detail accurately and fairlyreflect the transactions and dispositions of the assets of the company; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (iii) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use or dispositionof the company’s assets that could have a material effect on the financialstatements.

Management assessed our internal control overfinancial reporting as of January 31, 2006, the end of our fiscal year.Management based its assessment on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission. Management’s assessment included an evaluation of such elements asthe design and operating effectiveness of key financial reporting controls,process documentation, accounting policies, and our overall controlenvironment.

Based on its assessment, management has concluded thatour internal control over financial reporting was effective as of the end ofthe fiscal year to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalreporting purposes in accordance with U.S. generally accepted accountingprinciples. We reviewed the results of management’s assessment with the AuditCommittee of our Board of Directors.

Our independent registered public accounting firm,Ernst & Young LLP, audited management’s assessment and independentlyassessed the effectiveness of the company’s internal control over financialreporting. Ernst & Young LLP has issued an attestation report onmanagement’s assessment, which is included at the end of Part II, Item 8of this Form 10-K.

71

----

*Changesin Internal Control Over Financial Reporting.**  *There were no changes in ourinternal control over the financial reporting during the period covered by thisreport that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

*Limitation on Effectivenessof Controls.**  *Itshould be noted that any system of controls, however well designed andoperated, can provide only reasonable, and not absolute, assurance that theobjectives of the system are met. The design of any control system is based, inpart, upon the benefits of the control system relative to its costs. Controlsystems can be circumvented by the individual acts of some persons, bycollusion of two or more people, or by management override of the control. Inaddition, over time, controls may become inadequate because of changes inconditions, or the degree of compliance with the policies or procedures maydeteriorate. Because of these and other inherent limitations of controlsystems, there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions, regardless of howremote.

**ITEM 9B.**       OTHERINFORMATION 

Not applicable.

72

----

**PART III**

We have omitted certaininformation from this Annual Report on Form 10-K that is required byPart III. We intend to file a definitive proxy statement with theSecurities and Exchange Commission relating to our annual meeting ofstockholders no later than 120 days after the end of the fiscal year covered bythis Annual Report on Form 10-K, and such information isincorporated by reference as indicated below.

**ITEM 10.**         DIRECTORS,EXECUTIVE OFFICERS AND KEY EMPLOYEES OF THE REGISTRANT 

**Executive Officersand Directors**

Ourdirectors, executive officers and key employees and their ages as of April 1,2006 are as follows:

| **Name**               | ** ** | ** ** | ** ** | **Age** | ** ** | ** **                                              | **Position** | ** ** | ** ** |
|------------------------|------------|------------|------------|---------|------------|---------------------------------------------------------|--------------|------------|------------|
| Marc L.  Andreessen    |       |       | 34         |    |       | Chairman  of the Board of Directors                     |         |
| Benjamin A.  Horowitz  |       |       | 39         |    |       | President,  Chief Executive Officer and Director        |         |
| Timothy A. Howes       |       |       | 42         |    |       | Chief  Technical Officer                                |         |
| Sharlene P.  Abrams    |       |       | 48         |    |       | Chief  Financial Officer                                |         |
| John L. O’Farrell |       |       | 47         |    |       | Executive  Vice President of Business Development       |         |
| Jordan J. Breslow      |       |       | 50         |    |       | General  Counsel and Secretary                          |         |
| Sharmila N.  Shahani   |       |       | 40         |    |       | Executive  Vice President of Marketing                  |         |
| Mark D. Cranney        |       |       | 42         |    |       | Executive  Vice President of Worldwide Field Operations |         |
| James E. Adkins        |       |       | 44         |    |       | Executive  Vice President of Products                   |         |
| William V.  Campbell   |       |       | 65         |    |       | Director                                                |         |
| Mike J. Homer          |       |       | 48         |    |       | Director                                                |         |
| Simon M. Lorne         |       |       | 60         |    |       | Director                                                |         |
| Michael S. Ovitz       |       |       | 59         |    |       | Director                                                |         |
| Michelangelo A. Volpi  |       |       | 39         |    |       | Director                                                |         |

 

*Marc L. Andreessen*is a co-founder of Opsware and has served as theChairman of our board of directors since September 1999. Prior toco-founding Opsware, Mr. Andreessen served as Chief Technology Officer ofAmerica Online, Inc., a new media company, from March 1999 to September 1999.Mr. Andreessen was a co-founder of Netscape Communications Corporation, asoftware company, serving in various positions from April 1994 until March 1999,including as Chief Technology Officer and Executive Vice President of Products.He served on Netscape’s board of directors from April 1994 until March 1999.Mr. Andreessen serves on the board of directors of Orbitz, Inc. Mr. Andreessenholds a B.S. in computer science from the University of Illinois atUrbana-Champaign.

*Benjamin A. Horowitz*is a co-founder of Opsware and has served as ourPresident and Chief Executive Officer and as a director since September 1999.Prior to co-founding Opsware, Mr. Horowitz served as Vice President andGeneral Manager of the E-Commerce Platform division of America Online, Inc.from April 1999 to September 1999. From July 1995 to April 1999,Mr. Horowitz was a vice president at Netscape Communications. Mr. Horowitzserves on the board of directors of MIPS Technologies, Inc. Mr. Horowitzholds a B.A. in computer science from Columbia University and an M.S. incomputer science from the University of California, Los Angeles.

*Timothy A. Howes*is a co-founder of Opsware and has served as ourChief Technical Officer since September 1999 and our Executive VicePresident of Development from October 2001 to December 2004. Dr. Howesalso served as our Senior Vice President of Engineering from June 2000 to August 2000and as our President of Product Operations from September 2000 to September 2001.Prior to co-founding Opsware, Dr. Howes served as Vice President ofTechnology at America Online, Inc. from April 1999 to September 1999.From February 1998 to April 1999, Dr. Howes was Chief TechnologyOfficer of the 

73

----

*ServerProduct division at Netscape Communications. From April 1996 to February 1998,Dr. Howes was Principal Engineer, Directing Architect of several serverproducts at Netscape Communications. From September 1994 to April 1996,Dr. Howes was Project Director, Principal Investigator and Senior SystemsResearch Programmer at the University of Michigan. Dr. Howes serves on theboard of directors of Blue Coat Systems, Inc. Dr. Howes holds a Ph.D.in computer science, a B.S.E. in aerospace engineering and an M.S.E. incomputer science and engineering from the University of Michigan.*

*Sharlene P.*Abrams has served as our Chief Financial Officer since October 2002.Prior to joining Opsware, Ms. Abrams served as Chief Financial Officer andVice President of Finance and Administration of Mercury InteractiveCorporation, a software company, from November 1993 to November 2001.From February 1988 to November 1993, Ms. Abrams held managementpositions with PricewaterhouseCoopers, an auditing firm. Prior to joiningPricewaterhouseCoopers, Ms. Abrams held financial management positionswith Cullinet Software, a software company, and Compugraphic Corporation, amanufacturing company. Ms. Abrams began her career in 1978 as a certifiedpublic accountant with Laventhol & Horwath, an auditing firm. Ms. Abramsholds a B.S. in business administration from Boston University.

*John L. O’Farrell*has served as our Executive Vice President ofBusiness Development since March 2001. Prior to joining Opsware, Mr. O’Farrellserved as Executive Vice President, International for At Home Corporation, aprovider of broadband Internet access and media services, from March 2000to March 2001, and as Senior Vice President, International from April 1997to March 2000, including after its acquisition of Excite Inc. in May 1999.From August 1995 to April 1997, he was President of US WESTInteractive Services, an Internet content development and investment company.Prior to that time, Mr. O’Farrell served as Vice President, CorporateStrategy of US WEST Inc., a telephone and cable network operator, from May 1994to August 1995, and as Executive Director, Corporate Strategy from March 1992to May 1994. Before joining US WEST Inc., Mr. O’Farrell held generalmanagement, marketing and consulting positions in the United States and Europewith Telecom Ireland (Ireland), Booz, Allen and Hamilton (U.S.), the Commissionof the European Communities (Luxembourg), Digital Equipment Corporation andSiemens AG (both Germany). Mr. O’Farrell holds a B.E. degree fromUniversity College Dublin, Ireland, and an M.B.A. from the Stanford GraduateSchool of Business.

*Jordan J. Breslow*has served as our General Counsel and Secretary sinceAugust 2001. Mr. Breslow also served as our Chief Counsel from January 2000to August 2001. Prior to joining Opsware, Mr. Breslow served as VicePresident and General Counsel of Geoworks, a software company, from 1990 to1998 where he also served as Managing Director of European Operations, from1997 to 1998. From 1998 to 1999, Mr. Breslow was co-chair of theintellectual property practice group at Foster, Pepper and Shefelman, a lawfirm. From 1982 to 1989, Mr. Breslow was a partner at Stewart, Stewart &Breslow, a law firm. Mr. Breslow holds a B.A. in anthropology from SanFrancisco State University and J.D. from Hastings College of Law.

*Sharmila N. Shahani*has served as our Executive Vice President ofMarketing since February 2006 and as our Senior Vice President ofMarketing from May 2002 to February 2006. Prior to joining Opsware, Ms. Shahaniserved as Vice President of Marketing and Business Development for Totality, amanaged IT services provider, from June 2000 to May 2002. From November 1999to June 2000, Ms. Shahani served as a Vice President of ProductMarketing for America Online’s E-commerce Services group. Prior to AmericaOnline, Ms. Shahani served as Vice President of Product Marketing forNetscape Communications from November 1997 to November 1999. Prior toNetscape, Ms. Shahani led marketing for Kiva Software, an applicationserver company, from May 1996 to November 1997. Prior to Kiva, Ms. Shahaniheld multiple managerial positions at General Magic, a software company, MicrosoftCorporation and Hewlett Packard. Ms. Shahani holds a B.A. in business andeconomics and a B.S. in computer science from Northwestern University and anM.A. in management from the Kellogg Graduate School of Business.

74

----

*Mark D. Cranney*has served as our Executive Vice President ofWorldwide Field Operations since November 2005 and as our Executive VicePresident of Sales from May 2004 to November 2005. Prior to joiningOpsware, Mr. Cranney served as Senior Division Vice President-Americas atParametric Technology Corp., a provider of product life-cycle managemententerprise software and consulting solutions, from April 1998 to September 2003.From April 1996 to April 1998, Mr. Cranney served as a VicePresident of Sales and Marketing at DxU, a privately-held medical devicecompany. Prior to DxU, Mr. Cranney served as a national sales manager forthe Patient Care Division of C.R. Bard, Inc., a medical devicemanufacturer, and started his career in sales and sales management positions atLanier Worldwide. Mr. Cranney holds a B.S. degree in BusinessAdministration and Marketing from Southern Utah University.

*James E. Adkins* has served as our Executive Vice President ofProducts since November 2005 and previously served as our Senior VicePresident of Engineering for the Opsware Server Automation System and OpswareAsset Management System products from December 2004 to November 2005.Prior to joining Opsware, Mr. Adkins was Senior Vice President of theRational Suites Group at Rational Software, a provider of software developmentlife-cycle tools and infrastructure products which was acquired by IBM in 2003,from February 2001 to February 2004. Mr. Adkins joined Rationalfollowing its acquisition of Catapulse, a provider of hosted developmentservices, where he was Senior Vice President of Products from February 2000to February 2001. Prior to Catapulse, Mr. Adkins served as the VicePresident of the Commerce Exchange division at Netscape Communications and wasresponsible for the ECXpert and TradingXpert electronic commerce softwareproducts from June 1996 to February 2000. From 1985 to 1996, Mr. Adkinsheld management and engineering positions within the General Electric Company. Mr. Adkinsholds a B.S. in Biochemistry from David Lipscomb University in Nashville, TN,and an M.B.A from Belmont University in Nashville, TN.

*William V. Campbell*has served as a director of Opsware since August 2000.Mr. Campbell has served as a director of Intuit Inc., a finance softwareand services company, since April 1994 and as Chairman of the Board since August 1998.He also served as Intuit’s Acting Chief Executive Officer from September 1999to January 2000 and as its President and Chief Executive Officer from April 1994to July 1998. Mr. Campbell also serves on the board of directors ofApple Computer, Inc. Mr. Campbell holds both a B.A. in economics andan M.A. from Columbia University, where he has been appointed to the Board ofTrustees.

*Mike J. Homer* has served as a director of Opsware since August 2003.Mr. Homer has served as the Chairman of Kontiki, Inc., a video ondemand solutions company, since November 2000 and served as Kontiki’sChief Executive Officer from November 2000 to November 2003. From April 1999to November 2000, Mr. Homer was Senior Vice President at AmericaOnline. From October 1994 to April 1999, Mr. Homer held variouspositions at Netscape Communications, including Executive Vice President, Salesand Marketing and General Manager of Netscape Netcenter. From April 1994to October 1994, Mr. Homer was a consultant. From August 1993 toApril 1994, Mr. Homer served as Vice President, Engineering at EOCorporation, a hand-held computer manufacturer, and from July 1991 to July 1993,Mr. Homer was Vice President, Marketing of Go Corporation, a pen-basedsoftware company. From 1982 to 1991, Mr. Homer held various technical andmarketing positions at Apple Computer, Inc., a computer company. Mr. Homerholds a B.S. in finance from the University of California at Berkeley. Mr. Homeralso serves on the board of directors of palmOne, Inc.

*Simon M. Lorne*has served as a director of Opsware since September 2002.Mr. Lorne is currently Vice Chairman and Chief Legal Officer of MillenniumPartners L.P., a hedge fund. From 1997 to 2004, Mr. Lorne was a partner ofthe law firm Munger, Tolles & Olson LLP. From 1996 to 1997, Mr. Lornewas a Managing Director of Salomon Brothers, an investment banking firm, wherehe served as global head of internal audit of that firm and of its parentcorporation, Salomon Inc, and as a senior member of the control team. Followingthe 1997 merger of Salomon Inc into Travelers Group Inc. (and of Salomon 

75

----

*Brothersinto Salomon Smith Barney), he continued as a Managing Director and as a seniormember of the legal department. After the 1998 merger of Travelers Group Inc.with Citicorp to form Citigroup Inc., he organized and coordinated the globalcompliance function of Citigroup Inc., which embraced the securities, bankingand insurance activities of that entity while continuing as a Managing Directorof Salomon Smith Barney. From 1993 to 1996 Mr. Lorne served as GeneralCounsel of the United States Securities and Exchange Commission. From 1972 to1996, Mr. Lorne was a partner of the law firm Munger, Tolles &Olson LLP. Mr. Lorne also serves on the board of directors of TeledyneTechnologies Incorporated, a technology hardware company. Mr. Lorne holdsan A.B. in economics from Occidental College and a J.D. from the University ofMichigan Law School.*

*Michael S. Ovitz*has served as a director of Opsware since July 2000.Mr. Ovitz co-founded Creative Artists Agency, a talent representationcompany, and served as its Chairman from 1975 to 1995. Mr. Ovitz hasserved as a Principal of CKE Associates, a consulting company, since July 2002.From December 1998 to June 2002, Mr. Ovitz was a Principal ofArtists Management Group, a talent representation company. From January 1997to December 1998, Mr. Ovitz was a self-employed private investor.From October 1995 to December 1996, Mr. Ovitz was President ofThe Walt Disney Company, an entertainment company. Mr. Ovitz currentlyserves as a director of Yankee Candle Corporation, Chairman of the ExecutiveBoard of the University of California at Los Angeles Hospital and MedicalCenter, a member of the Board of Directors of D.A.R.E. America and a member ofthe Board of Advisors at the University of California, Los Angeles School ofTheater, Film and Television. Mr. Ovitz also serves on the Board ofTrustees of the Museum of Modern Art in New York City and is a member of theCouncil on Foreign Relations. Mr. Ovitz holds a B.A. in psychology fromUniversity of California, Los Angeles.

*Michelangelo A. Volpi*hasserved as a director of Opsware since August 2003. Mr. Volpicurrently serves as Senior Vice President, Routing Technology Group of CiscoSystems Inc., a network equipment manufacturer. From 1994 to 2001, Mr. Volpiheld various positions at Cisco, including Senior Vice President, ChiefStrategy Officer, Senior Vice President of Business Development/GlobalAlliances, Vice President of Business Development, Director of BusinessDevelopment, and Business Development Manager. Prior to joining Cisco, Mr. Volpiheld various management positions at the Hewlett Packard Company’sOptoelectronics Division. Mr. Volpi holds a B.S. in mechanicalengineering, an M.S. in manufacturing systems engineering and an M.B.A., allfrom Stanford University.

**Section 16(a) BeneficialOwnership Reporting Compliance**

Section 16(a) of the Securities Exchange Actof 1934 requires our executive officers and directors, and persons who own morethan ten percent of a registered class of our equity securities to file reportsof ownership and changes in ownership with the Securities and ExchangeCommission. Executive officers, directors and greater than ten percentstockholders are required by the Securities and Exchange Commission regulationto furnish us with copies of all Section 16(a) forms they file. Basedsolely on our review of the copies of such forms furnished to us, or writtenrepresentations from certain reporting persons, we believe that during ourfiscal year ended January 31, 2006 all the reporting persons complied withthe filing requirements.

We have adopted a written code of conduct and ethicsthat applies to all directors, officers and employees of Opsware, including ourprincipal executive officer, principal financial officer, and principalaccounting officer or controller, or persons performing similar functions, inaccordance with the rules of the Securities and Exchange Commissionpromulgated thereunder. The code of conduct and ethics is available on ourwebsite at www.opsware.com. We intend to make all required disclosuresconcerning any amendments to, or waivers from, our code of ethics on ourwebsite.

Additional informationrequired by this Item is incorporated by reference to our proxy statement underthe headings “Board Committees” and “Consideration of Director Nominees”.

76

----

**ITEM 11.**         EXECUTIVECOMPENSATION 

The information requiredby this Item is incorporated by reference to our proxy statement under theheading “Executive Compensation” and “Election of Directors”—“DirectorCompensation” and “Compensation Committee Interlocks and Insider Participation.”

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS 

The information requiredby this Item is incorporated by reference to our proxy statement under theheadings “Security Ownership of Certain Beneficial Owners and Management” and “ExecutiveCompensation”—“Equity Compensation Plans.”

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS 

The information requiredby this Item is incorporated by reference to our proxy statement under theheadings “Certain Relationships and Related Transactions.”

**ITEM 14.**         PRINCIPALACCOUNTANT FEES AND SERVICES 

The information required by this Item is incorporatedby reference to our proxy statement under the heading “Principal AccountantFees and Services”.

 

77

----

**PART IV**

**ITEM 15.**         EXHIBITSAND FINANCIAL STATEMENT SCHEDULES

**(a)   1.   ConsolidatedFinancial Statements.**

See Index to ConsolidatedFinancial Statements at Item 8 on page 38 of this Annual Report on Form 10-K.

**2.   Financial Statement Schedules.**

Schedules have been omitted because they are notapplicable or are not required or the information required to be set forththerein is included in the Consolidated Financial Statements or notes thereto.

**3.   Exhibits.**

The following exhibits are filed as part of, orincorporated by reference into, this Report on Form 10-K:

|                  | ** ** | ** **                                                                                                                                                                             | ** **  | **Incorporated By Reference** | ** ** | ** ** | ** ** |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------|-----------------------------------------|------------|------------|------------|
| **Exhibit**      | ** ** | ** **                                                                                                                                                                             | ** **  | ** **                              | ** ** | ** ** | ** ** | **Filing** | ** ** | **Exhibit** | ** ** | **Filed** | ** ** |
| **No.**          | ** ** |                                                                                                                                                                                        | **Exhibit** | ** **                              | ** ** | **Form**   | ** ** | **File No.** | ** ** | **Date** | ** ** | **No.** | ** ** | **Herewith** | ** ** |
|    2.1 |       | Asset Purchase Agreement between the Registrant and  Electronic Data Systems Corporation, dated June 14, 2002                                                                     |        | DEF14A                                  |       | 000-32377  |       | 7-10-02 |   | Annex A |   |   |   |   |   |
|    2.2 |       | Agreement and Plan of Reorganization between  Registrant, TES Acquisition Corp. and Tangram Enterprise  Solutions, Inc., dated December 4, 2003                              |        | S-4                                     |       | 333-111418 |       | 12-19-03 |   | Annex A |   |   |   |   |   |
|    2.3 |       | Amendment to Agreement and Plan of Reorganization  between Registrant, TES Acquisition Corp. and Tangram Enterprise  Solutions, Inc., dated February 20, 2004                |        | 8-K                                     |       | 000-32377  |       | 3-8-04 |   | 2.2 |   |   |   |   |   |
|    2.2 |       | Agreement and Plan of Reorganization between  Registrant, Rendition Networks, Inc., RN1 Acquisition Corp., RN2  Acquisition LLC and Cameron Myhrvold, dated December 1, 2004 |        | 8-K                                     |       | 000-32377  |       | 2-3-05 |   | 2.01 |   |   |   |   |   |
|    3.1 |       | Amended and Restated Certificate of Incorporation of  the Registrant.                                                                                                                  |        | S-1/A                                   |       | 333-46606  |       | 2-16-01 |   | 3.2 |   |   |   |   |   |
|    3.2 |       | Certificate of Amendment of the Amended and Restated  Certificate of Incorporation of the Registrant.                                                                                  |        | DEF14A                                  |       | 000-32377  |       | 7-10-02 |   | Annex B |   |   |   |   |   |
|    3.3 |       | Bylaws of the  Registrant.                                                                                                                                                             |        | 10-K                                    |       | 000-32377  |       | 5-1-02 |   | 3.2 |   |   |   |   |   |
| 10.1+            |       | Registrant’s 1999  Stock Plan.                                                                                                                                                    |        | S-1/A                                   |       | 333-46606  |       | 3-2-01 |   | 10.1 |   |   |   |   |   |
| 10.2+            |       | Registrant’s 2000  Stock Plan.                                                                                                                                                    |        | S-1/A                                   |       | 333-46606  |       | 3-2-01 |   | 10.2 |   |   |   |   |   |
| 10.3+            |       | Registrant’s Amended and Restated 2000 Incentive  Stock Plan.                                                                                                                     |        | 10-K                                    |       | 000-32377  |       | 5-3-01 |   | 10.3 |   |   |   |   |   |
| 10.4+            |       | Registrant’s Employee Stock Purchase Plan.                                                                                                                                        |        | 10-K                                    |       | 000-32377  |       | 5-3-01 |   | 10.4 |   |   |   |   |   |
| 10.5+            |       | Registrat’s Form of Stock Option Agreement under  the Amended and Restated 2000 Incentive Stock Plan                                                                         |        | 10-Q                                    |       | 000-32377  |       | 12-12-05 |   | 10.1 |   |   |   |   |   |
| 10.6+            |       | Registrat’s Form of Restricted Stock Agreement  under the Amended and Restated 2000 Incentive Stock Plan                                                                     |        | 10-Q                                    |       | 000-32377  |       | 12-12-05 |   | 10.2 |   |   |   |   |   |
|                  |            |                                                                                                                                                                                        |             |                                         |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

78

----

 

| ** **  | ** ** | ** **                                                                                                                                                           | ** **  | **Incorporated By Reference** | ** ** | ** ** | ** ** |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------|-----------------------------------------|------------|------------|------------|
| **Exhibit** | ** ** | ** **                                                                                                                                                           | ** **  | ** **                              | ** ** | ** ** | ** ** | **Filing** | ** ** | **Exhibit** | ** ** | **Filed** | ** ** |
| **No.**     |            | ** **                                                                                                                                                           | **Exhibit** | ** **                              | ** ** | **Form**   | ** ** | **File No.** | ** ** | **Date** | ** ** | **No.** | ** ** | **Herewith** | ** ** |
| 10.7+       |       | Form of Directors and Officers’ Indemnification  Agreement                                                                                                 |        | S-1/A                                   |       | 333-46606  |       | 10-31-00 |   | 10.5 |   |   |   |   |   |
| 10.8        |       | Investor Rights Agreement, dated June 23, 2000,  by and among the Registrant and the parties who are signatories thereto.                                       |        | S-1                                     |       | 333-46606  |       | 9-26-00 |   | 10.6 |   |   |   |   |   |
| 10.9        |       | Lease Agreement between the Registrant and Sequoia  Del Rey, dated January 31, 2000.                                                                            |        | S-1                                     |       | 333-46606  |       | 9-26-00 |   | 10.13 |   |   |   |   |   |
| 10.10       |       | Lease between the Registrant and Maude Avenue Land  Corporation, dated October 17, 2000.                                                                        |        | S-1/A                                   |       | 333-46606  |       | 12-5-00 |   | 10.14 |   |   |   |   |   |
| 10.11       |       | First Amendment to  Lease Agreement                                                                                                                                  |        | 10-Q                                    |       | 000-32377  |       | 12-12-03 |   | 10.1 |   |   |   |   |   |
| 10.12       |       | Second Amendment  to Lease Agreement                                                                                                                                 |        | 10-Q                                    |       | 000-32377  |       | 9-12-03 |   | 10.1 |   |   |   |   |   |
| 10.13       |       | License Agreement between the Registrant and  Electronics Data Systems Corporation, dated June 14, 2002                                                         |        | S-3                                     |       | 333-91064  |       | 6-24-02 |   | 10.1 |   |   |   |   |   |
| 10.14       |       | Amendment to EDS License and Maintenance Agreement,  effective August 15, 2004                                                                                  |        | 10-Q                                    |       | 000-32377  |       | 9-9-04 |   | 10.1 |   |   |   |   |   |
| 21.1        |       | Subsidiaries of the Registrant                                                                                                                                       |        |                                    |       |       |       |   |   |   |   |   | X |   |   |
| 23.1        |       | Consent of Independent Registered Public Accounting  Firm                                                                                                            |        |                                    |       |       |       |   |   |   |   |   | X |   |   |
| 24.1        |       | Power of Attorney  (See page 80)                                                                                                                                     |        |                                    |       |       |       |   |   |   |   |   | X |   |   |
| 31.1        |       | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a), as adopted pursuant to Section 302 of the  Sarbanes-Oxley A                          |        |                                    |       |       |       |   |   |   |   |   | X |   |   |
| 31.2        |       | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a), as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.               |        |                                    |       |       |       |   |   |   |   |   | X |   |   |
| 32.1        |       | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.* |        |                                    |       |       |       |   |   |   |   |   | X |   |   |
| 32.2        |       | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.* |        |                                    |       |       |       |   |   |   |   |   | X |   |   |
|             |            |                                                                                                                                                                      |             |                                         |            |            |            |  |  |  |  |  |  |  |  |  |  |

----

+                 Management contract, compensatory plan orarrangement.

*                     As contemplated by SEC Release No. 33-8212,these exhibits are furnished with this Annual Report on Form 10-Kand are not deemed filed with the Securities and Exchange Commission and arenot incorporated by reference in any filing of Opsware Inc. under theSecurities Act of 1933 or the Securities Act of 1934, whether made before orafter the date hereof and irrespective of any general incorporation language inany such filings.

**(b)   Exhibits.**

See Item 15(a)(3) above.

**(c)   FinancialStatements and Schedules.**

See Item 15(a)(2) above.

79

----

**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

|   | OPSWARE INC. |
|--------|--------------|
|   | By:          | /s/  BENJAMIN  A. HOROWITZ |
|   | ** **   | **Benjamin  A. Horowitz** |
|   | ** **   | **President,  Chief Executive Officer and Director** |
|   | Date:        | April 14, 2006 |

 

**POWER OF ATTORNEY**

KNOW ALL MEN BY THESEPRESENTS, that each person whose signature appears below constitutes andappoints Benjamin A. Horowitz and Jordan J. Breslow, and each of them, his orher true and lawful attorneys-in-fact and agents, each with full power ofsubstitution and resubstitution, for him or her and in his or her name, placeand stead, in any and all capacities, to sign any and all amendments, to thisreport on Form 10-K and to file the same, with exhibits thereto andother documents in connection therewith, with the Securities and ExchangeCommission, granting unto said attorneys-in-fact and agents, and each of them,full power and authority to do and perform each and every act and thingrequisite and necessary to be done, as fully to all intents and purposes as hemight or could do in person, hereby ratifying and confirming all that each ofsaid attorneys-in-fact and agents or their substitute or substitutes maylawfully do or cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed by the following persons on behalf of the registrant on April 14,2006 in the capacities indicated:

|                           | **Signature** | ** **                                       | ** ** |  | **Title** | ** ** | ** ** |
|---------------------------|---------------|--------------------------------------------------|------------|--|-----------|------------|------------|
| /s/ Benjamin A. Horowitz  |          | President, Chief  Executive Officer and Director |       |
| **Benjamin A. Horowitz**  |          | *(Principal Executive Officer)*                  | * *   |
| /s/ Sharlene P. ABRAMS    |          | Chief Financial  Officer                         |       |
| **Sharlene P. Abrams**    |          | *(Principal Financial and  Accounting Officer)*  | * *   |
| /S/ MARC L. ANDREESSEN    |          | Chairman of the  Board of Directors              |       |
| **Marc L. Andreessen**    |          |                                             |       |
| /s/ William V. Campbell   |          | Director                                         |       |
| **William V. Campbell**   |          |                                             |       |
| /s/ Mike J. Homer         |          | Director                                         |       |
| **Mike J. Homer**         |          |                                             |       |
| /s/ Simon M. Lorne        |          | Director                                         |       |
| **Simon M. Lorne**        |          |                                             |       |
| /s/ Michael S. Ovitz      |          | Director                                         |       |
| **Michael S. Ovitz**      |          |                                             |       |
| /s/ Michelangelo A. Volpi |          | Director                                         |       |
| **Michelangelo A. Volpi** |          |                                             |       |

 

80

----

**Exhibit Index**

|                  | ** ** | ** **                                                                                                                                                                              | ** **  | **Incorporated By Reference** | ** ** | ** ** | ** ** |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------|-----------------------------------------|------------|------------|------------|
| **Exhibit**      | ** ** | ** **                                                                                                                                                                              | ** **  | ** **                              | ** ** | ** ** | ** ** | **Filing** | ** ** | **Exhibit** | ** ** | **Filed** | ** ** |
| **No.**          | ** ** |                                                                                                                                                                                         | **Exhibit** | ** **                              | ** ** | **Form**   | ** ** | **File No.** | ** ** | **Date** | ** ** | **No.** | ** ** | **Herewith** | ** ** |
|    2.1 |       | Asset Purchase  Agreement between the Registrant and Electronic Data Systems Corporation,  dated June 14, 2002                                                                     |        | DEF14A                                  |       | 000-32377  |       | 7-10-02 |   | Annex A |   |   |   |   |   |
|    2.2 |       | Agreement and Plan  of Reorganization between Registrant, TES Acquisition Corp. and Tangram  Enterprise Solutions, Inc., dated December 4, 2003                               |        | S-4                                     |       | 333-111418 |       | 12-19-03 |   | Annex A |   |   |   |   |   |
|    2.3 |       | Amendment to  Agreement and Plan of Reorganization between Registrant, TES Acquisition  Corp. and Tangram Enterprise Solutions, Inc., dated February 20,  2004                |        | 8-K                                     |       | 000-32377  |       | 3-8-04 |   | 2.2 |   |   |   |   |   |
|    2.2 |       | Agreement and Plan  of Reorganization between Registrant, Rendition Networks, Inc., RN1  Acquisition Corp., RN2 Acquisition LLC and Cameron Myhrvold, dated  December 1, 2004 |        | 8-K                                     |       | 000-32377  |       | 2-3-05 |   | 2.01 |   |   |   |   |   |
|    3.1 |       | Amended and  Restated Certificate of Incorporation of the Registrant.                                                                                                                   |        | S-1/A                                   |       | 333-46606  |       | 2-16-01 |   | 3.2 |   |   |   |   |   |
|    3.2 |       | Certificate of  Amendment of the Amended and Restated Certificate of Incorporation of the  Registrant.                                                                                  |        | DEF14A                                  |       | 000-32377  |       | 7-10-02 |   | Annex B |   |   |   |   |   |
|    3.3 |       | Bylaws of the  Registrant.                                                                                                                                                              |        | 10-K                                    |       | 000-32377  |       | 5-1-02 |   | 3.2 |   |   |   |   |   |
| 10.1+            |       | Registrant’s 1999  Stock Plan.                                                                                                                                                     |        | S-1/A                                   |       | 333-46606  |       | 3-2-01 |   | 10.1 |   |   |   |   |   |
| 10.2+            |       | Registrant’s 2000  Stock Plan.                                                                                                                                                     |        | S-1/A                                   |       | 333-46606  |       | 3-2-01 |   | 10.2 |   |   |   |   |   |
| 10.3+            |       | Registrant’s  Amended and Restated 2000 Incentive Stock Plan.                                                                                                                      |        | 10-K                                    |       | 000-32377  |       | 5-3-01 |   | 10.3 |   |   |   |   |   |
| 10.4+            |       | Registrant’s  Employee Stock Purchase Plan.                                                                                                                                        |        | 10-K                                    |       | 000-32377  |       | 5-3-01 |   | 10.4 |   |   |   |   |   |
| 10.5+            |       | Registrant’s  Form of Stock Option Agreement under the Amended and Restated 2000  Incentive Stock Plan                                                                        |        | 10-Q                                    |       | 000-32377  |       | 12-12-05 |   | 10.1 |   |   |   |   |   |
| 10.6+            |       | Registrant’s  Form of Restricted Stock Agreement under the Amended and Restated 2000  Incentive Stock Plan                                                                    |        | 10-Q                                    |       | 000-32377  |       | 12-12-05 |   | 10.2 |   |   |   |   |   |
| 10.7+            |       | Form of  Directors and Officers’ Indemnification Agreement                                                                                                                    |        | S-1/A                                   |       | 333-46606  |       | 10-31-00 |   | 10.5 |   |   |   |   |   |
| 10.8             |       | Investor Rights  Agreement, dated June 23, 2000, by and among the Registrant and the  parties who are signatories thereto.                                                         |        | S-1                                     |       | 333-46606  |       | 9-26-00 |   | 10.6 |   |   |   |   |   |
| 10.9             |       | Lease Agreement  between the Registrant and Sequoia Del Rey, dated January 31, 2000.                                                                                               |        | S-1                                     |       | 333-46606  |       | 9-26-00 |   | 10.13 |   |   |   |   |   |
| 10.10            |       | Lease between the  Registrant and Maude Avenue Land Corporation, dated October 17, 2000.                                                                                           |        | S-1/A                                   |       | 333-46606  |       | 12-5-00 |   | 10.14 |   |   |   |   |   |
| 10.11            |       | First Amendment to  Lease Agreement                                                                                                                                                     |        | 10-Q                                    |       | 000-32377  |       | 12-12-03 |   | 10.1 |   |   |   |   |   |
|                  |            |                                                                                                                                                                                         |             |                                         |            |            |            |  |  |  |  |  |  |  |  |  |  |

81

----

 

| 10.12 |   | Second Amendment  to Lease Agreement                                                                                                                                 |   | 10-Q   |   | 000-32377 |   | 9-12-03 |   | 10.1   |   |   |   |   |   |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|-----------|--------|---------|--------|--------|--------|--------|--------|--------|--------|
| 10.13 |   | License Agreement between the Registrant and  Electronics Data Systems Corporation, dated June 14, 2002                                                         |   | S-3    |   | 333-91064 |   | 6-24-02 |   | 10.1   |   |   |   |   |   |
| 10.14 |   | Amendment to EDS  License and Maintenance Agreement, effective August 15, 2004                                                                                  |   | 10-Q   |   | 000-32377 |   | 9-9-04  |   | 10.1   |   |   |   |   |   |
| 21.1  |   | Subsidiaries of  the Registrant                                                                                                                                      |   |   |   |      |   |    |   |   |   |   | X      |   |   |
| 23.1  |   | Consent of  Independent Registered Public Accounting Firm                                                                                                            |   |   |   |      |   |    |   |   |   |   | X      |   |   |
| 24.1  |   | Power of Attorney  (See page 80)                                                                                                                                     |   |   |   |      |   |    |   |   |   |   | X      |   |   |
| 31.1  |   | Certification of  Chief Executive Officer pursuant to Rule 13a-14(a), as adopted  pursuant to Section 302 of the Sarbanes-Oxley A                          |   |   |   |      |   |    |   |   |   |   | X      |   |   |
| 31.2  |   | Certification of  Chief Financial Officer pursuant to Rule 13a-14(a), as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.               |   |   |   |      |   |    |   |   |   |   | X      |   |   |
| 32.1  |   | Certification of  Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |   |   |   |      |   |    |   |   |   |   | X      |   |   |
| 32.2  |   | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* |   |   |   |      |   |    |   |   |   |   | X      |   |   |

----

+                 Management contract, compensatory plan or arrangement.

*                     As contemplated by SEC Release No. 33-8212,these exhibits are furnished with this Annual Report on Form 10-Kand are not deemed filed with the Securities and Exchange Commission and arenot incorporated by reference in any filing of Opsware Inc. under theSecurities Act of 1933 or the Securities Act of 1934, whether made before orafter the date hereof and irrespective of any general incorporation language inany such filings.

82

----