<PAGE>   1
 
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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549
                            ------------------------
 
                                   FORM 10-Q
                            ------------------------
(MARK ONE)
 
     [X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
          EXCHANGE ACT OF 1934
 
                FOR THE QUARTERLY PERIOD ENDED NOVEMBER 30, 1998
 
                                       OR
 
     [ ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
           EXCHANGE ACT OF 1934
 
         FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .
 
                        COMMISSION FILE NUMBER: 0-26880
 
                                  VERITY, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
<TABLE>
<S>                                            <C>
                  DELAWARE                                      77-0182779
       (STATE OR OTHER JURISDICTION OF                       (I.R.S. EMPLOYER
       INCORPORATION OR ORGANIZATION)                       IDENTIFICATION NO.)
</TABLE>
 
                                 894 ROSS DRIVE
                          SUNNYVALE, CALIFORNIA 94089
                                 (408) 541-1500
         (ADDRESS AND TELEPHONE NUMBER OF PRINCIPAL EXECUTIVE OFFICES)
 
     Indicate by check mark whether registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
 
                               YES [X]     NO [ ]
 
     The number of shares outstanding of the Registrant's Common Stock, $0.001
par value, were 11,942,000 as of November 30, 1998.
 
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--------------------------------------------------------------------------------
<PAGE>   2
 
                                  VERITY, INC.
 
                                   FORM 10-Q
 
                               TABLE OF CONTENTS
 
<TABLE>
<CAPTION>
                                                                         PAGE
                                                                         ----
<S>       <C>                                                            <C>
PART I. FINANCIAL INFORMATION
Item 1.   Financial Statements........................................     1
          Condensed Consolidated Balance Sheets as of May 31, 1998 and
          November 30, 1998...........................................     1
          Condensed Consolidated Statements of Operations for the
          Three Months Ended November 30, 1997 and 1998 and the Six
          Months Ended November 30, 1997 and 1998.....................     2
          Condensed Consolidated Statements of Cash Flows for the Six
          Months Ended November 30, 1997 and 1998.....................     3
          Notes to Condensed Consolidated Financial Statements........     4
          Management's Discussion and Analysis of Financial Condition
Item 2.   and Results of Operations...................................     7
 
PART II. OTHER INFORMATION
Item 1.   Legal Proceedings...........................................    20
Item 2.   Changes in Securities.......................................    20
Item 3.   Defaults upon Senior Securities.............................    20
Item 4.   Submission of Matters to a Vote of Security Holders.........    20
Item 5.   Other Information...........................................    20
Item 6.   Exhibits and Reports on Form 8-K............................    20
Signatures............................................................    21
</TABLE>
 
                                        i
<PAGE>   3
 
                         PART I. FINANCIAL INFORMATION
 
ITEM 1. FINANCIAL STATEMENTS
 
                                  VERITY, INC.
 
                     CONDENSED CONSOLIDATED BALANCE SHEETS
                       (IN THOUSANDS, EXCEPT SHARE DATA)
 
                                     ASSETS
 
<TABLE>
<CAPTION>
                                                              MAY 31,     NOVEMBER 30,
                                                                1998          1998
                                                              --------    ------------
                                                                          (UNAUDITED)
<S>                                                           <C>         <C>
Current assets:
  Cash and cash equivalents.................................  $  5,505      $  5,915
  Short-term investments....................................    12,433        19,682
Trade accounts receivable, less allowance for doubtful
  accounts of $706 in 1998 and $718 in 1999.................    14,488        12,950
Prepaid and other current assets............................       878         1,350
                                                              --------      --------
          Total current assets..............................    33,304        39,897
Property and equipment, at cost, net of accumulated
  depreciation and amortization.............................     7,567         6,502
Other assets................................................       578           395
                                                              --------      --------
          Total assets......................................  $ 41,449      $ 46,794
                                                              ========      ========
 
LIABILITIES
Current liabilities:
  Current portion of long-term debt and capital lease
     obligations............................................  $    149      $     30
  Accounts payable..........................................     3,749         3,939
  Accrued compensation......................................     3,861         4,402
  Other accrued liabilities.................................     1,705         1,586
  Deferred revenue..........................................     7,928         6,899
                                                              --------      --------
          Total current liabilities.........................    17,392        16,856
  Long-term debt and capital lease obligations, net of
     current portion........................................         2            --
                                                              --------      --------
          Total liabilities.................................    17,394        16,856
                                                              --------      --------
 
STOCKHOLDERS' EQUITY
Common stock, $0.001 par value:
  Authorized: 30,000,000 shares in 1998 and 1999;
  Issued and outstanding: 11,565,000 shares in 1998 and
  11,942,000 shares in 1999.................................        12            12
Additional paid-in capital..................................    92,212        94,507
Unrealized gain on investments..............................         7            --
Accumulated deficit.........................................   (68,176)      (64,581)
                                                              --------      --------
          Total stockholders' equity........................    24,055        29,938
                                                              --------      --------
          Total liabilities and stockholders' equity........  $ 41,449      $ 46,794
                                                              ========      ========
</TABLE>
 
  The accompanying notes are an integral part of these condensed consolidated
                             financial statements.
 
                                        1
<PAGE>   4
 
                                  VERITY, INC.
 
                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                                     THREE MONTHS ENDED     SIX MONTHS ENDED
                                                        NOVEMBER 30,          NOVEMBER 30,
                                                     ------------------    -------------------
                                                      1997       1998        1997       1998
                                                     -------    -------    --------    -------
                                                        (UNAUDITED)            (UNAUDITED)
<S>                                                  <C>        <C>        <C>         <C>
Revenues:
  Software products................................  $ 6,666    $11,497    $  9,782    $21,386
  Service and other................................    2,522      3,713       4,746      7,044
                                                     -------    -------    --------    -------
          Total revenues...........................    9,188     15,210      14,528     28,430
                                                     -------    -------    --------    -------
Costs of revenues:
  Software products................................      861        401       1,566        838
  Service and other................................    1,294      1,074       2,979      2,156
                                                     -------    -------    --------    -------
          Total costs of revenues..................    2,155      1,475       4,545      2,994
                                                     -------    -------    --------    -------
Gross profit.......................................    7,033     13,735       9,983     25,436
                                                     -------    -------    --------    -------
Operating expenses:
  Research and development.........................    4,153      3,299       9,186      6,574
  Marketing and sales..............................    6,048      6,608      11,793     12,560
  General and administrative.......................    1,484      1,610       3,636      2,991
  Restructuring charges............................    3,006         --       3,006         --
                                                     -------    -------    --------    -------
          Total operating expenses.................   14,691     11,517      27,621     22,125
                                                     -------    -------    --------    -------
Income (loss) from operations......................   (7,658)     2,218     (17,638)     3,311
Other income, net..................................      549        297         813        584
                                                     -------    -------    --------    -------
Net income (loss) before provision for income
  taxes............................................   (7,109)     2,515     (16,825)     3,895
Provision for income taxes.........................       50        150         100        300
                                                     -------    -------    --------    -------
Net income (loss)..................................  $(7,159)   $ 2,365    $(16,925)   $ 3,595
                                                     =======    =======    ========    =======
Net income (loss) per share -- basic...............  $ (0.64)   $  0.20    $  (1.52)   $  0.31
                                                     =======    =======    ========    =======
Net income (loss) per share -- diluted.............  $ (0.64)   $  0.18    $  (1.52)   $  0.28
                                                     =======    =======    ========    =======
Number of shares -- basic..........................   11,168     11,823      11,101     11,725
                                                     =======    =======    ========    =======
Number of shares -- diluted........................   11,168     13,145      11,101     13,013
                                                     =======    =======    ========    =======
</TABLE>
 
  The accompanying notes are an integral part of these condensed consolidated
                             financial statements.
 
                                        2
<PAGE>   5
 
                                  VERITY, INC.
 
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                SIX MONTHS ENDED
                                                                  NOVEMBER 30,
                                                              --------------------
                                                                1997        1998
                                                              --------    --------
                                                                  (UNAUDITED)
<S>                                                           <C>         <C>
Cash flows from operating activities:
  Net income (loss).........................................  $(16,925)   $  3,595
  Adjustments to reconcile net income (loss) to net cash
     provided by (used in) operating activities:
     Depreciation and amortization..........................     3,041       1,372
     Non-cash restructuring charges.........................     2,315        (190)
     Provision for doubtful accounts........................       (79)         (4)
     Amortization of discount on securities.................       (19)       (379)
     Changes in operating assets and liabilities:
       Trade accounts receivable............................     2,272       1,598
       Prepaid and other current assets.....................       108        (352)
       Accounts payable.....................................      (786)        191
       Accrued compensation and other accrued liabilities...      (139)        607
       Deferred revenue.....................................       670      (1,118)
                                                              --------    --------
          Net cash provided by (used in) operating
            activities......................................    (9,542)      5,320
                                                              --------    --------
Cash flows from investing activities:
  Acquisition of property and equipment.....................    (1,127)       (195)
  Purchases of marketable securities........................    (5,302)    (31,392)
  Maturity of marketable securities.........................     1,400      13,705
  Proceeds from sale of marketable securities...............    13,773      10,811
  Investments in preferred stock............................        50          --
  Capitalization of software................................      (198)         --
                                                              --------    --------
          Net cash provided by (used in) investing
            activities......................................     8,596      (7,071)
                                                              --------    --------
Cash flows from financing activities:
  Borrowings under line of credit...........................     1,500          --
  Payments on line of credit................................    (1,500)         --
  Proceeds from stockholders on notes receivable............     1,027          --
  Proceeds from the sale of common stock....................       796       2,294
  Principal payments on notes payable and capital lease
     obligations............................................      (300)       (122)
                                                              --------    --------
          Net cash provided by financing activities.........     1,523       2,172
                                                              --------    --------
Effect of exchange rate changes on cash.....................       (22)        (11)
                                                              --------    --------
          Net increase in cash and cash equivalents.........       555         410
Cash and cash equivalents, beginning of period..............     2,934       5,505
                                                              --------    --------
Cash and cash equivalents, end of period....................  $  3,489    $  5,915
                                                              ========    ========
</TABLE>
 
  The accompanying notes are an integral part of these condensed consolidated
                             financial statements.
 
                                        3
<PAGE>   6
 
                                  VERITY, INC.
 
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
        (INFORMATION AS OF NOVEMBER 30, 1998 AND FOR THE QUARTERS ENDED
            NOVEMBER 30, 1997 AND 1998 AND THEREAFTER IS UNAUDITED)
 
 1. INTERIM FINANCIAL DATA (UNAUDITED)
 
     The unaudited financial statements for the quarters ended November 30, 1997
and 1998 have been prepared on the same basis as the audited financial
statements and, in the opinion of management, include all material adjustments,
consisting of normal recurring adjustments, necessary for a fair presentation of
the financial position and results of operations in accordance with generally
accepted accounting principles. Although certain information and footnote
disclosures normally included in financial statements prepared in accordance
with generally accepted accounting principles have been omitted pursuant to the
rules and regulations of the Securities and Exchange Commission, the Company
believes the disclosures made are adequate to make the information presented not
misleading. It is suggested that the accompanying financial statements be read
in conjunction with the Company's annual financial statements on Form 10-K for
the year ended May 31, 1998.
 
     The Company's balance sheet as of May 31, 1998 was derived from the
Company's audited financial statements, but does not include all disclosures
necessary for the presentation to be in accordance with generally accepted
accounting principles.
 
 2. COMPUTATION OF NET INCOME AND LOSS PER SHARE
 
     The Company has adopted Statement of Financial Accounting Standards No. 128
(SFAS 128), "Earnings Per Share," which requires the dual presentation of basic
and diluted earnings per share. Basic earnings per share are computed using the
weighted average number of common shares outstanding during the period. Diluted
earnings per share are computed using the weighted average number of common and
common equivalent shares outstanding during the period. Dilutive common
equivalent shares consist of stock options. For the three months and six months
ended November 30, 1997, the effects of outstanding stock options were excluded
from the computation of diluted earnings per share because their effect was
antidilutive.
 
 3. RECENT ACCOUNTING PRONOUNCEMENTS
 
     In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130 (SFAS 130), "Reporting Comprehensive
Income." This statement establishes requirements for disclosure of comprehensive
income and becomes effective for the Company for its fiscal year 1999, with
reclassification of earlier financial statements for comparative purposes.
Comprehensive income generally represents all changes in stockholders' equity
except those resulting from investments or contributions by stockholders. SFAS
130 requires unrealized gains or losses on the Company's available-for-sale
securities, which prior to adoption were reported separately in stockholders'
equity, to be included in other comprehensive income. The Company has adopted
SFAS 130, however, the effects of the adoption were immaterial to all periods
presented.
 
     In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131 (SFAS 131), "Disclosures about Segments
of an Enterprise and Related Information." This statement establishes standards
for disclosures about operating segments in annual financial statements and
selected information in interim financial reports. It also establishes standards
for related disclosures about products and services, geographic areas and major
customers. This statement supersedes statement of Financial Accounting Standards
No. 14, "Financial Reporting for Segments of a Business Enterprise." The new
standard becomes effective for the Company's fiscal year 1999, and requires that
comparative information from earlier years be restated to conform to the
requirements of this standard. The Company is evaluating the requirements of
SFAS 131 and the effects, if any, on the Company's current reporting and
disclosures.
 
                                        4
<PAGE>   7
                                  VERITY, INC.
 
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
        (INFORMATION AS OF NOVEMBER 30, 1998 AND FOR THE QUARTERS ENDED
            NOVEMBER 30, 1997 AND 1998 AND THEREAFTER IS UNAUDITED)
 
     In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 (SFAS 133), "Accounting for Derivative
Instruments and Hedging Activities." This Statement establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. It requires an entity to recognize all
derivatives as either assets or liabilities in the statement of financial
position and measure those instruments at fair value. This Statement is
effective for all quarters of fiscal years beginning after June 15, 1999. The
Company has not determined its strategy for the adoption of SFAS 133 or its
effect on the financial statements.
 
     During October 1997, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants issued Statement of Position
No. 97-2 (SOP 97-2), "Software Revenue Recognition." This statement delineates
the accounting for software product and maintenance revenues. It supersedes
Statement of Position No. 91-1, "Software Revenue Recognition," and is effective
for transactions entered into in fiscal years beginning after December 15, 1997.
The Company has evaluated the requirements of SOP 97-2 and its current revenue
recognition policy is in compliance with this pronouncement.
 
 4. BANK LINE OF CREDIT
 
     In March 1998, the Company negotiated a $5,000,000 line of credit under an
agreement with a bank, which expired on September 30, 1998. On September 22,
1998, the Company extended the term on its bank line of credit for an additional
two months until November 30, 1998. On November 15, 1998, the Company
renegotiated the agreement. The commitments made under this agreement expire on
September 30, 1999. The line of credit is collateralized by all corporate
assets, excluding leased equipment. Borrowings under the line of credit bear
interest at the lender's prime rate (7.75% at November 30, 1998). The agreement
requires the Company to comply with certain financial covenants and prohibits
the assumption of any major debt, except for equipment leases, without the
bank's approval. As of November 30, 1998, no borrowings were outstanding under
the line of credit.
 
 5. RESTRUCTURING CHARGES
 
     During the quarter ended November 30, 1997, the Company implemented a
worldwide restructuring of its operations, which resulted in workforce
reductions and business consolidations. In connection with the restructuring,
the Company recorded a $3.0 million restructuring charge in the quarter ended
November 30, 1997, of which approximately $1.6 million was related to severance
costs associated with the reduction in the worldwide workforce, approximately
$0.5 million to the termination of certain lease agreements, approximately $0.6
million to the write-off of certain assets and approximately $0.3 million to
other costs associated with the restructuring. Of the total $3.0 million in
restructuring charges, approximately $0.6 million is a current liability at
November 30, 1998.
 
                                        5
<PAGE>   8
                                  VERITY, INC.
 
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
        (INFORMATION AS OF NOVEMBER 30, 1998 AND FOR THE QUARTERS ENDED
            NOVEMBER 30, 1997 AND 1998 AND THEREAFTER IS UNAUDITED)
 
 6. COMPUTATION OF EARNINGS PER SHARE
 
     Basic and diluted income (loss) per share are calculated as follows for the
three months and six months ended November 30, 1997 and 1998 (in thousands,
except per share data):
 
<TABLE>
<CAPTION>
                                             THREE MONTHS ENDED     SIX MONTHS ENDED
                                                NOVEMBER 30,          NOVEMBER 30,
                                             ------------------    -------------------
                                              1997       1998        1997       1998
                                             -------    -------    --------    -------
<S>                                          <C>        <C>        <C>         <C>
Basic:
  Weighted-average shares..................   11,168     11,823      11,101     11,725
                                             =======    =======    ========    =======
  Net income (loss)........................  $(7,159)   $ 2,365    $(16,925)   $ 3,595
                                             =======    =======    ========    =======
  Net income (loss) per share..............  $ (0.64)   $  0.20    $  (1.52)   $  0.31
                                             =======    =======    ========    =======
Diluted:
  Weighted-average shares..................   11,168     11,823      11,101     11,725
  Common equivalent shares from stock
     options...............................       --      1,322          --      1,288
                                             -------    -------    --------    -------
  Shares used in per share calculation.....   11,168     13,145      11,101     13,013
                                             -------    -------    --------    -------
  Net income (loss)........................  $(7,159)   $ 2,365    $(16,925)   $ 3,595
                                             =======    =======    ========    =======
  Net income (loss) per share..............  $ (0.64)   $  0.18    $  (1.52)   $  0.28
                                             =======    =======    ========    =======
</TABLE>
 
     The calculation of diluted shares outstanding for the three months and six
months ended November 30, 1997 excludes 217,000 and 194,000 stock options,
respectively, as their effect was antidilutive in each period.
 
                                        6
<PAGE>   9
 
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
 
OVERVIEW
 
     THE FOLLOWING DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE
RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS MAY DIFFER MATERIALLY FROM
THOSE DISCUSSED HEREIN. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH
DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED BELOW IN "RISK
FACTORS."
 
     Verity develops, markets and supports knowledge retrieval software products
for application developers, corporate intranets, on-line publishers and
e-commerce providers, OEMs and independent software vendors. Verity's products
are designed to enable organizations to turn corporate intranets into powerful
knowledge bases. By providing critical components of corporate intranet portals,
Verity products help make business information accessible and reusable across
the enterprise.
 
     Verity's broad product family enables enterprise-wide document indexing,
classification, search and retrieval, personalized information dissemination,
and hybrid on-line and CD publishing all from the same underlying Verity
collections. Verity's products also enable application developers to embed
powerful search and retrieval functionality into their own commercial
applications. The Company's KeyView products enable viewing of documents stored
in more than 200 formats. Verity's KeyView viewing and filtering products are
used within the Company's own suite of applications and have been embedded by
many leading OEMs, including Lotus, Sybase, SAP and Netscape. Verity has
licensed its technology to many other prominent technology and content
providers, including Adobe Systems, AT&T WorldNet Services, CNET, Cisco, Compaq,
Dow Jones, Ernst & Young, Financial Times, IBM, NewsEDGE Corporation, Informix,
NEC, Siemens Nixdorf, Tandem and Time-Warner's Pathfinder. Verity's software has
been licensed to over 1,000 corporations, government agencies, software
developers, on-line service providers and Internet publishers worldwide.
 
     For the three months ended November 30, 1998, total revenues increased
65.5% over the corresponding fiscal 1997 period, primarily as a result of a
72.5% increase in software product revenues. Total revenues for the three months
ended November 30, 1998 increased 15.1% from the $13.2 million for the previous
three months ended August 31, 1998. Operating expenses for the three months
ended November 30, 1998 increased primarily as a result of a 11.0% increase in
marketing and sales expenses compared to the previous three months ended August
31, 1998. While it is the Company's goal to increase revenues and generate net
income in future periods, no assurance can be given that the Company's revenues
will continue to increase from quarter to quarter in future periods, or that the
Company will maintain positive cash flow or profitability.
 
     During the quarter ended November 30, 1997, the Company implemented a
worldwide restructuring of its corporate operations, which resulted in workforce
reductions and business consolidations. In connection with the restructuring,
the Company recorded a $3.0 million restructuring charge in the quarter ended
November 30, 1997, of which approximately $1.6 million was related to severance
costs associated with the reduction in the worldwide workforce, approximately
$0.5 million to the termination of certain lease agreements, approximately $0.6
million to the write-off of certain assets and approximately $0.3 million to
other costs associated with the restructuring. The Company believes that hiring
and retaining qualified individuals at all levels in the Company is essential to
its success, and there can be no assurance that the Company will be successful
in attracting and retaining the necessary personnel. The Company has experienced
significant turnover, including turnover of several senior members of
management. In particular, on July 31, 1997, Mr. Gary J. Sbona was appointed as
the Company's President and Chief Executive Officer, and the Company entered
into an agreement with Regent Pacific Management Corporation, a management firm
of which Mr. Sbona is the Chief Executive Officer. Pursuant to the original
agreement, Regent Pacific agreed to provide management services to the Company,
at a fee of $50,000 per week, including the services of Mr. Sbona as Chief
Executive Officer and President and at least three other Regent Pacific
personnel as part of the Company's management team. The agreement had a one-year
term and could be canceled by the Company after expiration of the initial
26-week period, with a minimum compensation to Regent Pacific of
 
                                        7
<PAGE>   10
 
$1.3 million for that initial period. The agreement required that the Company
indemnify Regent Pacific and Mr. Sbona for certain liabilities arising out of
the performance of services under the agreement. On April 13, 1998, the Company
and Regent Pacific agreed to amend the agreement to provide that Mr. Sbona and
at least four other Regent Pacific personnel would serve as part of the
Company's management team. The amendment also served to extend the term of the
agreement until August 31, 1999, and to extend the noncancelable period of the
agreement until February 28, 1999. In connection with Mr. Sbona's service as
President and CEO of the Company, the Compensation Committee of the Company's
Board also granted to him an option to purchase 350,000 shares of the Company's
common stock, at an exercise price of $5.125 per share. In October 1998, the
Company's Board granted Mr. Sbona another option to purchase an additional
260,000 shares of the Company's common stock, at an exercise price of $7.625 per
share. The shares subject to such options will vest on a monthly basis during
the 13-month period ending on February 28, 1999 and the 12-month period ending
on October 20, 1999, respectively, subject to Mr. Sbona's continued employment
as the Company's President and CEO; provided, however, that the shares subject
to such options will vest entirely upon certain change of control transactions
or upon a termination of Mr. Sbona without cause. The options will also remain
exercisable for one year following the termination of Mr. Sbona's services.
 
     If Company management is unable to effectively manage the Company's
operations, identify opportunities in a timely fashion, and evaluate and manage
the Company's business and competitive position, the Company's results of
operations and financial condition will be materially and adversely affected.
Furthermore, there can be no assurance that the Company will successfully
develop and introduce new products on a timely basis or that its new or recently
introduced products will achieve market acceptance.
 
     The Company's revenues are derived from license fees for its software
products and fees for services complementary to its products, including software
maintenance, consulting and training. Fees for services generally are charged
separately from the license fees for the Company's software products. Effective
for contracts entered into starting June 1, 1998, the Company recognizes
revenues in accordance with the provisions of American Institute of Certified
Public Accountants Statement of Position No. 97-2, "Software Revenue
Recognition." Maintenance revenues from ongoing customer support and product
upgrades are recognized ratably over the term of the applicable maintenance
agreement, which is typically 12 months. Payments for maintenance fees generally
are received in advance and are nonrefundable. Revenues for consulting and
training generally are recognized when the services are performed. Statement of
Position No. 97-2 supersedes Statement of Position No. 91-1, "Software Revenue
Recognition," and is effective for transactions entered into in fiscal years
beginning after December 15, 1997. This statement delineates the accounting for
software product and maintenance revenues. The Company has evaluated the
requirements of SOP 97-2 and its current revenue recognition policy is in
compliance with this pronouncement.
 
                                        8
<PAGE>   11
 
RESULTS OF OPERATIONS
 
     The following table sets forth the percentage of total revenues represented
by certain items in the Company's Condensed Consolidated Statements of
Operations for the periods indicated:
 
<TABLE>
<CAPTION>
                                                      THREE MONTHS       SIX MONTHS
                                                         ENDED              ENDED
                                                      NOVEMBER 30,      NOVEMBER 30,
                                                     --------------    ---------------
                                                     1997     1998      1997     1998
                                                     -----    -----    ------    -----
<S>                                                  <C>      <C>      <C>       <C>
Revenues:
  Software products................................   72.6%    75.6%     67.3%    75.2%
  Service and other................................   27.4     24.4      32.7     24.8
                                                     -----    -----    ------    -----
          Total revenues...........................  100.0    100.0     100.0    100.0
                                                     -----    -----    ------    -----
Costs of revenues:
  Software products................................    9.4      2.6      10.8      2.9
  Service and other................................   14.1      7.1      20.5      7.6
                                                     -----    -----    ------    -----
          Total costs of revenues..................   23.5      9.7      31.3     10.5
                                                     -----    -----    ------    -----
Gross profit.......................................   76.5     90.3      68.7     89.5
                                                     -----    -----    ------    -----
Operating expenses:
  Research and development.........................   45.2     21.7      63.2     23.1
  Marketing and sales..............................   65.8     43.4      81.2     44.2
  General and administrative.......................   16.2     10.6      25.0     10.5
  Restructuring charges............................   32.7      0.0      20.7      0.0
                                                     -----    -----    ------    -----
          Total operating expenses.................  159.9     75.7     190.1     77.8
                                                     -----    -----    ------    -----
Income (loss) from operations......................  (83.4)    14.6    (121.4)    11.7
Interest and other expenses........................    6.0      2.0       5.6      2.0
                                                     -----    -----    ------    -----
Income (loss) before provision for income taxes....  (77.4)    16.6    (115.8)    13.7
Provision for income taxes.........................    0.5      1.0       0.7      1.1
                                                     -----    -----    ------    -----
Net income (loss)..................................  (77.9)%   15.6%   (116.5)%   12.6%
                                                     =====    =====    ======    =====
</TABLE>
 
  Revenues
 
     Total revenues increased 95.7% from $14.5 million for the six months ended
November 30, 1997 to $28.4 million for the six months ended November 30, 1998.
Total revenues as compared to the six-month period ended November 30, 1997
increased primarily due to increased revenues from licensing of Internet/
Publishing products and enterprise products. Software product revenues increased
as a percentage of total revenues from 67.3% and 72.6% for the six months and
three months ended November 30, 1997, respectively, to 75.2% and 75.6%,
respectively, for the comparable periods in fiscal 1999. Conversely, service and
other revenues decreased as a percentage of total revenues from 32.7% and 27.4%
for the six months and three months ended November 30, 1997, respectively, to
24.8% and 24.4%, respectively, for the comparable periods in fiscal 1999.
 
     Software product revenues. Software product revenues increased 118.6% from
$9.8 million for the six months ended November 30, 1997 to $21.4 million for the
six months ended November 30, 1998. The increase for the six months ended
November 30, 1998 in comparison to the six months ended November 30, 1997 was
due principally to increased revenues from licensing of Internet/Publishing
products and enterprise products. Software product revenues increased 72.5% from
$6.7 million for the three months ended November 30, 1997 to $11.5 million for
the three months ended November 30, 1998. The increase for the three months
ended November 30, 1998 from the three months ended November 30, 1997 was due
principally to increased revenues from licensing of Internet/Publishing products
and enterprise products.
 
     Service and other revenues. Service and other revenues increased 48.4% from
$4.7 million for the six months ended November 30, 1997 to $7.0 million for the
six months ended November 30, 1998. Service and
 
                                        9
<PAGE>   12
 
other revenues increased 47.2% from $2.5 million for the three months ended
November 30, 1997 to $3.7 million for the three months ended November 30, 1998.
Maintenance and consulting revenues increased significantly between the
comparable periods.
 
     Revenues derived from European operations accounted for 8.1% and 6.2%,
respectively, for the six months ended November 30, 1997 and 1998. For the six
months ended November 30, 1997 and 1998, export sales accounted for 25.1% and
25.8% of total revenues, respectively. Revenues derived from European operations
accounted for 6.6% and 6.8% of total revenues, respectively, for the three
months ended November 30, 1997 and 1998. For the three months ended November 30,
1997 and 1998, export sales accounted for 27.0% and 28.7% of total revenues,
respectively. The Company expects that revenues derived from European operations
and export sales will continue to vary in future periods as a percentage of
total revenues.
 
     No single customer accounted for more than 10% of the Company's revenues
for the six months ended November 30, 1998. For the three months ended November
30, 1998, revenues derived from sales to Cisco Systems, Inc. accounted for 11.7%
of the Company's total revenues. For the six months ended November 30, 1997,
KPMG International accounted for approximately 10.8% of the Company's revenues
and for approximately 11.7% of the Company's revenues for the three months ended
November 30, 1997. Revenues derived from sales to the federal government and its
agencies were 10.3% and 9.2% of the Company's revenues for the six months ended
November 30, 1997 and 1998, respectively, and 11.2% and 13.9% of the Company's
revenues for the three months ended November 30, 1997 and 1998, respectively.
The Company expects that revenues from such government sales will continue to
vary in future periods as a percentage of revenues.
 
  Costs of Revenues
 
     Costs of software products. Costs of software products decreased 46.5% from
$1.6 million for the six months ended November 30, 1997 to $838,000 for the six
months ended November 30, 1998, representing 16.0% and 3.9%, respectively, of
the software product revenues. Costs of software products decreased 53.4% from
$861,000 for the three months ended November 30, 1997 to $401,000 for the three
months ended November 30, 1998, representing 12.9% and 3.5%, respectively, of
the software product revenues. In the six months ended November 30, 1997, the
Company incurred amortization expense relating to capitalized software, which
represented a significant part of the software costs. The decrease in absolute
dollars during the periods ended November 30, 1998, was primarily due to the
elimination of the amortization expense related to the capitalized software. The
decrease in costs as a percentage of software product revenues was primarily
related to the increased software product revenues for the six months ended
November 30, 1998.
 
     Costs of service and other. Costs of service and other revenues decreased
27.6% from $3.0 million for the six months ended November 30, 1997 to $2.2
million for the six months ended November 30, 1998, representing 62.8% and
30.6%, respectively, of service and other revenues. Costs of service and other
revenues decreased 17.0% from $1.3 million for the three months ended November
30, 1997 to $1.1 million for the three months ended November 30, 1998,
representing 51.3% and 28.9%, respectively, of service and other revenues. The
decrease in absolute dollars was due principally to a decrease in consulting and
technical support personnel. The decrease in costs as a percentage of service
and other revenues was primarily related to increased consulting and maintenance
revenues for the six months ended November 30, 1998.
 
  Operating Expenses
 
     Research and development. Research and development expenses decreased 28.4%
from $9.2 million for the six months ended November 30, 1997 to $6.6 million for
the six months ended November 30, 1998, representing 63.2% and 23.1%,
respectively, of total revenues. Research and development expenses decreased
20.6% from $4.2 million for the three months ended November 30, 1997 to $3.3
million for the three months ended November 30, 1998, representing 45.2% and
21.7%, respectively, of total revenues. The decrease in absolute dollars was
primarily due to a significant decrease in research and development personnel
during fiscal 1999 as a result of a discontinuation of the operations of the
Company's Insite, Cognisoft and 64K subsidiaries in fiscal 1998. The decrease in
costs as a percentage of total revenues was primarily related to the
 
                                       10
<PAGE>   13
 
increased revenues for the six months ended November 30, 1998. The Company
believes that research and development expenses may increase in the future
primarily due to the introduction of new products to the Company's product line
and other anticipated product development efforts. Future research and
development expenses may continue to vary as a percentage of total revenues.
 
     Marketing and sales. Marketing and sales expenses increased 6.5% from $11.8
million for the six months ended November 30, 1997 to $12.6 million for the six
months ended November 30, 1998, representing 81.2% and 44.2%, respectively, of
total revenues. Marketing and sales expenses increased 9.3% from $6.0 million
for the three months ended November 30, 1997 to $6.6 million for the three
months ended November 30, 1998, representing 65.8% and 43.4%, respectively, of
total revenues. The increase in absolute costs for the six months ended November
30, 1998, was primarily related to the expenses associated with the Company's
worldwide users conference held in October 1998. The decrease in costs as a
percentage of total revenues was primarily related to the increased revenues for
the six months ended November 30, 1998. The Company anticipates it will continue
to make significant investments in marketing and sales.
 
     General and administrative. General and administrative expenses decreased
17.7% from $3.6 million in the six months ended November 30, 1997 to $3.0
million for the six months ended November 30, 1998, representing 25.0% and
10.5%, respectively, of total revenues. General and administrative expenses
increased 8.5% from $1.5 million in the three months ended November 30, 1997 to
$1.6 million for the three months ended November 30, 1998, representing 16.2%
and 10.6%, respectively, of total revenues. The net increase in absolute costs
for the three months ended November 30, 1998 was primarily related to increased
expenses necessary to support the Company's infrastructure. The decrease in
costs as a percentage of total revenues was primarily related to the increased
revenues for the six months ended November 30, 1998.
 
     Restructuring charges. During the quarter ended November 30, 1997, the
Company implemented a worldwide restructuring of its corporate operations, which
resulted in workforce reductions and business consolidations. In connection with
the restructuring, the Company recorded a $3.0 million restructuring charge in
the quarter ended November 30, 1997, of which $1.6 million was related to
severance costs associated with the reduction in the worldwide workforce, $0.5
million to the termination of certain lease agreements, $0.6 million to the
write-off of certain assets and $0.3 million to other costs associated with the
restructuring. Of the total $3.0 million in restructuring charges, approximately
$0.6 million is a current liability at November 30, 1998.
 
  Income Taxes
 
     The Company has established a valuation allowance against its deferred tax
assets due to the uncertainty surrounding the realization of such assets.
Management evaluates on a quarterly basis the recoverability of the deferred tax
assets and the level of the valuation allowance. At such time as it is
determined that it is more likely than not that deferred tax assets are
realizable, the valuation allowance will be appropriately reduced.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     Since its inception, the Company has financed its operations primarily
through proceeds of approximately $23.6 million from private sales of Preferred
Stock, proceeds from its initial public offering and secondary public offering
of Common Stock and, to a lesser extent, bank credit lines and capital operating
leases. The Company completed its initial public offering of Common Stock in
October 1995 and realized net proceeds of $32.5 million. In January 1996, the
Company completed its secondary public offering of Common Stock, which generated
net proceeds of $16.5 million. The Company has used a portion of those proceeds
to repay borrowings under its line of credit in the amount of $1.6 million. As
of November 30, 1998, the Company had $25.6 million in cash and cash equivalents
and available-for-sale securities.
 
     The Company's operating activities used cash of $9.5 million and provided
cash of $5.3 million for the six months ended November 30, 1997 and 1998,
respectively. In the six months ended November 30, 1997, the Company's net loss
for the period was partially offset by depreciation and amortization expense,
non-cash restructuring charges and a decrease in accounts receivable. For the
six months ended November 30, 1998, the
 
                                       11
<PAGE>   14
 
Company's net income, a decrease in accounts receivable, and depreciation and
amortization expense provided cash associated with operating activities.
 
     The Company's investing activities provided cash of $8.6 million and used
cash of $7.1 million for the six months ended November 30, 1997 and 1998,
respectively. For the six months ended November 30, 1997, cash provided by
investing activities consisted primarily of proceeds from the sale and maturity
of marketable securities partially offset by purchases of marketable securities
and purchases of property and equipment. For the six months ended November 30,
1998, cash used by investing activities consisted principally of purchases of
marketable securities partially offset by proceeds from the sale and maturity of
marketable securities.
 
     Cash provided by financing activities was $1.5 million and $2.2 million for
the six months ended November 30, 1997 and 1998, respectively. In the six months
ended November 30, 1997, financing activities consisted primarily of proceeds
from the sale of Common Stock in connection with the Company's Employee Stock
Purchase Plan and proceeds from stockholders on notes receivable. In the six
months ended November 30, 1998, financing activities consisted primarily of
proceeds from the sale of Common Stock in connection with the Company's Employee
Stock Purchase Plan.
 
     At November 30, 1998, the Company's principal sources of liquidity were its
cash, cash equivalents, and short-term investments of $25.6 million. In March
1998, the Company negotiated a $5,000,000 line of credit under an agreement with
a bank, which expired on September 30, 1998. On September 22, 1998, the Company
extended the term on its bank line of credit for an additional two months until
November 30, 1998. On November 15, 1998, the Company renegotiated the agreement.
The commitments made under this agreement expire on September 30, 1999. The line
of credit is collateralized by all corporate assets, excluding leased equipment.
Borrowings under the line of credit bear interest at the lender's prime rate.
The agreement requires the Company to comply with certain financial covenants
and prohibits the assumption of any major debt, except for equipment leases,
without the bank's approval. As of November 30, 1998, no borrowings were
outstanding under the line of credit. See Note 4 of Notes to Condensed
Consolidated Financial Statements.
 
     Capital expenditures, including capital leases, were approximately $1.1
million and $195,000 for the six months ended November 30, 1997 and 1998,
respectively. For the six months ended November 30, 1997 and 1998, these
expenditures consisted principally of purchases of property and equipment,
primarily for computer hardware and software.
 
     The Company believes that its current cash and cash equivalents, its bank
line of credit and its funds generated from operations, if any, will provide
adequate liquidity to meet the Company's capital and operating requirements
through at least fiscal 1999. Thereafter, or if the Company's spending plans
change, the Company may find it necessary to seek to obtain additional sources
of financing to support its capital needs, but there is no assurance that such
financing will be available on commercially reasonable terms, or at all.
 
RECENT ACCOUNTING PRONOUNCEMENTS
 
     In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130 (SFAS 130), "Reporting Comprehensive
Income." This statement establishes requirements for disclosure of comprehensive
income and becomes effective for the Company for its fiscal year 1999, with
reclassification of earlier financial statements for comparative purposes.
Comprehensive income generally represents all changes in stockholders' equity
except those resulting from investments or contributions by stockholders. SFAS
130 requires unrealized gains or losses on the Company's available-for-sale
securities, which prior to adoption were reported separately in stockholders'
equity, to be included in other comprehensive income. The Company has adopted
SFAS 130, however, the effects of the adoption were immaterial to all periods
presented.
 
     In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131 (SFAS 131), "Disclosures about Segments
of an Enterprise and Related Information." This statement establishes standards
for disclosures about operating segments in annual financial statements and
selected information in interim financial reports. It also establishes standards
for related disclosures about products and services, geographic areas and major
customers. This statement supersedes statement of
 
                                       12
<PAGE>   15
 
Financial Accounting Standards No. 14, "Financial Reporting for Segments of a
Business Enterprise." The new standard becomes effective for the Company's
fiscal year 1999, and requires that comparative information from earlier years
be restated to conform to the requirements of this standard. The Company is
evaluating the requirements of SFAS 131 and the effects, if any, on the
Company's current reporting and disclosures.
 
     In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 (SFAS 133), "Accounting for Derivative
Instruments and Hedging Activities." This Statement establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. It requires an entity to recognize all
derivatives as either assets or liabilities in the statement of financial
position and measure those instruments at fair value. This Statement is
effective for all quarters of fiscal years beginning after June 15, 1999. The
Company has not determined its strategy for the adoption of SFAS 133 or its
effect on the financial statements.
 
     During October 1997, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants issued Statement of Position
No. 97-2 (SOP 97-2), "Software Revenue Recognition." This statement delineates
the accounting for software product and maintenance revenues. It supersedes
Statement of Position No. 91-1, "Software Revenue Recognition," and is effective
for transactions entered into in fiscal years beginning after December 15, 1997.
The Company has evaluated the requirements of SOP 97-2 and its current revenue
recognition policy is in compliance with this pronouncement.
 
YEAR 2000
 
     The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Such computer
programs or hardware may have date-sensitive software or embedded chips that
always assume the century is "19." This could cause miscalculations or failure
in the Company's information systems. Such system miscalculations or failures
could cause disruptions of operations including, among other things, a temporary
inability to process transactions or engage in normal business activities.
Disruptions of the Company's operations may also occur if key suppliers or
customers experience disruptions in their ability to purchase, supply or
transact with the Company due to Year 2000 problems.
 
     Significant uncertainty exists in the software and other industries
concerning the scope and magnitude of problems associated with the century
change. To the extent Year 2000 issues cause significant delay in, or
cancellation of, decisions to purchase the Company's products or product
support, due to the reallocation of resources to address Year 2000 issues or
otherwise, the Company's business, results of operations and financial condition
could be materially and adversely affected.
 
     The Company has developed a phased Year 2000 readiness plan for the current
versions of its products. The plan includes development of corporate awareness,
assessment, implementation (including remediation, upgrading and replacement of
certain product versions), validation testing, and contingency planning. The
Company continues to respond to customer concerns about prior versions of its
products on a case-by-case basis. The Company has largely completed all phases
of its plan, except for contingency planning, with respect to the current
versions of all of its products. Based on the Company's recent assessment of
Year 2000 issues, the Company has determined that the current versions of its
products are "Year 2000 Compliant," as defined below, when configured and used
in accordance with the related documentation, and provided that the underlying
operating system of the host machine and any other software used with or in the
host machine or Verity products are also Year 2000 Compliant. The Company has
not tested its products on all platforms or all versions of operating systems
that it currently supports and has advised its customers to verify that their
platforms and operating systems support the transition to the year 2000. The
Company considers its software to be "Year 2000 Compliant" if, based upon
reasonable verification procedures, the software recognizes and processes Verity
fields with a date type change from December 31, 1999 to January 1, 2000. Those
products, which we have determined to conform to be Year 2000 Compliant will a)
perform correct date-dependent calculations and operations (including sorting,
comparing and reporting) relating to such date change and b) will not experience
abnormal software termination, invalid or incorrect results as a result of such
date changes (without human intervention, other than original data entry of
valid dates), provided that they have
 
                                       13
<PAGE>   16
 
received correct and properly formatted date inputs from all software and
hardware that exchanges data with or provides data to them.
 
     The Company has not specifically tested software obtained from third
parties (licensed software, shareware, and freeware) that is incorporated into
its products, but the Company is seeking assurances from its vendors that
licensed software is Year 2000 Compliant. Despite testing by the Company and
current and potential customers, and assurances from developers of products
incorporated into the Company's products, the Company's products may contain
undetected errors or defects associated with Year 2000 date functions. Known or
unknown errors or defects in the Company's products could result in delay or
loss of revenue, diversion of development resources, damage to the Company's
reputation, or increased service and warranty costs, any of which could
materially and adversely affect the Company's business, operating results, or
financial condition.
 
     The Company has completed the implementation of Oracle 2000 developer as
part of its internal management information system, which has been certified as
Year 2000 Compliant by the supplier The new system was implemented during the
normal course of business due to the Company's growth. The Company is continuing
to review other systems, primarily its accounting system, in order to identify
areas that may not be Year 2000 compliant.
 
     The Company faces additional risk to the extent that suppliers of products,
services and systems purchased by the Company and others with whom the Company
transacts business are not Year 2000 Compliant. To the extent that the Company
is not able to test the technology provided by third-party vendors, the Company
is seeking assurances from such vendors that their systems are Year 2000
Compliant. Although Verity is not currently aware of any material operational
issues or costs associated with preparing its internal management information
and other systems for the Year 2000, it may experience material unanticipated
problems and costs caused by undetected errors or defects in the technology used
in such systems. In the event that any such third parties cannot provide the
Company with products, services or systems that are Year 2000 Compliant on a
timely basis, or in the event Year 2000 issues prevent such third parties from
delivery products, services or systems required by the Company on a timely
basis, the Company's business, results of operations and financial condition
could be materially and adversely affected.
 
     The Company does not currently have any information concerning the Year
2000-compliance status of its customers. As is the case with other similarly
situated software companies, if Verity's current or future customers fail to
achieve Year 2000 compliance of if they divert technology expenditures
(especially technology expenditures that were reserved for enterprise software)
to address Year 2000 compliance problems, the Company's business, results of
operations, or financial condition could be materially and adversely affected.
 
     The Company has funded its Year 2000 plan from operating cash flows and has
not separately accounted for these costs in the past. To date, the Company has
not incurred any material costs related to Year 2000 compliance activities.
Verity may continue to incur additional amounts related to the Year 2000 for
administrative personnel to manage the project, outside contractor assistance,
technical support for its products, product engineering and customer
satisfaction. The costs of these Year 2000 compliance activities are currently
being reviewed and analyzed by management to determine the potential exposure,
which could adversely affect the Company's business, results of operations, and
financial condition. These estimates will be derived utilizing numerous
assumptions of future events including the continued availability of certain
resources, third party modification plans and other factors. However, there can
be no assurance that these estimates will be achieved and actual results could
differ significantly from those plans. The Company may experience material
problems and costs with Year 2000 compliance. There can be no assurance that the
Company will identify and remedy all significant Year 2000 problems in a timely
fashion, that remedial efforts in this regard will not involve significant time
and expense, or that such problems will not have a material adverse effect on
the Company's business, results of operations and financial condition. The
Company has not yet fully developed a comprehensive contingency plan to address
situations that may results if it is unable to
 
                                       14
<PAGE>   17
 
achieve Year 2000 readiness of its critical operations. The cost of developing
and implementing such a plan may itself be material. The Company is also subject
to external forces that might generally affect industry and commerce, such as
utility or transportation company Year 2000 compliance failures and related
service interruptions.
 
     Verity has not been a party to any litigation or any proceedings to date
involving its products or services related to Year 2000 compliance issues,
however, there can be no assurance that the Company will not in the future be
required to defend its products or services in such proceedings, or to negotiate
the resolution of claims based on Year 2000 issues. Some commentators have
predicted significant litigation regarding Year 2000 compliance issues, and the
Company is aware of such lawsuits against other software vendors. Because of the
unprecedented nature of such litigation, it is uncertain whether or to what
extent the Company may be affected by it. The costs of defending and resolving
Year 2000-related disputes, and any liability of the Company for Year
2000-related damages, including consequential damages, could have a material
adverse effect on the Company's business, results of operations and financial
condition.
 
RISK FACTORS
 
     The Company operates in a rapidly changing environment that involves
numerous risks, a number of which are beyond the Company's control. The
following discussion highlights some of those risks. A comprehensive summary of
the risks can be found in the Company's Annual Report on Form 10-K for the
fiscal year ended May 31, 1998 and the Company's definitive Proxy Statement on
Schedule 14A as filed on August 27, 1998.
 
     History of Losses; Strategic Realignment. Since inception, the Company has
incurred significant losses and substantial negative cash flow. The Company was
founded in 1988, and historically derived the substantial majority of its
revenues from the licensing of high-priced, custom search and retrieval
applications for use almost entirely by large organizations and government
agencies. During these years, the Company also generated a substantial portion
of its revenues by providing the consulting services required to support these
products. In early fiscal 1994, the Company shifted its strategy to focus
increasingly on more versatile, lower-priced software applications, which
require less specialized consulting. To achieve revenue growth, the Company
must, among other things, increase market acceptance of the Company's
technology, achieve significantly increased sales levels, respond effectively to
competitive developments, continue to attract, retain and motivate qualified
persons, and continue to upgrade its technologies and commercialize products and
services incorporating such technologies. There can be no assurance that the
Company's strategy will be successful or that the Company will continue to
experience increased revenues, profitability or remain cash flow positive.
 
     Management in Transition; Employee Turnover. The Company is experiencing a
period of transition and new product introductions that have placed, and will
continue to place, a significant strain on its resources, including personnel.
During the past few years, management and other personnel have focused on
modifying and enhancing the Company's core technology to support a broader set
of search and retrieval solutions for use on desktop and enterprise-wide
systems, and over on-line services, the Internet and on CD-ROM. In order for the
Company's strategy to succeed, the Company must, among other things, leverage
its core technology to develop new product offerings by the Company and by its
original equipment manufacturer ("OEM") customers that address the needs of
these new markets. Many of the Company's products are still being developed or
have only recently been introduced, and there is no assurance that such products
will be successfully completed on a timely basis, will achieve market acceptance
or will generate significant revenues. Projects relating to these efforts,
including Verity's suite of products, continued enhancement of the functionality
of the Company's search engine and related products, and technical integration
of the Company's products with the products of the Company's strategic partners,
when added to the day-to-day activities of the Company, will continue to strain
the Company's resources and personnel.
 
     In connection with its strategy, the Company has also replaced the majority
of its work force and substantially reorganized all of the departments within
the Company. Continuity of personnel can be an important factor in the
successful completion of the Company's development projects, and ongoing
turnover in
 
                                       15
<PAGE>   18
 
the Company's research and development personnel could materially and adversely
impact the Company's development and marketing efforts. The Company believes
that hiring and retaining qualified individuals at all levels in the Company is
essential to its success, and there can be no assurance that the Company will be
successful in attracting and retaining the necessary personnel. As noted above,
the Company has experienced significant turnover, including turnover of several
senior members of management. In particular, on July 31, 1997, Mr. Gary J. Sbona
was appointed as the Company's President and Chief Executive Officer, and the
Company entered into an agreement with Regent Pacific Management Corporation, a
management firm of which Mr. Sbona is the Chief Executive Officer. Pursuant to
the original agreement, Regent Pacific agreed to provide management services to
the Company, including the services of Mr. Sbona as Chief Executive Officer and
President and at least three other Regent Pacific personnel as part of the
Company management team. The agreement had a one-year term and could be canceled
by the Company after expiration of the initial 26-week period, with a minimum
compensation to Regent Pacific of $1.3 million for that initial period. On April
13, 1998, the Company and Regent Pacific agreed to amend the agreement to
provide that Mr. Sbona and at least four other Regent Pacific personnel would
serve as part of the Company's management team. The amendment also served to
extend the term of the agreement until August 31, 1999, and to extend the
noncancelable period of the agreement until February 28, 1999. In connection
with Mr. Sbona's service as President and CEO of the Company, the Compensation
Committee of the Company's Board also granted to him an option to purchase
350,000 shares of the Company's common stock at an exercise price of $5.125 per
share. In October 1998, the Company's Board granted Mr. Sbona another option to
purchase an additional 260,000 shares of the Company's common stock, at an
exercise price of $7.625 per share. The shares subject to such options will vest
on a monthly basis during the 13-month period ending on February 28, 1999 and
the 12-month period ending on October 20, 1999, respectively, subject to Mr.
Sbona's continued employment as the Company's President and CEO; provided,
however, that the shares subject to such options will vest entirely upon certain
change of control transactions or upon a termination of Mr. Sbona without cause.
The options will also remain exercisable for one year following the termination
of Mr. Sbona's services.
 
     If Company management is unable to effectively manage the Company's
operations, identify opportunities in a timely fashion, and evaluate and manage
the Company's business and competitive position, results of operations and
financial condition will be materially and adversely affected.
 
     Fluctuations in Operating Results. The Company's quarterly operating
results have varied and are expected to vary significantly in the future. These
fluctuations may be caused by many factors, including, among others, the size
and timing of individual orders; customer order deferrals in anticipation of new
products; changes in the budgets or purchasing patterns of government agencies;
timing of introduction or enhancement of products by the Company or its
competitors; market acceptance of new products; technological changes in search
and retrieval, database, networking, or communications technology; competitive
pricing pressures; changes in the Company's operating expenses; personnel
changes; customer order deferrals resulting from reallocation of budgets to
address Year 2000 issues; foreign currency exchange rates; mix of products sold;
quality control of products sold; and general economic conditions.
 
     A significant portion of the Company's revenues in recent quarters have
been derived from relatively large sales to a limited number of customers, and
the Company currently anticipates that future quarters will continue to reflect
this trend. Sales cycles for these customers can be up to six months or longer.
In addition, like many software companies, the Company has generally recognized
a substantial portion of its revenues in the last month of each quarter, with
these revenues concentrated in the last weeks of the quarter. Accordingly, the
cancellation or deferral of even a small number of purchases of the Company's
products could have a material adverse effect on the Company's business, results
of operations and financial condition in any particular quarter. To the extent
that significant sales occur earlier than expected, operating results for
subsequent quarters may fail to keep pace or even decline.
 
     Product revenues are also difficult to forecast because the market for
search and retrieval software is uncertain and evolving. Because the Company
generally ships software products within a short period after receipt of an
order, the Company typically does not have a material backlog of unfilled
orders, and revenues in any quarter are substantially dependent on orders booked
in that quarter. In addition, a portion of the Company's revenues is derived
from royalties based upon sales by third-party vendors of products incorporat-
 
                                       16
<PAGE>   19
 
ing the Company's technology. These revenues may be subject to extreme
fluctuation and are difficult for the Company to predict. The Company's expense
levels are based, in part, on its expectations as to future revenues and to a
large extent are fixed. Therefore, the Company may be unable to adjust spending
in a timely manner to compensate for any unexpected revenue shortfall. Any
significant shortfall of demand in relation to the Company's expectations or any
material delay of customer orders would have an almost immediate adverse affect
on the Company's operating results and on the Company's ability to achieve
profitability.
 
     As a result of the foregoing and other factors, the Company believes that
period-to-period comparisons of its results of operations are not necessarily
meaningful and should not be relied upon as indications of future performance.
Fluctuations in operating results have in the past, and may in the future, also
result in volatility in the price of the shares of the Company's Common Stock.
 
     Developing Market; Unproven Acceptance of the Company's Products. The
Company's development efforts are focused on expanding Verity's suite of
products, designing enhancements to the Company's core technology, and
addressing additional technical challenges inherent in developing new
applications for enterprise, e-commerce, OEM and sophisticated CD-ROM publishing
markets. The Company plans to undertake development of further enhancements of
the search performance, scalability, functionality and deployability of its
products. There is no assurance that such products will be developed and
released on a timely basis, or that such products will achieve market
acceptance.
 
     As is typical in the case of a new and evolving industry, demand and market
acceptance for recently introduced products and services are subject to a high
level of uncertainty. The software industry addressing the information
management requirements of networked systems, CD-ROM, on-line services and the
Internet is young and has few proven products. Moreover, critical issues
concerning the commercial use of on-line services and the Internet (including
security, reliability, cost, ease of use and access, and quality of service)
remain unresolved and may impact the growth of the Internet and on-line markets,
together with the software standards and electronic media employed in such
markets.
 
     The Company's future operating results will depend in substantial part upon
its ability to increase the installed base of its intelligent search and
filtering technology and to begin to generate significant product revenues from
its CD Publisher, Information Server, Agent Server, KeyView products and other
products addressing the information retrieval and viewing requirements of
individuals and corporations from data sources within an enterprise and on
CD-ROM, on-line services and the Internet. The Company's future operating
results will also depend upon its ability to successfully market its technology
to on-line and Internet publishers who use such technology to index their
published information in the format used by Verity. To the extent that such
publishers do not adopt the Company's technology for indexing their published
information, users will be unable to search such information using the Company's
search and retrieval products, which in turn will limit the demand for the
Company's products.
 
     Because the market for certain of the Company's products and services is
new and evolving, it is difficult to assess or predict with any assurance the
growth rate, if any, and size of this market. There can be no assurance that the
market for the Company's products and services will develop, or that the
Company's products or services will achieve market acceptance. If the market
fails to develop, develops more slowly than expected or becomes saturated with
competitors, or if the Company's products do not achieve significant market
acceptance, the Company's business, operating results and financial condition
will be materially and adversely affected.
 
     A significant element of the Company's strategy is to embed Verity's
technology in products offered by the Company's OEM customers. Many of the
markets for such products are also new and evolving and, therefore, subject to
the same risks faced by the Company in the markets for its own products. In
addition, consolidation in the industries served by the Company could, and
acquisition or development by any of the Company's significant customers of
technology competitive with the Company's would, materially and adversely affect
the Company's business and prospects.
 
     Dependence on International Operations. Revenues derived from European
operations accounted for 8.1% and 6.2%, respectively, for the six months ended
November 30, 1997 and 1998. For the six months ended
 
                                       17
<PAGE>   20
 
November 30, 1997 and 1998, export sales accounted for 25.1% and 25.8% of total
revenues, respectively. Revenues derived from European operations accounted for
6.6% and 6.8% of total revenues, respectively, for the three months ended
November 30, 1997 and 1998. For the three months ended November 30, 1997 and
1998, export sales accounted for 27.0% and 28.7% of total revenues,
respectively. The Company expects that revenues derived from European operations
and export sales will continue to account for a significant percentage of the
Company's revenues for the foreseeable future; however, these revenues may
fluctuate significantly as a percentage of revenues from period to period.
Certain of these revenues have been derived from sales to foreign government
agencies, which may be subject to risks similar to those described below.
 
     There are a number of risks inherent in the Company's international
business activities, including unexpected changes in regulatory requirements,
tariffs and other trade barriers, costs and risks of localizing products for
foreign countries, longer accounts receivable payment cycles, potentially
adverse tax consequences, limits on repatriation of earnings and the burdens of
complying with a wide variety of foreign laws. The introduction of the Euro as a
common currency for members of the European Union is scheduled to take place in
January 1999. The use of the Euro could impact the Company's foreign exchange
exposure. At the present time, the Company does not engage in hedging activities
to protect against the risk of currency fluctuations, however, the Company is
preparing to hedge against fluctuations in the Euro if this exposure becomes
material. The Company also expects that its internal systems will be affected by
the introduction of the Euro, but expects these systems to be capable of
processing Euro denominated transactions by early 1999, although there can be no
assurance in this regard.
 
     Fluctuations in currency exchange rates could cause sales denominated in
U.S. dollars to become relatively more expensive to customers in a particular
country, leading to a reduction in sales or profitability in that country. Also,
such fluctuations could cause sales denominated in foreign currencies to affect
a reduction in the current U.S. dollar revenues derived from sales in a
particular country. Furthermore, future international activity may result in
increased foreign currency denominated sales and, in such event, gains and
losses on the conversion to U.S. dollars of accounts receivable and accounts
payable arising from international operations may contribute significantly to
fluctuations in the Company's results of operations. The financial stability of
foreign markets could also affect the Company's international sales. In
addition, revenues of the Company earned in various countries where the Company
does business may be subject to taxation by more than one jurisdiction, thereby
adversely affecting the Company's earnings. There can be no assurance that such
factors will not have an adverse effect on the revenues from the Company's
future international sales and, consequently, the Company's results of
operations.
 
     Dependence on United States Government and the Risk of Contract
Termination. Agencies of the United States government have accounted for a
significant portion of the Company's revenues. Specifically, these agencies
accounted for approximately 10.3% and 9.2% of the Company's revenues for the six
months ended November 30, 1997 and 1998, respectively, and 11.2% and 13.9% of
the Company's revenues for the three months ended November 30, 1997 and 1998,
respectively. Sales to government agencies fluctuated as a percentage of
revenues during these periods, and may decline in the future. In recent years,
budgets of many government agencies have been reduced, causing certain customers
and potential customers of the Company's products to re-evaluate their needs.
Such budget reductions are expected to continue over at least the next several
years. Future reductions in United States spending on information technologies
could have a material adverse effect on the Company's operating results.
 
     Almost all of the Company's government contracts contain termination
clauses, which permit contract termination upon the Company's default or for
convenience of the other contracting party. There can be no assurance such
cancellations will not occur in the future, and any such termination could
adversely affect the Company's operating results.
 
     Technological Change; Market Acceptance of Evolving
Standards. Historically, the Company has derived substantially all of its
revenues from the license of custom search and retrieval applications and
consulting and other services related to such applications. Recently, the
Company has refined and enhanced its core technology to add functionality and
facilitate incorporation of the Company's technology in a variety of
applications addressing the desktop, CD-ROM, enterprise, on-line and Internet
markets. Nevertheless, the
 
                                       18
<PAGE>   21
 
Company expects that for the foreseeable future it will continue to derive the
largest portion of its revenues from licensing its technology for enterprise
applications.
 
     The computer software industry is subject to rapid technological change,
changing customer requirements, frequent new product introductions and evolving
industry standards that may render existing products and services obsolete. As a
result, the Company's position in its existing markets or other markets that it
may enter could be eroded rapidly by product advancements by competitors. The
life cycles of the Company's products are difficult to estimate. The Company's
future success will depend, in part, upon its ability to enhance existing
products and to develop new products on a timely basis. In addition, its
products must keep pace with technological developments, conform to evolving
industry standards, particularly client/server and Internet communication and
security protocols, as well as publishing formats such as Hypertext Markup
Language ("HTML"), and address increasingly sophisticated customer needs. There
can be no assurance that the Company will not experience difficulties that could
delay or prevent the successful development, introduction and marketing of new
products, or that new products and product enhancements will meet the
requirements of the marketplace and achieve market acceptance. If the Company is
unable to develop and introduce products in a timely manner in response to
changing market conditions or customer requirements, the Company's financial
condition and results of operations would be materially and adversely affected.
 
     In addition, a significant strategy of the Company is to achieve
compatibility between the Company's products and the text publication formats
the Company believes are or will become popular and widely adopted. The Company
invests substantial resources in development efforts aimed at achieving such
compatibility. Any failure by the Company to anticipate or respond adequately to
technology or market developments could result in a loss of competitiveness or
revenue. For instance, to date the Company has focused its efforts on
integration with the Adobe PDF, Lotus Notes and Microsoft Exchange environments.
Should any of these products or technologies lose or fail to achieve acceptance
in the marketplace or be replaced by other products or technologies, the
Company's business could be materially and adversely affected.
 
     Because one of the Company's strategies is to embed its basic search engine
in key OEM application products, the Company's sales of its intelligent search
and filtering products depend in part on its ability to maintain compatibility
with these OEM applications. There is no assurance that the Company will be able
to maintain compatibility with these vendors' products or continue to be the
search technology of choice for such OEMs, and the failure to maintain
compatibility with or be selected by such OEMs would materially and adversely
affect the Company's sales. Further, the failure of the products of the
Company's key OEM partners to achieve market acceptance could have a material
adverse effect on the Company's results of operations.
 
     Software products as complex as those offered by the Company may contain
errors that may be detected at any point in the products' life cycles. The
Company has in the past discovered software errors in certain of its products
and has experienced delays in shipment of products during the period required to
correct these errors. There can be no assurance that, despite testing and
quality assurance efforts by the Company and by current and potential customers,
errors will not be found, resulting in loss of or delay in market acceptance and
sales, diversion of development resources, injury to the Company's reputation,
or increased service and warranty costs, any of which could have a material
adverse effect on the Company's business, results of operations and financial
condition. Although the Company generally attempts to limit by contract its
exposure to incidental and consequential damages, and to cap the Company's
liabilities under the contract, if a court failed to enforce the liability
limiting provisions of the Company's contracts for any reason, or if liabilities
arose which were not effectively limited, the Company's operating results could
be materially and adversely affected. See "Year 2000" above.
 
                                       19
<PAGE>   22
 
                           PART II. OTHER INFORMATION
 
ITEM 1. LEGAL PROCEEDINGS
 
     Not Applicable.
 
ITEM 2. CHANGES IN SECURITIES
 
     Not Applicable.
 
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
 
     Not Applicable.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
     The Company's Annual Meeting of Stockholders was held on September 24,
1998. Proxies for the meeting were solicited pursuant to Regulation 14A. At the
meeting, management's nominee for director and three proposals were submitted to
the stockholders of the Company. Management's nominee for director was elected
by the following vote:
 
<TABLE>
<CAPTION>
                                                                 SHARES
                                                         ----------------------
                        NOMINEE                          VOTING FOR    WITHHELD
                        -------                          ----------    --------
<S>                                                      <C>           <C>
Gary J. Sbona..........................................  9,456,089     107,864
</TABLE>
 
     Steven M. Krausz, Charles P. Waite, Jr. and Stephen A. MacDonald continued
to serve as directors of the Company after the annual meeting. The terms of Mr.
Krausz and Mr. Waite are effective until the Annual Meeting of Stockholders to
be held in 1999, and the term of Mr. MacDonald is effective until the Annual
Meeting of Stockholders to be held in 2000.
 
     A second proposal to amend the 1995 Stock Option Plan (the "Option Plan")
of the Company to increase the number of shares of Common Stock of the Company
authorized for issuance thereunder from 3,310,836 shares to 4,060,836 shares,
was submitted to a vote of the stockholders of the Company. The proposal was
approved by the following vote:
 
<TABLE>
<CAPTION>
FOR THE PROPOSAL   AGAINST THE PROPOSAL   ABSTENTIONS   BROKER NON-VOTES
----------------   --------------------   -----------   ----------------
<S>                <C>                    <C>           <C>
   2,431,021         1,241,356             38,058        5,853,518
</TABLE>
 
     A final proposal to ratify the selection of PricewaterhouseCoopers LLP as
independent accountants of the Company for its fiscal year ending May 31, 1999
was also submitted to a vote of the stockholders of the Company. The proposal
was approved by the following vote:
 
<TABLE>
<CAPTION>
FOR THE PROPOSAL   AGAINST THE PROPOSAL   ABSTENTIONS   BROKER NON-VOTES
----------------   --------------------   -----------   ----------------
<S>                <C>                    <C>           <C>
   9,548,340           4,905               10,708            0
</TABLE>
 
ITEM 5. OTHER INFORMATION
 
     Not Applicable.
 
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
 
     A. Exhibits -- See Exhibit Index
 
     B. Reports on Form 8-K
        None.
 
                                       20
<PAGE>   23
 
                                   SIGNATURES
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
 
                                          VERITY, INC.
 
                                          By:    /s/ JAMES E. TICEHURST
                                            ------------------------------------
                                                    James E. Ticehurst
                                            Vice President, Administration and
                                                        Controller
                                              (Principal Financial Officer)
 
Dated: January 12, 1999
 
                                       21
<PAGE>   24
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                      DESCRIPTION OF DOCUMENT
 -------                     -----------------------
 <S>       <C>
  2.1      Form of Agreement and Plan of Merger between Verity, Inc., a
           California corporation, and Verity Delaware Corporation, a
           Delaware corporation, filed September 22, 1995.(1)
  2.2      Agreement and Plan of Reorganization dated January 10, 1997
           among Verity, Inc., Cognisoft Acquisition Corporation and
           Cognisoft Corporation, and certain shareholders of
           Cognisoft.(7)
  2.3      Form of Stock Purchase Agreement dated as of May 31, 1997
           among Verity, 64k and certain shareholders of 64k.(8)
  2.4      Agreement for Purchase and Sale of Assets dated as of May
           30, 1997 among FTP US, FTP Canada, Verity US and Verity
           Canada.(9)
  3.1      Certificate of Incorporation of the Company.(1)
  3.2      By-Laws.(1)
  3.3      Certificate of Retirement of Series of Preferred Stock.(7)
  3.4      Certificate of Designation, Preferences and Rights of Series
           A Preferred Stock.(7)
  4.1      Amended and Restated Rights Agreement dated August 1, 1995,
           as amended.(1)
  4.2      Form of Rights Agreement between Verity, Inc. and First
           National Bank of Boston dated September 18, 1996.(6)
 10.1      Form of Indemnification Agreement for directors and
           officers.(1)
 10.2      Amended and Restated 1995 Stock Option Plan and forms of
           agreements thereunder.(7)
 10.3      1995 Employee Stock Purchase Plan.(1),(4)
 10.4      1995 Outside Directors Stock Option Plan and forms of
           agreement thereunder.(1),(4)
 10.5      Employment Agreement between Philippe F. Courtot and the
           Company dated July 15, 1993, together with related Amended
           and Restated Stock Purchase Agreement dated as of June 1,
           1995.(1),(4)
 10.7      Series G Preferred Stock Purchase Agreement dated August 29,
           1994.(2)
 10.8      Series H Preferred Stock Purchase Agreement dated August 1,
           1995.(2)
 10.18     Lease Agreement between Ross Drive Investors and the Company
           dated January 22, 1996.(3)
 10.19     Retainer Agreement between Regent Pacific Management
           Corporation and Verity, Inc. dated July 13, 1997.(10)
 10.20     Confidential Severance Option Agreement between Verity, Inc.
           and Richard Lo dated August 20, 1997.(10)
 10.21     Employment Agreement between Anthony J. Bettencourt and the
           Company dated August 28, 1997.(11)
 10.22     Security and Loan Agreement between Imperial Bank and the
           Company dated November 30, 1997.(12)
 10.23     Amendment to Retainer Agreement between Regent Pacific
           Management Corporation and Verity, Inc. dated February 1,
           1998.(13)
 10.24     Amendment to Security and Loan Agreement between Imperial
           Bank and the Company dated November 15, 1998
 10.25     Amendment to Employment Agreement between Anthony J.
           Bettencourt and the Company dated October 6, 1998
 27.1      Financial Data Schedule
</TABLE>
 
---------------
 (1) Incorporated by reference from the exhibits with corresponding numbers from
     the Company's Registration Statement (No. 33-96228), declared effective on
     October 5, 1995.
<PAGE>   25
 
 (2) Incorporated by reference from the exhibits with corresponding numbers from
     the Company's Registration Statement (No. 33-80567), declared effective on
     January 17, 1996.
 
 (3) Incorporated by reference from the exhibits with corresponding numbers from
     the Company's Form 10-Q for the quarter ended February 29, 1996.
 
 (4) Management contract or compensatory plan covering executive officers and
     directors of the Company.
 
 (5) Confidential Treatment has been granted for portions of these exhibits.
 
 (6) Incorporated by reference from exhibit no. 1 from the Company's Form 8-K as
     filed with the Securities and Exchange Commission on October 10, 1996.
 
 (7) Incorporated by reference from the exhibits with corresponding numbers from
     the Company's Form 10-Q for the quarter ended August 31, 1996.
 
 (8) Relating to the 64k acquisition, incorporated by reference from Exhibit No.
     2.1 to the Company's report on Form 8-K as filed with the Securities and
     Exchange Commission on June 13, 1997.
 
 (9) Relating to the KeyView acquisition, incorporated by reference from Exhibit
     No. 2.1 to the Company's report on Form 8-K as filed with the Securities
     and Exchange Commission on June 13, 1997.
 
(10) Incorporated by reference from the exhibits with corresponding numbers from
     the Company's Form 10-K for the year ended May 31, 1997.
 
(11) Incorporated by reference from the exhibits with corresponding numbers from
     the Company's Form 10-Q for the quarter ended August 31, 1997.
 
(12) Incorporated by reference from the exhibits with corresponding numbers from
     the Company's Form 10-Q for the quarter ended February 28, 1998.
 
(13) Incorporated by reference from the exhibits with corresponding numbers from
     the Company's Form 10-K for the year ended May 31, 1998.