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                                 UNITED STATES
 
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
 
                            ------------------------
 
                                   FORM 10-K
              ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
 
                     FOR THE FISCAL YEAR ENDED MAY 31, 1998
                         COMMISSION FILE NUMBER 0-26880
 
                            ------------------------
 
                                  VERITY, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
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                   DELAWARE                                      77-0182779
       (STATE OR OTHER JURISDICTION OF                        (I.R.S. EMPLOYER
        INCORPORATION OR ORGANIZATION)                      IDENTIFICATION NO.)
                894 ROSS DRIVE
            SUNNYVALE, CALIFORNIA                                  94089
   (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                      (ZIP CODE)
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       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 541-1500
        SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
                         COMMON STOCK, $0.001 PAR VALUE
                                (TITLE OF CLASS)
 
                            ------------------------
 
     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes [X]  No [ ]
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
 
     The aggregate market value of the voting stock held by non-affiliates of
the registrant, based upon the closing price of the Common Stock on July 31,
1998, as reported on Nasdaq National Market was approximately $88,775,000.
Shares of Common Stock held by each executive officer and director and by each
person who owned 5% or more of the outstanding Common Stock as of such date have
been excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive determination
for other purposes.
 
     The number of shares of the registrant's $0.001 par value Common Stock
outstanding on July 31, 1998 was 11,674,000.
 
     Part III incorporates by reference from the definitive proxy statement for
the registrant's 1998 annual meeting of stockholders to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end of
the fiscal year covered by this Form.
 
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                               TABLE OF CONTENTS
 
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Part I......................................................    1
  Item  1. Business.........................................    1
  Item  2. Properties.......................................   10
  Item  3. Legal Proceedings................................   10
  Item  4. Submission of Matters to a Vote of Securities
     Holders................................................   10
Part II.....................................................   11
  Item  5. Market for the Registrant's Common Stock and
     Related Stockholder Matters............................   11
  Item  6. Selected Consolidated Financial Data.............   12
  Item  7. Management's Discussion and Analysis of Financial
           Condition and Results of Operations..............   13
  Item  8. Financial Statements and Supplementary Data......   28
  Item  9. Changes in and Disagreements with Accountants on
           Accounting and Financial Disclosure..............   28
Part III....................................................   29
  Item 10. Directors and Executive Officers of the
     Registrant.............................................   29
  Item 11. Executive Compensation...........................   29
  Item 12. Security Ownership of Certain Beneficial Owners
           and Management...................................   29
  Item 13. Certain Relationships and Related Transactions...   29
Part IV.....................................................   30
  Item 14. Exhibits, Financial Statement Schedules, and
     Reports on Form 8-K....................................   30
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                                     PART I
 
     The statements contained in this report on Form 10-K that are not purely
historical are forward-looking statements which reflect the Company's current
views with respect to future events and financial performance. These
forward-looking statements are subject to certain risks and uncertainties,
including those discussed in this Part I and in "Management's Discussion and
Analysis of Financial Condition and Results of Operations" in Part II below that
could cause actual results to differ materially from historical results or those
anticipated. In this report, the words "anticipates," "believes," "expects,"
"intends," "future" and similar expressions identify forward-looking statements.
Readers are cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date hereof. The Company assumes no
obligation to update any such forward-looking statements.
 
ITEM 1. BUSINESS
 
     Verity develops, markets and supports knowledge retrieval software products
for application developers, corporate Intranet users and e-commerce sites.
Verity's technology enables organizations to manage text-based information
residing on their networks, making corporate content reusable across Intranets,
the Internet and CD-ROM.
 
     Verity's knowledge retrieval products are designed primarily to index,
search, retrieve, organize and disseminate unstructured, textual information,
which typically constitutes the substantial majority of an enterprise's business
information and does not reside in a traditional relational database. Verity's
products also enable application developers to embed powerful search and
retrieval functionality into their own commercial applications. The Company's
knowledge retrieval and 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 key e-commerce vendors, including AT&T WorldNet Services, Netscape
Communications, Time-Warner, Knight-Ridder, Reuters, Dow Jones, The Financial
Times and CDnow. Verity's software has been licensed to over 1,000 corporations,
government agencies, software developers, online service providers and Internet
publishers.
 
     Verity was incorporated in California in March 1988 and reincorporated in
Delaware in September 1995. The Company's principal executive offices are
located at 894 Ross Drive, Sunnyvale, CA 94089, and the telephone number at that
address is (408) 541-1500. Verity's home page on the Web can be located at
http://www.verity.com. Information contained in the Company's Web site shall not
be deemed a part of this Report.
 
INDUSTRY BACKGROUND
 
     The corporate Intranet has become a universal information portal connecting
the user to business information of all kinds. The majority of business
information accessible by these universal portals, both within the enterprise
and on the Internet, is text stored electronically in a variety of different
formats, including Adobe's Portable Document Format ("PDF"), Microsoft Word,
Corel's WordPerfect, Standard Generalized Mark-up Language ("SGML"), Hypertext
Mark-up Language ("HTML") and ASCII. In addition, the physical location or
source of unstructured information varies widely, including CD-ROM and dynamic
information sources such as electronic mail, text files and newswire feeds. The
typical large organization stores documents on hundreds or thousands of
individual web servers, file servers and document repository systems. As a
result of the Internet, the amount of information potentially available to the
user has increased dramatically. Consequently, navigating this vast array of
information, document types, formats and storage systems has become complex and
confusing. Verity's core business is to provide products which help simplify the
process of searching, retrieving, navigating and reusing this kind of text-based
networked information.
 
     The proliferation of information on corporate Intranets has been
accompanied by a growing recognition that large institutions need to manage
their corporate knowledge more effectively. Knowledge management seeks to
improve an organization's ability to leverage its core skills and competencies.
Knowledge retrieval, a key component of knowledge management, seeks to improve
the organization of a company's digitally stored information assets by creating
a searchable and shared knowledge warehouse out of the disparate file and web
 
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servers and document repositories scattered across a typical large organization.
The dramatic increase in the amount of electronic information accessible via
networks has created a need for software to improve the usability of networked
information, particularly software, enabling users to find, organize and reuse
information efficiently.
 
     Traditional information retrieval applications have been limited by several
factors. Information retrieval systems have not been able to scale to support
very large collections of documents efficiently and effectively. At the same
time, the precision of typical search and retrieval technology has been limited
by the relative sophistication of the user. Typical "simple" queries yield poor
results, while complex queries have been able to better separate significant
from extraneous information. Moreover, information retrieval applications have
focused on the ability to conduct user-initiated ad-hoc searches, when, for many
organizations, the real problem is proactive notification: real-time awareness
that new business critical information is now available. Finally, those products
that provide some type of real-time notification tend to use a general-purpose
solution offering limited options or choices, when, in reality, users desire a
high degree of personalization. Scalability, precision, personalization and
active agents define many of the objectives that have frustrated users of
traditional information retrieval technology.
 
THE VERITY SOLUTION
 
     Verity's knowledge retrieval product suite is a scalable and cross-platform
product designed to solve the knowledge retrieval problems of large institutions
and electronic commerce sites. Verity's product family manages the lifecycle of
corporate information. Once information has been created and stored
electronically, Verity's products are designed to enable the information to be
located precisely, and reused and disseminated broadly.
 
     Verity's core search engine (Verity Developer's Kit) is both an OEM
solution as well as the core technology underlying the Company's own corporate
products. Verity's search engine uses a combination of full text, metadata and
knowledge-based methods to index and retrieve textual information stored in a
variety of formats across corporate Intranets and the Internet. The Company's
products organize and rank the relevance of selected information, thereby
enabling users to filter and evaluate information personalized to their specific
needs and interests. Verity's products enable user-initiated interactive query,
and also enable the construction of automated software agents, which actively
and continuously monitor Internet and Intranet information sources such as web
sites, news feeds and file systems for new information or changes in content
matching user profiles. Additionally, the products allow organizations to build
hybrid online and offline information distribution systems by publishing
information on CD-ROM. This CD-ROM based information maintains links to active
web sites and enables automatic synchronization between the Web and a user's
local computer.
 
     The Company originally developed its core search and retrieval technology
for use by large government agencies, such as the Central Intelligence Agency
and the National Security Agency. In the past several years, Verity has enhanced
and expanded the Company's family of products and markets. Today, Verity offers
a broad range of information retrieval products for three primary markets:
corporate and institutional Intranets, e-commerce systems and high-technology
OEMs.
 
     Corporate Intranet. The Company markets an integrated product suite
enabling public and private organizations to index, search, retrieve,
disseminate and publish textual information residing in more than two hundred
document formats and in web and file servers distributed across the enterprise.
 
     Internet Electronic Commerce and Publishing. The Company's Internet
products are designed to provide e-commerce vendors and online information
publishers with an integrated solution enabling their users to navigate
efficiently through large bodies of online information such as product catalogs,
news services and document repositories. The Company recently expanded its
product offering to include a search engine (Verity K2 Toolkit) designed to
scale to support the largest commercial Internet sites, and to enable millions
of documents to be searched by hundreds of users simultaneously. The Company
also offers an integrated solution for publishers seeking to disseminate
information in hybrid form via both CD-ROM and the Web.
 
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     OEMs and Embedded Solutions. The Company offers toolkits that allow
software developers to embed the Company's search-and-retrieval, profiling
agent, and viewing and filtering technologies within their products. Verity's
technology has been embedded in document repository systems such as Documentum
and IntraDoc!; groupware such as Microsoft Exchange, Novell GroupWise and Lotus
Notes; popular web application development systems from Netscape; ERP systems
from SAP; and many business applications including customer care and help desk
systems.
 
PRODUCTS
 
     The Company's products include the following:
 
  Enterprise Knowledge Retrieval Products:
 
     Verity Information Server. Verity's Information Server enables
administrators to organize, build and centrally maintain Verity
collections -- indices of documents stored on web and file servers. One-button
domain indexing can turn an existing web site into a searchable Verity
collection. Based on Verity's Topic knowledge framework, Information Server is
designed to enable users to construct rich queries or to select queries from
corporate query libraries.
 
     Verity Intranet Spider. Verity's Intranet Spider is designed to extend the
reach for Information Server by enabling users to index multiple domains and by
providing administrators with extensive control over what is indexed. Combined
with Information Server, Verity Intranet Spider helps assure efficient search,
retrieval and automatic monitoring of Intranet and Internet content.
 
     Verity Agent Server. Verity's Agent Server is a companion product to
Information Server, which enables proactive notification and dissemination of
information. It is designed to enable proactive searching, filtering,
categorization and delivery of personalized information across the Internet and
corporate Intranet to users and workgroups. New information matching users'
interests can be delivered automatically according to administrator or
user-specified delivery options, including electronic mail and personal web
pages. The Agent Server includes extensive customization capabilities for the
creation of special delivery services and products, and also provides
cross-platform administrative tools.
 
  OEM and Custom Application Development Tools:
 
     Verity Developer's Kit. Verity's Developer's Kit (VDK) provides an
application programmer interface (API) to Verity's core search engine. The
Developer's Kit enables organizations to embed Verity's high performance search
and retrieval capabilities within their own custom or commercial applications,
products and services.
 
     Verity K2 Toolkit. Verity's K2 Toolkit, announced in April of 1998, enables
developers to build, search and retrieve applications supporting millions of
documents and hundreds of simultaneous queries. The K2 Toolkit is designed to
exploit clustered symmetric multiprocessing systems, enabling parallel indexing,
and search and retrieval of very large information collections. This product, in
use today by a few of the largest e-commerce sites, is designed for large
corporate Intranets, scalable OEM products, and public Internet commerce sites.
 
     Verity Agent Server Toolkit. Verity's Agent Server Toolkit is designed to
enable developers to build custom information dissemination applications using
the capabilities of the Agent Server.
 
     Verity Information Connectors and Gateways. Verity develops and markets
access and indexing for popular information repositories, including Lotus Notes,
Microsoft Exchange and relational databases.
 
     Verity CD-Web Publisher. Verity's CD-Web Publisher is a hybrid CD/Web
static and dynamic information publishing system. CD-Web Publisher is designed
to publish the contents of a web site on CD-ROM while maintaining links to the
online elements of web sites that change frequently. CD-Web Publisher is
designed for high-volume information publishers, customer service organizations
and others who need to use web-based information off-line. CD-Web Publisher
includes Verity's standard search capabilities.
 
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  KeyView Products
 
     Acquired from FTP Software in 1997, the KeyView product family enables
users to filter and view documents residing in hundreds of application formats.
Verity has integrated KeyView technology into Verity's own core products and
sells the KeyView family of filtering and viewing products to OEMs and corporate
customers. The KeyView product family includes desktop viewing and filtering,
compression application, KeyView Pro, and software development toolkits,
including the KeyView SDK and HTML Export SDK. These toolkits enable viewing of
many documents in different formats from within commercial applications, and the
automatic conversion of any document to HTML. The KeyView Developer's Kit is
designed to allow ISVs to embed KeyView functionality within their own
applications.
 
SERVICES
 
     The Company makes extensive technical support and training services
available for its customers, and also provides consulting services designed to
assist its customers in utilizing Verity software to develop custom search and
retrieval applications. As of May 31, 1998, the Company employed 17 people in
its technical support organization, 18 people in its consulting group and 1
person focused on developing and coordinating training services.
 
     Technical Support and Maintenance. The Company provides post-sale customer
support directly through its own technical support engineers, who handle most
support calls by telephone and electronic mail. The Company offers annual
maintenance contracts, which entitle its customers to full telephone support
service, software updates and bug fixes. The Company also provides its customers
access to technical support services by electronic mail and over a bulletin
board system.
 
     Consulting. The Company offers consulting services to its enterprise
customers, OEMs, VARs and system integrators (SIs) to assist them in designing
and deploying Verity applications tailored to meet their particular information
search and retrieval needs. Consulting services have typically been offered on a
time and materials basis. The Company has significantly streamlined the API for
its search engine to reduce the need for specialized consulting services in
connection with the incorporation by OEMs and other third parties of the
Company's search technology.
 
     Training. The Company provides training services at its own training
facilities located in Sunnyvale, California, as well as at the facilities of its
enterprise customers, VARs and SIs worldwide. The Company also provides training
through certain authorized third parties. Verity has developed an extensive set
of courses and materials for presentation by its professional instructors. The
Company believes its high quality training helps assure increased customer
satisfaction while enhancing the Company's ability to make additional sales to
its existing customer base. Customers typically pay for training services on a
course or fee basis.
 
CUSTOMERS
 
     Verity focuses on three core markets: Intranet-based knowledge retrieval
applications for large corporate and government organizations, embedded
solutions for OEMs and information retrieval solutions for e-commerce and
electronic publishers, including publishers of CD-ROM based information.
Verity's software has been licensed directly to over 1,000 corporations,
government agencies, software developers, information publishers and e-commerce
vendors.
 
     The OEM, corporate Intranet and Internet e-commerce markets are rapidly
evolving and are characterized by an increasing number of market entrants. As is
typical in the case of a new and rapidly evolving industry, demand and market
acceptance for recently introduced products and services are subject to a high
level of uncertainty. There can be no assurance that the use of intelligent
information retrieval and filtering technologies will become widespread in these
or any markets, or that the Company's products or technologies will achieve
market acceptance.
 
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SALES AND MARKETING
 
     The Company's goal is to make its software a de facto standard and the most
popular means to search, filter, view and disseminate information within the
enterprise and beyond the enterprise on the Internet and online services. Verity
seeks to tailor its marketing and sales efforts to most effectively reach
customers in each of these market segments. The Company pursues opportunities
within large organizations and government agencies through the combined efforts
of the Company's direct sales and telesales forces. The Company's products and
tools are sold indirectly through a network of VARs, SIs and OEMs.
 
     Direct Sales. Members of the Company's direct sales force are trained to
assist enterprise customers to acquire and utilize the Company's suite of tools
and products to integrate information residing within the organization over a
variety of sources such as word processing documents, relational database
document repositories and Internet servers. The Company's direct sales force
also targets online service providers and publishers of information stored on
both CD-ROM and the Internet. The Company maintains direct sales offices or
personnel in a number of cities across the United States, including Washington,
D.C., Dallas, Denver, Atlanta, Sunnyvale, Chicago and New York. European direct
sales operations are located in London, Utrecht, Frankfurt, Munich and Paris.
Additional information regarding foreign sales and operations is available in
Note 14 of Notes to Consolidated Financial Statements.
 
     Telesales. The Company began a telesales operation in 1995, which was
initially focused on selling the Company's Internet products. Although the
telesales operation's initial focus is on the Company's own products, the
Company also plans to offer and sell products developed by its partners through
the telesales program.
 
     Value Added Resellers and System Integrators. The Company's VARs and SIs
frequently distribute the Company's products as part of integrated turnkey
solutions for the enterprise and Internet. The Company also markets products
such as document management or support automation which incorporate the
Company's information retrieval toolkits.
 
     Original Equipment Manufacturers. The Company's search technology is sold
as an integrated feature of software products offered by OEM providers of
software products. These OEMs participate in a variety of markets, including
groupware, document management (Documentum and Intranet Solutions), support
automation (Remedy), resume tracking (Restrac) and publishing (Adobe, the
Financial Times and Compaq Computer). The Company has also licensed its search
technology for use by database management software companies including Informix
and Sybase.
 
     The Company's marketing activities are targeted at building market
awareness and identifying prospective customers for enterprise, CD-ROM,
Internet/publishing and online service applications. Certain of the Company's
OEM contracts provide for brand name exposure in the OEM's packaging of embedded
Verity search technology. The Company believes such exposure helps promote
market awareness for its products and can create sales opportunities for add-on
products to the OEM's installed base. The Company's marketing efforts include
participation in tradeshows, conferences, industry speaking engagements,
advertising and direct mail campaigns targeting specific market niches such as
the Internet, document management and online services. The Company also
maintains a home page on the Internet, which has been a source of sales leads.
As of May 31, 1998, the Company's sales and marketing organizations consisted of
91 employees.
 
THE VERITY TECHNOLOGY
 
     The Company's core technology was originally developed by the Company for
use by large government agencies, such as the Central Intelligence Agency and
the National Security Agency, to perform complex, customized search and
retrieval applications over stand-alone, host-based systems. Since early fiscal
1994, Verity expanded its products offering to support client/server and
web-based computing environments. The Company has expanded its markets to
include OEMs, corporate Intranets and e-commerce vendors, and online and CD-ROM
information publishers. Verity technologies address the major aspects of the
intelligent search and filtering process, including document indexing, query
formulation and ranking and presentation of results.
 
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     Indexing. The search engine incorporated in Verity's server products or OEM
applications indexes documents automatically based upon user-specified criteria,
into a structured database, or "collection." Verity indices exploit full text,
metadata and Verity's unique knowledge mapping system, Topics(R). Collections
created through the indexing process contain the results of text analysis
performed by the Verity engine as well as information about the document's
context and structure. End users with Verity-based applications or standard web
browsers can search those collections that administrators make available to
them. Verity architecture is designed to permit real-time indexing of new
documents into a Verity collection, even while users actively search that
collection. As a result, the system provides enhanced availability, and is
designed to operate during maintenance and back up. Verity's new K2 Toolkit
enhances the availability of Verity applications by providing redundant
processing paths, further enhancing system availability.
 
     Query Formulation. The Company's search technology is designed to enable
users to formulate and refine queries using a variety of search tools such as
keywords, thesauri, dictionaries and concept-based Topics. Once formulated,
queries can be used to retrieve archived information with a standard,
interactive search. In addition, the same query may be incorporated in an agent
deployed to watch and "clip" relevant information arriving in dynamic text
files. This "profiling" feature of the Company's query technology is designed to
address high user and data volumes, such as those associated with enterprise
applications and large online services.
 
     The Verity search engine is designed with an open architecture which
employs multiple search techniques and supports incorporation of additional
techniques by the Company in future products or custom applications. This open
environment also allows third party developers to extend Verity's products and
tools. The concept-based "topic" search metaphor is one method by which the
Company's products permit construction of sophisticated search requests, which
can then easily be deployed by users. Users construct a hierarchical "tree" of
concepts with weighted branches, which defines a "topic." The topic tree
graphically represents relationships among the user's terms, providing increased
refinement of typical Boolean or natural language expressions. Topics(R) serve
as weighted rules of evidence describing the probability that a document is
about a given subject. Using Topics(R), organizations can map large bodies of
knowledge and enable automatic document classification, sophisticated search and
intelligent information dissemination.
 
     Results Presentation. The results obtained through matching queries against
document collections are provided with a relevance score calculated by the
Verity engine. This score may be presented, along with other available
document-attribute information desired by the user, in a customizable results
list. The Company is actively developing added functionality designed to enable
the organization, or "clustering" of search results according to common themes
within the retrieved documents. Verity also provides automatic document
summarization and query by example, a facility allowing any document to be
turned into a "find more documents like this" query.
 
     Viewers and Filters. Document filtering, provided by Verity's incorporation
of its KeyView technology, automatically detects the kind of document (e.g.,
Microsoft Word, WordPerfect, Lotus 1-2-3 spreadsheet) being indexed and isolates
the text to be indexed from embedded formatting information. Filters are
designed to enable the indexing engine to handle a wide variety of document
types and formats. The threadsafe nature of the Verity filters helps assure fast
and reliable access to documents for searching. Verity's KeyView viewing
technology is designed to provide users with the ability to view documents in a
variety of formats without the use of the application which generated the
document.
 
PRODUCT DEVELOPMENT
 
     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. The Company is also engaged in research and development relating to
enhanced presentation and organization of retrieved information, such as the
organization and navigation of search results. As of May 31, 1998, there were 90
employees on the Company's
 
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research and development staff. The Company's research and development
expenditures in fiscal 1996, fiscal 1997 and fiscal 1998 were $8.5 million,
$14.3 million and $15.5 million, respectively, which represented 27.6%, 33.5%
and 40.0% of total revenues, respectively. The Company expects that it will
continue to commit substantial resources to product development in the future.
 
     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 its 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 address increasingly sophisticated customer needs and 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 HTML. 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
or 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.
 
     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, 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.
 
COMPETITION
 
     The electronic information search and retrieval software market is
intensely competitive. The Company believes that the principal competitive
factors in such market are product quality, performance and price, vendor and
product reputation, product architecture, strategic alliances, functionality and
features, ease of use and quality of support. A number of companies offer
competitive products addressing certain of the Company's target markets. In the
enterprise market, the Company competes with Dataware, InfoSeek, PC Docs and
Excalibur, among others. Microsoft has also begun to supply entry-level products
for the enterprise market. In the Internet/publishing market, the Company
competes with Folio, PC Docs and Dataware, among others. The Company also
competes indirectly with database vendors that offer information search and
retrieval capabilities with their core database products. In the future, the
Company may encounter competition from companies that enhance products such as
word processing software, document management systems, groupware applications,
Internet products and operating systems to include text search and retrieval
features. Many of the Company's existing competitors, as well as Microsoft and a
number of other potential new competitors, have significantly greater financial,
technical and marketing resources than the Company. Because the success of the
Company's strategy is dependent in part on the success of the Company's
strategic partners, competition between the Company's strategic partners and the
strategic partners of the Company's competitors, or failure of the Company's
strategic partners to achieve or maintain market acceptance could have a
material adverse effect on the Company's competitive position. Although the
Company believes that its products and technologies compete favorably with
respect to the factors outlined above, there can be no assurance that the
Company will be able to compete successfully against its current or future
competitors or that competition will not have a material adverse effect on the
Company's business, results of operations and financial condition.
 
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PROPRIETARY RIGHTS
 
     To date, the Company has relied upon a combination of copyrights and trade
secret law to protect its proprietary rights. The Company generally enters into
confidentiality or license agreements with its employees, distributors,
customers and potential customers and limits access and distribution of the
source code to its software and other proprietary information. To license its
client products, the Company primarily relies on "shrink-wrap" licenses that are
not signed by the end user and, therefore, may be unenforceable under the laws
of certain jurisdictions. Policing unauthorized use of the Company's products is
difficult. There can be no assurance that the steps taken by the Company in this
regard will be adequate to prevent misappropriation of its technology or that
the Company's competitors will not independently develop technologies that are
substantially equivalent or superior to the Company's technology.
 
     In the future, the Company may receive communications from third parties or
have other reasons to seek licenses under third-party intellectual property
rights. In such cases, the Company may evaluate whether to obtain such licenses.
However, there can be no assurance that such licenses will be available or if
such licenses are made available, that the terms will not have a material
adverse effect on the Company's results of operations.
 
     Certain technology used in the Company's products is licensed from third
parties, generally on a nonexclusive basis. These licenses generally require the
Company to pay royalties and to fulfill confidentiality obligations. The Company
believes that there are alternative sources for each of the material components
of technology licensed by the Company from third parties. However, the
termination of any of such licenses, or the failure of the third party licensors
to adequately maintain or update their products, could result in delay in the
Company's ability to ship certain of its products while it seeks to implement
technology offered by alternative sources. Any required replacement licenses
could prove costly. Also, any such delay, to the extent it becomes extended or
occurs at or near the end of a fiscal quarter, could result in a material
adverse effect on the Company's results of operations. While it may be necessary
or desirable in the future to obtain other licenses relating to one or more of
the Company's products or relating to current or future technologies, there can
be no assurance that the Company will be able to do so on commercially
reasonable terms or at all. See "Business Risks -- Dependence on Proprietary
Technology."
 
EMPLOYEES
 
     As of May 31, 1998, the Company had a total of 250 employees, including 90
in research and development, 133 in sales, marketing and related customer
support services, 22 in administration and 5 in manufacturing. Of these
employees, 176 were located in the United States, 37 in Europe and 37 in Canada.
None of the Company's employees is represented by a collective bargaining
agreement, nor has the Company experienced any work stoppage. The Company
considers its relations with its employees to be good.
 
     The Company is heavily dependent upon its ability to attract, retain and
motivate skilled technical and managerial personnel. The loss of services of any
of its executive officers or other key employees could have a material adverse
effect on the business, operating results or financial condition of the Company.
The Company's future success also depends on its continuing ability to identify,
hire, train and retain other highly qualified technical and managerial
personnel. Competition for such personnel is intense, and there can be no
assurance that the Company will be able to attract, assimilate or retain other
highly qualified technical and managerial personnel in the future. The inability
to attract, hire or retain the necessary technical and managerial personnel
could have a material adverse effect upon the Company's business, operating
results and financial condition.
 
                                        8
<PAGE>   11
 
DIRECTORS, EXECUTIVE OFFICERS AND KEY EMPLOYEES
 
     As of July 31, 1998, the directors, executive officers and key employees of
the Company were as follows:
 
<TABLE>
<CAPTION>
                  NAME                    AGE                        POSITION
                  ----                    ---                        --------
<S>                                       <C>   <C>
Gary J. Sbona...........................  55    President, Chief Executive Officer and Director
Stephen W. Young........................  49    Chief Operating Officer
James E. Ticehurst......................  53    Vice President, Administration and Controller and
                                                Assistant Secretary
Anthony J. Bettencourt..................  37    Senior Vice President, Worldwide Sales and
                                                Marketing
John Navas..............................  54    Vice President, Development and Technical Services
Hugh S. Njemanze........................  41    Chief Technology Officer
Ronald F.E. Weissman....................  48    Vice President, Strategy and Corporate Development
Steven M. Krausz(1).....................  43    Director
Stephen A. MacDonald....................  52    Director
Charles P. Waite, Jr.(1)................  43    Director
</TABLE>
 
---------------
(1) Member of the Compensation and Audit Committees.
 
     Mr. Sbona has served as the Company's President and Chief Executive Officer
since July 1997 and has served as a director of the Company since May 1998.
Since 1974, Mr. Sbona has also served as the Chairman and Chief Executive
Officer of Regent Pacific Management Corporation, a professional services
company, which is currently providing management services to the Company. Mr.
Sbona received his B.S. in Business and Engineering from San Jose State
University.
 
     Mr. Young commenced his service to Verity as part of the Regent Pacific
Management team in July 1997 and was subsequently appointed to the position of
Chief Operating Officer. Since 1990, Mr. Young has served as a principal of
Regent Pacific Management Corporation, a professional services company, which is
currently providing management services to the Company. Mr. Young received his
B.S. in Industrial Administration and his M.B.A. from the University of
Illinois.
 
     Mr. Ticehurst joined the Company as Accounting Manager in December 1988 in
a consulting capacity. He was subsequently promoted to Controller and in October
1997 was appointed to the position of Vice President, Administration and
Controller and Assistant Secretary. Mr. Ticehurst received his B.S. in
Accounting from San Jose State University.
 
     Mr. Bettencourt joined the Company in July 1995 as Vice President of North
American Sales. He was subsequently promoted to Vice President of Worldwide
Sales and Marketing and served in this position until his departure in December
1996. Mr. Bettencourt has subsequently rejoined the Company in September 1997 as
Senior Vice President, Worldwide Sales and Marketing. Prior to rejoining the
Company, Mr. Bettencourt served as an officer of OnLive! Technologies, a private
technology company. Prior to initially joining the Company, Mr. Bettencourt
served as Vice President of Sales for Versant Object Technology from 1992 to
June 1995 and as Director of U.S. Sales for Versant Object Technology from July
1990 to 1992. From December 1988 to July 1990, Mr. Bettencourt served as Vice
President of Sales for Rockwell CMC. Mr. Bettencourt received his B.A. from
Santa Clara University.
 
     Mr. Navas commenced his service to Verity as part of the Regent Pacific
Management team in August 1997 and was subsequently appointed to the position of
Vice President, Development and Technical Services. Since 1985, Mr. Navas has
served as a principal of Regent Pacific Management Corporation, a professional
services company, which is currently providing management services to the
Company. Mr. Navas received his B.S. in Engineering from Massachusetts Institute
of Technology.
 
     Mr. Njemanze has served as the Company's Vice President, Desktop Products
since February 1997 and its Chief Technology Officer since July 1997. Mr.
Njemanze joined the Company in November 1993 serving as Software Architect until
April 1994. He then served as Director, Applications Development until February
 
                                        9
<PAGE>   12
 
1997. Prior to his services at Verity, he served as a member of the Technical
Staff at Apple Computer. Mr. Njemanze received his B.S. in Computer Science from
Purdue University.
 
     Mr. Weissman joined the Company in May 1997 as Vice President, Corporate
Marketing. In October 1997, he became Vice President of Worldwide Marketing. In
July 1998, he took on a new role at Verity, Vice President, Strategy and
Corporate Development. Mr. Weissman was employed by Filoli Information Systems
as Vice President, Sales and Marketing from April 1995 to May 1997. From January
1990 to April 1995, he was employed by NeXT Software, Inc. as Director,
Corporate Marketing where he managed European Marketing and American Corporate
Marketing. Mr. Weissman received his B.A., M.A. and Ph.D. from U.C. Berkeley.
 
     Mr. Krausz has served as a director of the Company since May 1988. Mr.
Krausz has been a General Partner of U.S. Venture Partners III, U.S.V.
Entrepreneur Partners and BHMS Partners III since 1985. Mr. Krausz is also a
director of Photon Dynamics, Inc.
 
     Mr. MacDonald has served as a director of the Company since December 1988.
From May 1983 until May 1996, Mr. MacDonald was employed by Adobe Systems
Incorporated where he served as Senior Vice President and Chief Operating
Officer. From May 1996 to April 1998, he served as President and Chief Executive
Officer of Active Software. Mr. MacDonald is currently a consultant. Mr.
MacDonald is a director of Network Computing Devices, Inc. and Imaging
Technologies Corporation.
 
     Mr. Waite has served as a director of the Company since May 1988. Mr. Waite
has been a General Partner of Olympic Venture Partners II and a Vice President
of Northwest Venture Services Corp. since 1987, a General Partner of Olympic
Venture Partners III since 1994 and a General Partner of Olympic Venture
Partners IV since 1997. Mr. Waite is also a director of CellPro Incorporated,
Cardima, Inc., Originet, Inc., Seattle Genetics, SignalSoft Corp., WatchGuard
Technologies and Rossetta Inpharmatics.
 
     The Company's Certificate of Incorporation provides that the Board of
Directors is divided into three classes serving staggered three-year terms. Each
class of directors consists of one or two directors. The Class I directors,
whose terms will end in 1999, are Steven M. Krausz and Charles P. Waite, Jr.;
the Class II director, whose term will end in 2000, is Stephen A. MacDonald; and
the Class III director, whose term will end in September 1998, is Gary J. Sbona.
 
     Officers are elected by and serve at the discretion of the Board of
Directors. There are no family relationships among the directors or officers of
the Company.
 
ITEM 2. PROPERTIES
 
     The Company's principal administrative, sales, marketing and research and
development facilities occupy approximately 51,000 square feet in Sunnyvale,
California. The Company's operating lease agreement for this facility commenced
in June 1996 and expires in September 2005. The Company's average annual lease
payment, based on the total 96,000 square feet leased property, is scheduled to
be approximately $1.1 million. In addition, the Company also leases sales
offices in England, Netherlands, France and Germany and a development and
technical support office in Canada.
 
ITEM 3. LEGAL PROCEEDINGS
 
     On March 11, 1998, the Company announced that it had filed a lawsuit in
United States District Court for the District of Delaware against Lotus
Development Corporation for copyright infringement, unfair competition, breach
of a 1992 agreement under which Verity licensed certain software to Lotus,
misappropriation of trade secrets and unjust enrichment and conversion. On June
8, 1998, Verity, Inc. and Lotus Development Corporation announced that they have
concluded a settlement agreement that makes available to Lotus a range of Verity
technologies for use with Lotus products. The settlement agreement resolves
issues that had arisen between the two companies. Accordingly, the Company has
withdrawn its legal action against Lotus Development Corporation by virtue of a
settlement agreement dated June 8, 1998.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
 
     Not applicable.
 
                                       10
<PAGE>   13
 
                                    PART II
 
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
 
  Market Price of Common Stock
 
     The Company's stock has been traded on the Nasdaq National Market since the
Company's initial public offering on October 5, 1995 under the Nasdaq symbol
VRTY. The following table sets forth, for the periods indicated, the high and
low closing sales prices for the Company's common stock as reported by Nasdaq:
 
<TABLE>
<CAPTION>
                                                              HIGH      LOW
                                                             ------    ------
<S>                                                          <C>       <C>
FISCAL 1996
  Second Quarter (from October 6, 1995)....................  $49.75    $18.50
  Third Quarter............................................  $55.25    $33.75
  Fourth Quarter...........................................  $44.00    $30.00
 
FISCAL 1997
  First Quarter............................................  $39.00    $19.50
  Second Quarter...........................................  $24.62    $ 9.50
  Third Quarter............................................  $20.75    $ 9.81
  Fourth Quarter...........................................  $ 9.75    $ 5.50
 
FISCAL 1998
  First Quarter............................................  $ 7.75    $ 5.19
  Second Quarter...........................................  $ 5.63    $ 4.56
  Third Quarter............................................  $ 5.94    $ 4.38
  Fourth Quarter...........................................  $10.22    $ 5.06
</TABLE>
 
HOLDERS OF COMPANY STOCK
 
     The closing sale price for the Common Stock on July 31, 1998 was $10.375.
 
     As of July 31, 1998, there were approximately 4,062 shareholders of the
Company's Common Stock and 11,674,000 shares of Common Stock outstanding.
 
     The market price of the Company's Common Stock has fluctuated significantly
and is subject to significant fluctuations in the future. See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Business Risks."
 
DIVIDEND POLICY
 
     The Company has never paid cash dividends on its capital stock. The Company
currently intends to retain earnings, if any, for use in its business and does
not anticipate paying any cash dividends in the foreseeable future.
 
                                       11
<PAGE>   14
 
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
 
                      SELECTED CONSOLIDATED FINANCIAL DATA
 
     The following selected financial data should be read in conjunction with
"Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations" and the consolidated financial statements and the notes thereto
included in "Item 8. Financial Statements and Supplementary Data."
 
<TABLE>
<CAPTION>
                                                            FISCAL YEAR ENDED MAY 31,
                                               ---------------------------------------------------
                                                 1994       1995      1996       1997       1998
                                               --------   --------   -------   --------   --------
                                                      (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                            <C>        <C>        <C>       <C>        <C>
Consolidated Statements of Operations Data:
Revenues:
  Software products..........................  $  9,217   $ 10,143   $24,472   $ 34,934   $ 28,658
  Service and other..........................     7,385      5,743     6,246      7,737     10,200
                                               --------   --------   -------   --------   --------
          Total revenues.....................    16,602     15,886    30,718     42,671     38,858
                                               --------   --------   -------   --------   --------
Costs of revenues:
  Software products..........................       720        623     2,074      2,688      2,426
  Service and other..........................     4,350      2,926     2,785      3,892      5,178
                                               --------   --------   -------   --------   --------
          Total costs of revenues............     5,070      3,549     4,859      6,580      7,604
                                               --------   --------   -------   --------   --------
Gross profit.................................    11,532     12,337    25,859     36,091     31,254
                                               --------   --------   -------   --------   --------
Operating expenses:
  Research and development...................     4,872      5,892     8,488     14,310     15,544
  Acquisition of in-process research and
     development and other...................        --         --       381     14,894         --
  Marketing and sales........................     7,783      9,280    14,912     21,505     22,757
  General and administrative.................     2,302      2,747     3,469      4,864      7,610
  Restructuring charges......................     1,175         --        --         --      3,006
                                               --------   --------   -------   --------   --------
          Total operating expenses...........    16,132     17,919    27,250     55,573     48,917
                                               --------   --------   -------   --------   --------
Loss from operations.........................    (4,600)    (5,582)   (1,391)   (19,482)   (17,663)
Other income (expense), net..................      (234)        57     1,342      1,943      1,553
Interest expense.............................      (270)      (313)     (264)      (212)      (100)
                                               --------   --------   -------   --------   --------
Loss before provision for income taxes.......    (5,104)    (5,838)     (313)   (17,751)   (16,210)
Provision for income taxes...................        --         --        --       (180)      (300)
                                               --------   --------   -------   --------   --------
Net loss.....................................  $ (5,104)  $ (5,838)  $  (313)  $(17,931)  $(16,510)
                                               ========   ========   =======   ========   ========
Net loss per share -- basic and diluted(1)...  $  (2.67)  $  (2.18)  $ (0.12)  $  (1.65)  $  (1.47)
                                               ========   ========   =======   ========   ========
Number of shares used in per share
  calculation -- basic and diluted(1)........     2,903      3,635     7,829     10,840     11,225
                                               ========   ========   =======   ========   ========
Consolidated Balance Sheet Data:
Cash and cash equivalents....................  $  2,184   $    324   $ 2,482   $  2,934   $  5,505
Working capital (deficit)....................       100     (1,338)   44,087     18,676     15,912
Total assets.................................     8,199      6,987    62,724     49,443     41,449
Long-term obligations, net of current
  portion....................................     1,154        924       639        167          2
Mandatorily redeemable convertible preferred
  stock......................................    25,582     32,069        --         --         --
Stockholders' (deficit) equity...............   (24,602)   (32,439)   52,808     37,273     24,055
</TABLE>
 
---------------
(1) The net loss used in computing net loss per share has been increased by the
    accretion of the mandatorily redeemable convertible preferred stock to its
    redemption value in the years ended May 31, 1994, 1995 and 1996 of
    $2,646,000, $2,081,000 and $611,000, respectively. See Note 2 of Notes to
    Consolidated Financial Statements for an explanation of the method used to
    determine the number of shares used to compute per share amounts.
 
                                       12
<PAGE>   15
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
 
     The statements contained in this report on Form 10-K that are not purely
historical are forward-looking statements which reflect the Company's current
views with respect to future events and financial performance. These
forward-looking statements are subject to certain risks and uncertainties,
including those discussed in this Part I and in "Management's Discussion and
Analysis of Financial Condition and Results of Operations" in Part II below that
could cause actual results to differ materially from historical results or those
anticipated. In this report, the words "anticipates," "believes," "expects,"
"intends," "future" and similar expressions identify forward-looking statements.
Readers are cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date hereof. The Company assumes no
obligation to update any such forward-looking statements.
 
     The following discussion provides an analysis of the Company's financial
condition and results of operations and should be read in conjunction with the
"Selected Consolidated Financial Data" and the Note thereto and the Consolidated
Financial Statements and the Notes thereto of the Company.
 
OVERVIEW
 
     Verity develops, markets and supports knowledge retrieval software products
for application developers, corporate Intranet users and e-commerce sites.
Verity's technology enables organizations to manage text-based information
residing on their networks, making corporate content reusable across Intranets,
the Internet and CD-ROM. The Company was founded in 1988, and, historically,
derived the substantial majority of its revenue 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 from the sale of
high-priced products requiring significant customization to leveraging the
Company's core technology to develop a number of new, lower-priced products that
address the needs of broader markets. During this period, the Company also
focused on building strategic alliances for the primary purpose of expanding the
user base of the Company's technology, rather than generating significant
revenues. The objectives of the Company's strategy are to establish its software
as a de facto standard and to offset lower unit prices for its products with
higher sales volumes.
 
     The Company's ongoing implementation of this strategy has involved several
significant actions. During recent years, the Company has reduced significantly
its average unit license fees. Also, during this period, the Company has devoted
significant resources to modify and enhance its core technology to support a
broader set of search and retrieval solutions for use on desktop and
enterprise-wide systems and over the Internet. Key engineering efforts in this
regard have included the continued enhancement of the functionality of the
Company's search engine and related products, and the modification of software
to facilitate incorporation in third parties' information management, publishing
and groupware software applications. In recent years, the Company's engineering
efforts have also resulted in the development of new applications of software
for use with CD-ROM, online services and the Internet. The Company's knowledge
retrieval and 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
key e-commerce vendors, including, AT&T WorldNet Services, Netscape
Communications, Time-Warner, Knight-Ridder, Reuters, Dow Jones, The Financial
Times and CDnow.
 
     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. While experiencing significant turnover, the Company increased the
number of research and development personnel from 29 at the beginning of fiscal
1994 to 90 at the end of fiscal 1998. Given its reduced focus on offering custom
solutions, the Company decreased the number of personnel involved in its
consulting business from 29 at the beginning of fiscal 1994 to 18 at the end of
fiscal 1998.
 
     Since inception, the Company has incurred significant losses and
substantial negative cash flow. Due in part to the transition, the Company
experienced declining revenues and increased net losses in fiscal years
 
                                       13
<PAGE>   16
 
1994 and 1995. At May 31, 1998, the Company had cumulative operating losses of
$58.6 million, with net losses of $313,000, $17.9 million and $16.5 million for
fiscal years 1996, 1997 and 1998, respectively. In fiscal 1997, total revenues
increased 39% over fiscal 1996 primarily as a result of a 43% increase in
software product revenues. In fiscal 1998, total revenues decreased 9% in
comparison with fiscal 1997 primarily as a result of an 18% decrease in software
product revenues. The increase for fiscal 1997 over the prior year was due
principally to revenues from Internet/publishing products and, to a lesser
extent, the Company's TDK Toolkit. The decrease for fiscal 1998 in comparison to
the prior year was due principally to lower revenues from the Company's
enterprise products. The loss in fiscal 1997 reflects one-time charges against
earnings of a total of $14.9 million related to the acquisitions of Cognisoft
Corporation, 64k Incorporated and the KeyView Business Unit from FTP Software.
The loss in fiscal 1998 reflects management and organizational changes,
including $3.0 million of restructuring charges. While it is the Company's goal
to increase revenue and generate net income in future periods, no assurance can
be given that the Company's strategy will be successful, that the rate of
revenue increase experienced by the Company in the last two quarters of fiscal
1998 will be experienced in future periods, or that the Company will achieve or
maintain positive cash flow or profitability.
 
     The ongoing implementation of the Company's new strategy has placed, and
may continue to place, a significant strain on the Company's resources,
including its personnel. 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 replaced Mr.
Philippe F. Courtot 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, but could be canceled by the Company after
expiration of the initial 26-week period, with a minimum compensation to Regent
Pacific of $1,300,000 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. The shares subject to
such option will vest on a monthly basis during the 13-month period ending on
February 28, 1999, subject to Mr. Sbona's continued employment as the Company's
President and CEO; provided, however, that the option will vest entirely upon
certain change of control transactions or upon termination of Mr. Sbona without
cause. The option 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.
 
     On March 11, 1998, the Company announced that it had filed a lawsuit in
United States District Court for the District of Delaware against Lotus
Development Corporation for copyright infringement, unfair competition, breach
of a 1992 agreement under which Verity licensed certain software to Lotus,
misappropriation of trade secrets and unjust enrichment and conversion. On June
8, 1998, Verity, Inc. and Lotus Development Corporation announced that they have
concluded a settlement agreement that makes available to Lotus a range of Verity
technologies for use with Lotus products. The settlement agreement resolves
issues
 
                                       14
<PAGE>   17
 
that had arisen between the two companies. Accordingly, the Company has
withdrawn its legal action against Lotus Development Corporation by virtue of a
settlement agreement dated June 8, 1998.
 
     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. The
Company recognizes revenues in accordance with the provisions of American
Institute of Certified Public Accountants Statement of Position No. 91-1,
Software Revenue Recognition. Accordingly, 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. Additionally, the Company is currently evaluating the impact of
Statement of Position 97-2 (SOP 97-2), Software Revenue Recognition, and has not
determined the result, if any, on the Company's financial position, results of
operations or cash flows. SOP 97-2, issued by American Institute of Public
Accountants during October 1997, establishes requirements for revenue
recognition for software companies for fiscal years beginning after December 15,
1997.
 
RESULTS OF OPERATIONS
 
     The following table sets forth the percentage of revenue represented by
certain items in the Company's Consolidated Statements of Operations for the
periods indicated:
 
<TABLE>
<CAPTION>
                                                              FISCAL YEAR ENDED MAY 31,
                                                              --------------------------
                                                               1996      1997      1998
                                                              ------    ------    ------
<S>                                                           <C>       <C>       <C>
Revenues:
  Software products.........................................   79.7%     81.9%     73.8%
  Service and other.........................................   20.3      18.1      26.2
                                                              -----     -----     -----
     Total revenues.........................................  100.0     100.0     100.0
                                                              -----     -----     -----
Costs of revenues:
  Software products.........................................    6.8       6.3       6.3
  Service and other.........................................    9.1       9.1      13.3
                                                              -----     -----     -----
     Total costs of revenues................................   15.9      15.4      19.6
                                                              -----     -----     -----
Gross margin................................................   84.1      84.6      80.4
                                                              -----     -----     -----
Operating expenses:
  Research and development..................................   27.6      33.5      40.0
  Acquisition of in-process research and development and
     other..................................................    1.2      34.9       0.0
  Marketing and sales.......................................   48.5      50.4      58.6
  General and administrative................................   11.3      11.4      19.6
  Restructuring charges.....................................    0.0       0.0       7.7
                                                              -----     -----     -----
     Total operating expenses...............................   88.6     130.2     125.9
                                                              -----     -----     -----
Loss from operations........................................   (4.5)    (45.7)    (45.5)
Other income and expenses, net..............................    3.5       4.1       3.8
                                                              -----     -----     -----
Net loss before provision for income taxes..................   (1.0)    (41.6)    (41.7)
Provision for income taxes..................................    0.0      (0.4)     (0.8)
                                                              -----     -----     -----
Net loss....................................................   (1.0)%   (42.0)%   (42.5)%
                                                              =====     =====     =====
</TABLE>
 
  Revenues
 
     Total revenues increased 38.9% from $30.7 million in fiscal 1996 to $42.7
million in fiscal 1997 and decreased 8.9% to $38.9 million in fiscal 1998. The
increase from fiscal 1996 to fiscal 1997 was due primarily to increased revenues
from licensing of Internet/publishing products and, to a lesser extent, the
Company's TDK Toolkit. The decrease from fiscal 1997 to fiscal 1998 was due
principally to lower revenues from licensing enterprise products and, to a
lesser extent, lower revenues from Internet/publishing products.
 
                                       15
<PAGE>   18
 
Software product revenues increased as a percentage of total revenues from 79.7%
in fiscal 1996 to 81.9% in fiscal 1997 and decreased to 73.8% in fiscal 1998.
Conversely, service and other revenues declined as a percentage of total
revenues from 20.3% in fiscal 1996 to 18.1% in fiscal 1997 and increased to
26.2% in fiscal 1998.
 
     Software product revenues. Software product revenues increased 42.8% from
$24.5 million in fiscal 1996 to $34.9 million in fiscal 1997 and decreased 18.0%
to $28.9 million in fiscal 1998. The increase from fiscal 1996 to fiscal 1997
was due primarily to increased revenues from licensing of Internet/publishing
products and, to a lesser extent, the Company's TDK Toolkit. The decrease from
fiscal 1997 to fiscal 1998 was due principally to lower revenues from licensing
enterprise products and, to a lesser extent, lower revenues from
Internet/publishing products.
 
     Service and other revenues. Service and other revenues consist primarily of
fees for software maintenance, consulting and training. Service and other
revenues increased 23.9% from $6.2 million in fiscal 1996 to $7.7 million in
fiscal 1997 and increased 31.8% to $10.2 million in fiscal 1998. The increase in
service revenues in fiscal 1997 and fiscal 1998 was due primarily to increases
in maintenance revenues and, to a lesser extent, consulting revenues.
 
     Revenues derived from foreign operations accounted for 6.6%, 4.6% and 6.1%
of total revenues, respectively, in fiscal 1996, 1997 and 1998, with European
operations alone accounting for 5.6%, 4.6% and 6.1% of total revenues for these
periods, respectively. The Company's export sales consist primarily of products
licensed for delivery outside of the United States. In fiscal years 1996, 1997
and 1998, export sales accounted for 19.1%, 23.8% and 26.6% of total revenues,
respectively.
 
     No single customer accounted for 10% or more of the Company's revenues
during fiscal years 1996, 1997 or 1998. However, revenues derived from sales to
the federal government and its agencies were 10.5%, 9.5% and 9.0% of total
revenues in fiscal years 1996, 1997 and 1998, respectively. Sales to government
agencies declined as a percentage of revenues from fiscal 1996 to fiscal 1998,
and may decline in the future.
 
  Costs of Revenues
 
     Costs of software products. Costs of software products consist primarily of
product media, duplication, manuals, packaging materials, shipping expenses and
royalties and, in certain instances, licensing of third-party software
incorporated in the Company's products. Costs of software products increased
29.6% from $2.1 million in fiscal 1996 to $2.7 million in fiscal 1997 and
decreased 9.7% to $2.4 million in fiscal 1998, representing 8.5%, 7.7% and 8.5%,
respectively, of software product revenues. The increase in costs of revenues
from fiscal 1996 to fiscal 1997 was related to the higher level of software
product sales and increasing costs of third-party software components. The
decrease in costs of revenues from fiscal 1997 to fiscal 1998 was related to the
lower level of software product sales and decreasing costs of third-party
software components. During fiscal 1997 and 1998, the Company capitalized
software development costs in the amounts of $1,411,000 and $198,000,
respectively, which have been fully amortized as of May 31, 1998. In fiscal
1996, the Company did not capitalize any software development costs since such
costs were not significant. Amortization is included in costs of product
revenue.
 
     Costs of service and other. Costs of service and other consist of costs
incurred in providing consulting services, customer training, telephone support
and product upgrades to customers. Costs of service and other increased 39.7%
from $2.8 million in fiscal 1996 to $3.9 million in fiscal 1997 and increased
33.0% to $5.2 million in fiscal 1998. As a percentage of service and other
revenue, these costs represented 44.6%, 50.3% and 50.8% in fiscal years 1996,
1997 and 1998, respectively. The increase in costs of service and other from
fiscal 1996 to fiscal 1998 was related to staff additions associated with the
Company's customer support and consulting businesses.
 
  Operating Expenses
 
     Research and development. Research and development expenses increased 68.6%
from $8.5 million in fiscal 1996 to $14.3 million in fiscal 1997 and increased
8.6% to $15.5 million in fiscal 1998, representing 27.6%, 33.5% and 40.0% of
total revenues, respectively. This increase in absolute dollars was primarily
due to a significant increase in research and development personnel during
fiscal 1997 and the first six months of fiscal
 
                                       16
<PAGE>   19
 
1998, focused on development of products addressing Internet/publishing, CD-ROM,
online and groupware applications. The Company believes that research and
development expenses will 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 vary
as a percentage of total revenues.
 
     During fiscal 1998, the Company capitalized software development costs in
the amount of $198,000. In fiscal 1997, the Company capitalized approximately
$1.4 million of software development costs, in connection with the development
of a number of products included in the Company's Knowledge Retrieval product
line and the IntelliServ product.
 
     Acquisition of in-process research and development. During fiscal 1998,
there were no costs for acquisition of in-process research and development.
Acquisition of in-process research and development increased from $381,000 in
fiscal 1996 to $14.9 million in fiscal 1997, representing 1.2% and 34.9% of
total revenues, respectively. Acquisition of in-process research and development
costs for fiscal 1997 were primarily related to the Company's acquisitions of
Cognisoft, 64k and the KeyView product line and technology.
 
     Marketing and sales. Marketing and sales expenses consist primarily of
salaries and commissions of sales and marketing personnel, advertising and
promotion expenses and pre-sales customer service and support costs. Marketing
and sales expenses increased 44.2% from $14.9 million in fiscal 1996 to $21.5
million in fiscal 1997 and increased 5.8% to $22.8 million in fiscal 1998,
representing 48.5%, 50.4% and 58.6% of total revenues, respectively. These
increases in absolute dollars were primarily related to the Company's expansion
of its marketing and sales organization, particularly in the United States and
Europe. The Company anticipates it will continue to make significant investments
in marketing and sales.
 
     General and administrative. General and administrative expenses increased
40.2% from $3.5 million in fiscal 1996 to $4.9 million in fiscal 1997 and
increased 56.5% to $7.6 million in fiscal 1998, representing 11.3%, 11.4% and
19.6% of total revenues, respectively. These increases in absolute dollars were
primarily due to increases in professional service fees required to support the
Company's operations relative to prior years. In particular, in fiscal 1998, the
Company incurred increased professional service fees, in accordance with the
Regent Pacific Management Agreement, in connection with the support of the
Company's operations. In addition, in fiscal 1998, the Company incurred
additional legal expenses associated with the lawsuit filed with Lotus
Development Corporation. See "Item 3. Legal Proceedings."
 
     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 charges 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 $0.8
million is a current liability at May 31, 1998. Of the $0.8 million, $0.6
million relates to severance costs to be paid out in future quarters, $0.1
million to the termination of certain lease obligations which are scheduled to
be paid out over the remaining life of the lease agreements and $0.1 million to
other costs associated with the restructuring.
 
  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 reduced.
 
     The Company's deferred tax asset related to its net operating loss
carryforwards includes the tax benefit derived from the disqualifying
dispositions of incentive stock options and the exercise of nonqualified stock
options. The benefit, which totaled $270,000 and $372,000, at May 31, 1997 and
1998, respectively, will be credited directly to additional paid-in capital when
the Company's deferred tax asset is recognized.
 
                                       17
<PAGE>   20
 
     As of May 31, 1998, the Company had approximately $31,000,000 and
$14,300,000 of net operating loss carryforwards for federal and California
purposes, respectively, to offset future taxable income. The Company also has
federal and state research and development tax credit carryforwards of
approximately $1,500,000 and $500,000, respectively, at May 31, 1998. These
carryforwards expire in the years 1999 to 2013 if not utilized. The Company's
net operating loss and tax credit carryforwards are subject to an annual
limitation of approximately $4,900,000 as a result of an ownership change, as
defined by tax laws. See Note 10 of Notes to Consolidated Financial Statements.
 
QUARTERLY RESULTS OF OPERATIONS
 
     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; timing of introduction
or enhancement of products by the Company or its competitors; market acceptance
of new products; changes in the budgets or purchasing patterns of government
agencies; technological changes in search and retrieval, database, networking,
or communication technology; competitive pricing pressures; changes in the
Company's operating expenses; personnel changes; foreign currency exchange
rates; mix of products and services sold; quality control of products sold; and
general economic conditions.
 
     A significant portion of the Company's revenues in recent quarters has 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.
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
results of operations and financial condition in any particular quarter.
 
     Product revenues are also difficult to forecast because the market for
search and retrieval software is uncertain and evolving. In addition, a
significant portion of the Company's revenues is derived from royalties based
upon sales by third-party vendors of products incorporating the Company's
technology. These revenues may be subject to extreme fluctuations and are
difficult for the Company to predict. Further, the Company typically generates a
large percentage of its quarterly revenues during the last weeks of the quarter.
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. Accordingly, 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 impact on the Company's operating results and on the
Company's ability to achieve profitability.
 
     The Company's revenues, and particularly its software products revenues,
increased significantly on a quarter-to-quarter basis during fiscal 1996.
However, revenues for the first quarter of fiscal 1997 decreased relative to the
last quarter of fiscal 1996, and revenues in each of the third and fourth
quarters of fiscal 1997 were lower than revenues for the second quarter of
fiscal 1997. In addition, revenues for the first quarter of fiscal 1998 were
significantly lower than revenues for the fourth quarter of fiscal 1997. Due to
the evolving nature of the markets for the Company's products and other factors,
there can be no assurance that the Company's revenues will increase on a
quarter-to-quarter basis or at all in future periods.
 
     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 may also result in volatility in the price of
the shares of the Company's Common Stock.
 
                                       18
<PAGE>   21
 
     The following table sets forth certain unaudited consolidated statements of
operations data, both in dollar amount and as a percentage of total revenues,
for each of the eight quarters in the period ended May 31, 1998. In the opinion
of management, this information has been presented on the same basis as the
audited consolidated financial statements appearing elsewhere in this annual
report, and all necessary adjustments, consisting only of normal recurring
adjustments, have been included in the amounts stated below to present fairly
the unaudited quarterly results when read in conjunction with the audited
consolidated financial statements of the Company and related notes thereto. The
operating results for any quarter should not be relied upon as necessarily
indicative of results for any future period.
 
<TABLE>
<CAPTION>
                                                                                 QUARTER ENDED
                                              -----------------------------------------------------------------------------------
                                              AUG. 31,   NOV. 30,   FEB. 28,   MAY 31,   AUG. 31,   NOV. 30,   FEB. 28,   MAY 31,
                                                1996       1996       1997      1997       1997       1997       1998      1998
                                              --------   --------   --------   -------   --------   --------   --------   -------
                                                                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                           <C>        <C>        <C>        <C>       <C>        <C>        <C>        <C>
Consolidated Statements of Operations Data:
Revenues:
  Software products.........................  $ 7,229    $ 9,726    $  9,181   $ 8,798   $ 3,116    $ 6,666    $ 8,652    $10,224
  Service and other.........................    1,583      1,870       1,942     2,342     2,224      2,522      2,553      2,901
                                              -------    -------    --------   -------   -------    -------    -------    -------
        Total revenues......................    8,812     11,596      11,123    11,140     5,340      9,188     11,205     13,125
                                              -------    -------    --------   -------   -------    -------    -------    -------
Costs of revenues:
  Software products.........................      616      1,003         585       484       705        861        682        178
  Service and other.........................      873        980         918     1,121     1,685      1,294      1,148      1,051
                                              -------    -------    --------   -------   -------    -------    -------    -------
        Total costs of revenues.............    1,489      1,983       1,503     1,605     2,390      2,155      1,830      1,229
                                              -------    -------    --------   -------   -------    -------    -------    -------
Gross profit................................    7,323      9,613       9,620     9,535     2,950      7,033      9,375     11,896
                                              -------    -------    --------   -------   -------    -------    -------    -------
Operating expenses:
  Research and development..................    3,499      3,290       4,050     3,471     5,033      4,153      3,405      2,953
  Acquisition of in-process research and
    development and other...................       --         --      10,029     4,865        --         --         --         --
  Marketing and sales.......................    4,529      5,459       5,466     6,051     5,745      6,048      5,530      5,434
  General and administrative................    1,175      1,177       1,196     1,316     2,152      1,484      1,340      2,634
  Restructuring charges.....................       --         --          --        --        --      3,006         --         --
                                              -------    -------    --------   -------   -------    -------    -------    -------
        Total operating expenses............    9,203      9,926      20,741    15,703    12,930     14,691     10,275     11,021
                                              -------    -------    --------   -------   -------    -------    -------    -------
Income (loss) from operations...............   (1,880)      (313)    (11,121)   (6,168)   (9,980)    (7,658)      (900)       875
Other income and expense, net...............      597        535         296       303       264        549        340        300
                                              -------    -------    --------   -------   -------    -------    -------    -------
Income (loss) before provision for income
  taxes.....................................   (1,283)       222     (10,825)   (5,865)   (9,716)    (7,109)      (560)     1,175
Provision for income taxes..................       --         --          --      (180)      (50)       (50)       (50)      (150)
                                              -------    -------    --------   -------   -------    -------    -------    -------
Net income (loss)...........................  $(1,283)   $   222    $(10,825)  $(6,045)  $(9,766)   $(7,159)   $  (610)   $ 1,025
                                              =======    =======    ========   =======   =======    =======    =======    =======
Net income (loss) per share -- basic........  $ (0.12)   $  0.02    $  (1.00)  $ (0.55)  $ (0.89)   $ (0.64)   $ (0.05)   $  0.09
                                              =======    =======    ========   =======   =======    =======    =======    =======
Net income (loss) per share -- diluted......  $ (0.12)   $  0.02    $  (1.00)  $ (0.55)  $ (0.89)   $ (0.64)   $ (0.05)   $  0.08
                                              =======    =======    ========   =======   =======    =======    =======    =======
Number of shares used in per share
  calculation -- basic......................   10,744     10,815      10,841    10,961    11,033     11,168     11,254     11,444
                                              =======    =======    ========   =======   =======    =======    =======    =======
Number of shares used in per share
  calculation -- diluted....................   10,744     11,421      10,841    10,961    11,033     11,168     11,254     12,430
                                              =======    =======    ========   =======   =======    =======    =======    =======
</TABLE>
 
<TABLE>
<CAPTION>
                                                                                AS A PERCENTAGE OF REVENUES
                                                           ----------------------------------------------------------------------
<S>                                                        <C>      <C>      <C>       <C>      <C>       <C>      <C>      <C>
Revenues:
  Software products......................................   82.0%    83.9%     82.5%    79.0%     58.4%    72.6%    77.2%    77.9%
  Service and other......................................   18.0     16.1      17.5     21.0      41.6     27.4     22.8     22.1
                                                           -----    -----    ------    -----    ------    -----    -----    -----
        Total revenues...................................  100.0    100.0     100.0    100.0     100.0    100.0    100.0    100.0
                                                           -----    -----    ------    -----    ------    -----    -----    -----
Costs of revenues:
  Software products......................................    7.0      8.6       5.3      4.3      13.2      9.4      6.1      1.3
  Service and other......................................    9.9      8.5       8.2     10.1      31.6     14.1     10.2      8.0
                                                           -----    -----    ------    -----    ------    -----    -----    -----
        Total costs of revenues..........................   16.9     17.1      13.5     14.4      44.8     23.5     16.3      9.3
                                                           -----    -----    ------    -----    ------    -----    -----    -----
Gross profit.............................................   83.1     82.9      86.5     85.6      55.2     76.5     83.7     90.7
                                                           -----    -----    ------    -----    ------    -----    -----    -----
Operating expenses:
  Research and development...............................   39.7     28.4      36.4     31.2      94.2     45.2     30.4     22.5
  Acquisition of in-process research and development and
    other................................................     --       --      90.2     43.7        --       --       --       --
  Marketing and sales....................................   51.4     47.1      49.1     54.3     107.6     65.8     49.3     41.4
  General and administrative.............................   13.3     10.1      10.8     11.8      40.3     16.2     12.0     20.1
  Restructuring charges..................................     --       --        --       --        --     32.7       --       --
                                                           -----    -----    ------    -----    ------    -----    -----    -----
        Total operating expenses.........................  104.4     85.6     186.5    141.0     242.1    159.9     91.7     84.0
                                                           -----    -----    ------    -----    ------    -----    -----    -----
Income (loss) from operations............................  (21.3)    (2.7)   (100.0)   (55.4)   (186.9)   (83.4)    (8.0)     6.7
Other income and expense, net............................    6.7      4.6       2.7      2.7       4.9      6.0      3.0      2.3
                                                           -----    -----    ------    -----    ------    -----    -----    -----
Income (loss) before provision for income taxes..........  (14.6)     1.9     (97.3)   (52.7)   (182.0)   (77.4)    (5.0)     9.0
Provision for income taxes...............................     --       --        --      1.6       0.9      0.5      0.4      1.2
                                                           -----    -----    ------    -----    ------    -----    -----    -----
Net income (loss)........................................  (14.6)%    1.9%    (97.3)%  (54.3)%  (182.9)%  (77.9)%   (5.4)%    7.8%
                                                           =====    =====    ======    =====    ======    =====    =====    =====
</TABLE>
 
     In fiscal 1997 and 1998, costs of software product revenues fluctuated both
in amount and as a percentage of software product revenues due to software
product sales, which required the incorporation of certain third-party software
products and associated royalty payments.
 
                                       19
<PAGE>   22
 
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 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 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
May 31, 1998, the Company had $17.9 million in cash and cash equivalents and
investments.
 
     The Company's operating activities used cash of $1.2 million, $791,000 and
$9.0 million in fiscal 1996, 1997 and 1998, respectively. The cash used in
operations in fiscal 1996, 1997 and 1998, was accounted for primarily by the
Company's net losses reduced in each period by the acquisition of in-process
research and development and depreciation. In fiscal 1996, 1997 and 1998,
accounts receivable increased by $4.8 million, $2.4 million and $3.7 million,
respectively, increasing cash used in operations.
 
     Cash used in investing activities in fiscal 1996 and 1997 was $48.7 million
and $922,000, respectively, and cash provided by investing activities in fiscal
1998 was $9.0 million. In fiscal 1996, the Company invested $44.6 million, net,
in marketable securities with its proceeds from the Company's initial public
offering and secondary offering of Common Stock, and, to a lesser extent, the
sale of Preferred Stock. In fiscal 1997, the investing activities consisted
primarily of cash paid in acquisitions and purchases of property and equipment.
These investments were substantially offset by net proceeds from the sale of
marketable securities. In fiscal 1998, the Company had a net proceed of $27.1
million from the sale and maturity of marketable securities. These investments
were substantially offset by the purchase of marketable securities and property
and equipment.
 
     Cash provided by financing activities was $52.0 million, $2.0 million, and
$2.7 million in fiscal 1996, 1997 and 1998, respectively. In fiscal 1996, such
financing activities consisted primarily of the proceeds of the Company's
initial public offering and secondary offering of Common Stock, and, to a lesser
extent, the sale of Preferred Stock. In fiscal 1997 and 1998, such financing
activities consisted primarily of the sale of Common Stock to employees through
the Company's Employee Stock Purchase Plan. In fiscal 1998, financing activities
also consisted of the proceeds from stockholders on notes receivable.
 
     At May 31, 1998, the Company's principal sources of liquidity were its cash
and cash equivalents and short-term investments of $17.9 million. The Company's
unsecured line of credit, which provided for up to $7.5 million in credit,
expired on November 29, 1997. In March 1998, the Company obtained a $5 million
line of credit under an agreement with the same bank, which expires on September
30, 1998. 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 May 31, 1998,
there were no borrowings outstanding under the line of credit. See Note 6 of
Notes to Consolidated Financial Statements.
 
     Capital expenditures, including capital leases, were approximately $3.9
million, $8.6 million and $707,000 in fiscal 1996, 1997 and 1998, respectively.
These expenditures consisted principally of purchases of property and equipment,
primarily for computer hardware and software in fiscal 1996. In fiscal 1997,
these expenditures consisted primarily of purchases of computer hardware and
software and leasehold improvements for its new facilities to which the Company
relocated in July 1996. In fiscal 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.
 
                                       20
<PAGE>   23
 
RECENT 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. The
Company is evaluating alternative formats for presenting this information, but
does not expect this pronouncement to materially impact the Company's results of
operations.
 
     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
disclosure 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.
 
     During October 1997, the American Institute of Certified Public Accountants
issued Statement of Position 97-2 (SOP 97-2), Software Revenue Recognition. This
statement establishes requirements for revenue recognition for software
companies for fiscal years beginning after December 15, 1997. The Company is
currently evaluating the impact of SOP 97-2 and has not determined the result,
if any, on the Company's financial position, results of operations or cash
flows.
 
YEAR 2000 COMPLIANCE
 
     Many currently installed computer systems are not capable of distinguishing
21st century dates from 20th century dates. As a result, in less than two years,
computer systems or applications used by many companies in a wide variety of
industries will experience operating difficulties unless the systems or
applications are modified to process information related to the century change
adequately. 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.
 
  Products:
 
     Although the Company's assessment of Year 2000 issues is not yet complete,
based on its assessment to date, the Company believes that the current versions
of its products are "Year 2000 compliant." In spite of the fact that the Company
has not been a party to any litigation or any proceedings to date involving its
products or services related to Year 2000 compliance issues, 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. The costs of defending and resolving Year
2000-related damages, including consequential damages, could have a material
adverse effect on the Company's business, results of operations and financial
condition.
 
  Operations:
 
     The Company is reviewing its internal management information and other
systems in order to identify and modify those products, services or systems that
are not Year 2000 compliant. The total cost of these Year 2000 compliance
activities has not been material to date. 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
 
                                       21
<PAGE>   24
 
effect on the Company's business, results of operations and financial condition.
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. 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 delivering 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.
 
BUSINESS RISKS
 
     This report includes a number of forward-looking statements, which reflect
the Company's current views with respect to future events and financial
performance. These forward-looking statements are subject to certain risks and
uncertainties, including those discussed below that could cause actual results
to differ materially from historical results or those anticipated. In this
report, the words "anticipates," "believes," "expects," "intends," "future" and
similar expressions identify forward-looking statements. Readers are cautioned
not to place undue reliance on these forward-looking statements, which speak
only as of the date hereof. In addition to the other information in this report
on Form 10-K, the following risk factors should be considered carefully in
evaluating the Company and its business:
 
     History of Losses; Strategic Realignment. Since inception, the Company has
incurred significant losses and substantial negative cash flow. At May 31, 1998,
the Company had cumulative operating losses of $58.6 million, with net losses of
$313,000, $17.9 million and $16.5 million for fiscal 1996, fiscal 1997 and
fiscal 1998, respectively. 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 experience increased revenues or become profitable or cash flow
positive at any time in the future.
 
     Management of 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 online 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 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
 
                                       22
<PAGE>   25
 
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
replaced Mr. Philippe F. Courtot 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 management team. The
agreement had a one-year term, but could be canceled by the Company after
expiration of the initial 26-week period, with a minimum compensation to Regent
Pacific of $1,300,000 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 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. The shares subject to
such option will vest on a monthly basis during the 13-month period ending on
February 28, 1999, subject to Mr. Sbona's continued employment as the Company's
President and CEO; provided, however, that the option will vest entirely upon
certain change of control transactions or upon a termination of Mr. Sbona
without cause. The option 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. See "Dependence on Key Personnel" below.
 
     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; 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 incorporating
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
 
                                       23
<PAGE>   26
 
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.
 
     The Company's revenues, and particularly its software product revenues,
decreased in fiscal 1998. As evidenced in fiscal 1998, there can be no assurance
that the Company's revenues will continue to increase significantly or at all in
future periods.
 
     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 may 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, online services and the
Internet is young and has few proven products. Moreover, critical issues
concerning the commercial use of online 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 online 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, online services and the Internet. The Company's future operating results
will also depend upon its ability to successfully market its technology to
online 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. See "Item 1. Business -- Industry
Background."
 
     Dependence on International Operations. In fiscal 1996, fiscal 1997 and
fiscal 1998, revenues derived from foreign operations accounted for
approximately 6.6%, 4.6% and 6.1% of the Company's total revenues, respectively,
with European operations alone accounting for 5.6%, 4.6% and 6.1% of revenues
for these periods.
 
                                       24
<PAGE>   27
 
The Company's export sales accounted for 19.1%, 23.8% and 26.6% of revenues in
fiscal 1996, fiscal 1997 and fiscal 1998, respectively. Accordingly, on a
combined basis, foreign operations and export sales accounted for approximately
25.7%, 28.4% and 32.7% of revenues in fiscal 1996, fiscal 1997 and fiscal 1998,
respectively. The Company expects that revenues derived from foreign 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. Additionally, the Company does
not engage in hedging activities to protect against the risk of currency
fluctuations. 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 10.5%, 9.5% and 9.0% of revenues in fiscal 1996,
fiscal 1997 and fiscal 1998, respectively. Sales to government agencies declined
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, online and Internet
markets. Nevertheless, the 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
 
                                       25
<PAGE>   28
 
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 and Lotus Notes environments and, more recently,
the Microsoft Exchange environment. 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 to its proceeds 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.
 
     Dependence on the Internet. The Company's Topic Internet Server product was
released in May 1995, and its Topic CD Publisher product was released in early
1996. Sales of the Company's products addressing Internet search requirements
will depend to a substantial degree upon the continued use and future expansion
of the Internet for text-based information publication and distribution. Because
global commerce and online exchange of information on the Internet and other
similar open wide area networks are new and evolving, it is difficult to predict
with any assurance whether the Internet will prove to be a viable medium for the
publication and distribution of information, including, for example, sensitive
proprietary information developed and published by private enterprises.
 
     Competition. The electronic information search and retrieval software
market is intensely competitive. The Company believes that the principal
competitive factors in such market are product quality, performance and price,
vendor and product reputation, product architecture, strategic alliances,
functionality and features, ease of use and quality of support. A number of
companies offer competitive products addressing certain of the Company's target
markets. In the enterprise market, the Company competes with Dataware, InfoSeek,
 
                                       26
<PAGE>   29
 
PC Docs and Excalibur, among others. Microsoft has also begun to supply
entry-level products for the enterprise market. In the Internet/publishing
market, the Company competes with Folio, PC Docs and Dataware, among others. The
Company also competes indirectly with database vendors that offer information
search and retrieval capabilities with their core database products. In the
future, the Company may encounter competition from companies that enhance
products such as word processing software, document management systems,
groupware applications, Internet products and operating systems to include text
search and retrieval features. Many of the Company's existing competitors, as
well as Microsoft and a number of other potential new competitors, have
significantly greater financial, technical and marketing resources than the
Company. Because the success of the Company's strategy is dependent in part on
the success of the Company's strategic partners, competition between the
Company's strategic partners and the strategic partners of the Company's
competitors, or failure of the Company's strategic partners to achieve or
maintain market acceptance could have a material adverse effect on the Company's
competitive position. Although the Company believes that its products and
technologies compete favorably with respect to the factors outlined above, there
can be no assurance that the Company will be able to compete successfully
against its current or future competitors or that competition will not have a
material adverse effect on the Company's results of operations and financial
condition.
 
     Dependence on Strategic Alliances. The Company is relying on a number of
strategic relationships to achieve commercialization of the Company's
technologies and leverage the Company's development, sales and marketing
resources. Although the Company views these relationships as important factors
in development and commercialization of the Company's technologies, a majority
of the Company's agreements with its strategic partners or customers do not
require future minimum commitments to license the Company's technology, are not
exclusive and may be terminated at the convenience of the Company's customer.
There can be no assurance that the Company's strategic partners regard their
relationship with the Company as strategic to their own respective businesses
and operations, that they will not re-assess their commitment to the Company's
technologies at any time in the future or that they will not develop their own
competitive technology. Further, there can be no assurance that products of the
Company's strategic partners will achieve market acceptance or commercial
success.
 
     In order to achieve widespread adoption of Verity technology, it will be
necessary for third-party developers to create, produce and market applications,
which employ the Company's search and retrieval technology. A significant
component of the Company's strategy is to leverage its technology through the
applications of third-party vendors and third-party information publishers.
However, no third-party developer is obligated to select or continue to use the
Company's technology, and there can be no assurance that Verity technology will
be selected or used by any significant number of third-party developers in the
future. To assist in the development of third-party applications, the Company
has developed and is licensing its Developer's Toolkit and its Agent Server.
There can be no assurance that these products will achieve widespread commercial
acceptance or will result in the incorporation of Verity technology in
commercially successful third-party products.
 
     Dependence on Key Personnel. The Company's performance is substantially
dependent on the performance of its executive officers and key employees, many
of whom have worked together for only a short period of time. Further, on July
31, 1997, Verity announced the departure of Philippe Courtot as the Company's
Chairman, President and Chief Executive Officer. Gary J. Sbona who serves as
Verity's President and Chief Executive Officer replaced Mr. Courtot. The Company
is heavily dependent upon its ability to attract, retain and motivate skilled
technical and managerial personnel. The Company does not have in place key
person life insurance policies on any of its employees. The loss of the services
of any of its executive officers or other key employees could have a material
adverse effect on the business, operating results or financial condition of the
Company.
 
     The Company's future success also depends on its continuing ability to
identify, hire, train and retain other highly qualified technical and managerial
personnel. Competition for such personnel is intense, and there can be no
assurance that the Company will be able to attract, assimilate or retain other
highly qualified technical and managerial personnel in the future. The inability
to attract, hire or retain the necessary technical
 
                                       27
<PAGE>   30
 
and managerial personnel could have a material adverse effect upon the Company's
business, operating results and financial condition. See "Management of
Transition; Employee Turnover" above.
 
     Dependence on Proprietary Technology. The Company's success and ability to
compete is dependent in part upon its proprietary technology. While the Company
relies on trademark, trade secret and copyright law to protect its technology,
the Company believes that factors such as the technological and creative skills
of its personnel, new product developments, frequent product enhancements, name
recognition and reliable product maintenance are more essential to establishing
and maintaining a technology leadership position. The Company presently has one
issued patent, and a few patent applications pending. There can be no assurance
that others will not develop technologies that are similar or superior to the
Company's technology. The source code for the Company's proprietary software is
protected both as a trade secret and as a copyrighted work. Despite these
precautions, it may be possible for a third party to copy or otherwise obtain
and use the Company's products or technology without authorization, or to
develop similar technology independently. In addition, effective copyright and
trade secret protection may be unavailable or limited in certain foreign
countries. To license its client products, the Company primarily relies on
"shrink wrap" licenses that are not signed by the end user and, therefore, may
be unenforceable under the laws of certain jurisdictions. Despite the Company's
efforts to protect its proprietary rights, unauthorized parties may attempt to
copy aspects of the Company's products or to obtain and use information that the
Company regards as proprietary. Policing unauthorized use of the Company's
products is difficult. There can be no assurance that the steps taken by the
Company will prevent misappropriation of its technology or that such agreements
will be enforceable. In addition, litigation may be necessary in the future to
enforce the Company's intellectual property rights, to protect the Company's
trade secrets, to determine the validity and scope of the proprietary rights of
others, or to defend against claims of infringement or invalidity. Such
litigation could result in substantial costs and diversion of resources and
could have a material adverse effect on the Company's business, operating
results and financial condition.
 
     Certain technology used by the Company's products is licensed from third
parties, generally on a nonexclusive basis. The Company believes that there are
alternative sources for each of the material components of technology licensed
by the Company from third parties. However, the termination of any of such
licenses, or the failure of the third-party licensors to adequately maintain or
update their products, could result in delay in the Company's ability to ship
certain of its products while it seeks to implement technology offered by
alternative sources. Any required replacement licenses could prove costly. Also,
any such delay, to the extent it becomes extended or occurs at or near the end
of a fiscal quarter, could result in a material adverse effect on the Company's
quarterly results of operations. While it may be necessary or desirable in the
future to obtain other licenses relating to one or more of the Company's
products or relating to current or future technologies, there can be no
assurance that the Company will be able to do so on commercially reasonable
terms or at all.
 
     Possible Volatility of Stock Price. The Company's Common Stock is quoted
for trading on the Nasdaq National Market. The market price for the Common Stock
may continue to be highly volatile for a number of reasons including future
announcements concerning the Company or its competitors, quarterly variations in
operating results, announcements of technological innovations, the introduction
of new products or changes in product pricing policies by the Company or its
competitors, proprietary rights or other litigation, changes in earnings
estimates by analysts or other factors. In addition, stock prices for many
technology companies fluctuate widely for reasons which may be unrelated to
operating results. These fluctuations, as well as general economic, market and
political conditions such as recessions or military conflicts, may materially
and adversely affect the market price of the Company's Common Stock.
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
     The Financial Statements and supplemental data of the Company required by
this item are set forth at the pages indicated at Item 14(a).
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
     None.
 
                                       28
<PAGE>   31
 
                                    PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
     Information relating to the directors and executive officers of the Company
is set forth in Part I of this report under the caption "Directors, Executive
Officers and Key Employees of the Registrant."
 
ITEM 11. EXECUTIVE COMPENSATION
 
     The information required by this Item is incorporated by reference from the
definitive proxy statement for the Company's 1998 annual meeting of stockholders
to be filed with the Commission pursuant to Regulation 14A not later than 120
days after the end of the fiscal year covered by this Form (the "Proxy
Statement") under the caption "EXECUTIVE COMPENSATION AND OTHER MATTERS."
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     The information required by this Item is incorporated by reference from the
Proxy Statement under the captions "STOCK OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT."
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     The information required by this Item is incorporated by reference from the
Proxy Statement under the captions "CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS" and "EXECUTIVE COMPENSATION AND OTHER MATTERS -- Compensation
Committee Interlocks and Insider Participation in Compensation Decisions."
 
                                       29
<PAGE>   32
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
     (a) The following documents are filed as a part of this Form:
 
<TABLE>
<CAPTION>
                                                                    PAGE
                                                                   NUMBER
                                                                   ------
<C>  <S>                                                           <C>
1... Financial Statements:
     Reports of Independent Accountants..........................    31
     Consolidated Balance Sheets -- As of May 31, 1997 and
     1998........................................................    32
     Consolidated Statements of Operations -- For the Three Years
     Ended May 31, 1998..........................................    33
     Consolidated Statements of Changes in Stockholders'
     Equity -- For the Three Years Ended May 31, 1998............    34
 ...  Consolidated Statements of Cash Flows -- For the Three Years
     Ended May 31, 1998..........................................    35
 ...  Notes to Consolidated Financial Statements..................    36
2... Financial Statement Schedules -- For years ended May 31,
     1996, 1997 and 1998:
 ...  Schedule II -- Valuation and Qualifying Accounts............    54
 ...  All other schedules are omitted because they are not
     applicable or the required information is shown in the
     consolidated financial statements or notes thereto.
3... Exhibits: See Index to Exhibits on page 55. The Exhibits
     listed in the accompanying Index to Exhibits are filed or
     incorporated by reference as part of this report.
</TABLE>
 
     (b) Reports on Form 8-K:
 
          None.
 
                                       30
<PAGE>   33
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
To the Board of Directors and Stockholders
Verity, Inc.:
 
     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, changes in stockholders' equity
and of cash flows present fairly, in all material respects, the financial
position of Verity, Inc. and Subsidiaries at May 31, 1997 and 1998, and the
results of their operations and their cash flows for each of the three years in
the period ended May 31, 1998, in conformity with generally accepted accounting
principles. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with generally accepted auditing standards which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for the opinion expressed
above.
 
                                          PricewaterhouseCoopers LLP
 
San Jose, California
June 19, 1998
 
                                       31
<PAGE>   34
 
                                  VERITY, INC.
 
                          CONSOLIDATED BALANCE SHEETS
                       (IN THOUSANDS, EXCEPT SHARE DATA)
 
<TABLE>
<CAPTION>
                                                                    MAY 31,
                                                              --------------------
                                                                1997        1998
                                                              --------    --------
<S>                                                           <C>         <C>
ASSETS
Current assets:
  Cash and cash equivalents.................................  $  2,934    $  5,505
  Short-term investments....................................    15,183      12,433
  Trade accounts receivable, less allowance for doubtful
     accounts of $540 in 1997 and $706 in 1998..............    10,868      14,488
  Prepaid and other current assets..........................     1,694         878
                                                              --------    --------
          Total current assets..............................    30,679      33,304
Equipment and leasehold improvements, at cost, net of
  accumulated depreciation and amortization.................    10,048       7,567
Long-term investments.......................................     7,057           5
Other assets................................................     1,659         573
                                                              --------    --------
          Total assets......................................  $ 49,443    $ 41,449
                                                              ========    ========
LIABILITIES
Current liabilities:
  Current portion of long-term debt and capital lease
     obligations............................................  $    617    $    149
  Accounts payable..........................................     4,409       3,749
  Accrued compensation......................................     2,106       3,861
  Other accrued liabilities.................................     1,156       1,705
  Deferred revenue..........................................     3,715       7,928
                                                              --------    --------
          Total current liabilities.........................    12,003      17,392
Long-term debt and capital lease obligations, net of current
  portion...................................................       167           2
                                                              --------    --------
          Total liabilities.................................    12,170      17,394
                                                              --------    --------
Commitments (Note 8)
STOCKHOLDERS' EQUITY
Preferred stock, $.001 par value:
  Authorized: 2,000,000 shares in 1997 and 1998
  Issued and outstanding: none
Common stock, $.001 par value:
  Authorized: 30,000,000 shares in 1997 and 1998
  Issued and outstanding: 11,018,000 shares in 1997 and
     11,565,000 shares in 1998..............................        11          12
Additional paid-in capital..................................    90,012      92,212
Notes receivable from stockholders..........................    (1,090)
Unrealized gain on investments..............................         6           7
Accumulated deficit.........................................   (51,666)    (68,176)
                                                              --------    --------
          Total stockholders' equity........................    37,273      24,055
                                                              --------    --------
          Total liabilities and stockholders' equity........  $ 49,443    $ 41,449
                                                              ========    ========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
 
                                       32
<PAGE>   35
 
                                  VERITY, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                                                    YEAR ENDED MAY 31,
                                                              -------------------------------
                                                               1996        1997        1998
                                                              -------    --------    --------
<S>                                                           <C>        <C>         <C>
Revenues:
  Software products.........................................  $24,472    $ 34,934    $ 28,658
  Service and other.........................................    6,246       7,737      10,200
                                                              -------    --------    --------
          Total revenues....................................   30,718      42,671      38,858
                                                              -------    --------    --------
Costs of revenues:
  Software products.........................................    2,074       2,688       2,426
  Service and other.........................................    2,785       3,892       5,178
                                                              -------    --------    --------
          Total costs of revenues...........................    4,859       6,580       7,604
                                                              -------    --------    --------
Gross profit................................................   25,859      36,091      31,254
                                                              -------    --------    --------
Operating expenses:
  Research and development..................................    8,488      14,310      15,544
  Acquisition of in-process research and development and
     other..................................................      381      14,894
  Marketing and sales.......................................   14,912      21,505      22,757
  General and administrative................................    3,469       4,864       7,610
  Restructuring charges.....................................                            3,006
                                                              -------    --------    --------
          Total operating expenses..........................   27,250      55,573      48,917
                                                              -------    --------    --------
Loss from operations........................................   (1,391)    (19,482)    (17,663)
Other income, net...........................................    1,342       1,943       1,553
Interest expense............................................     (264)       (212)       (100)
                                                              -------    --------    --------
Loss before provision for income taxes......................     (313)    (17,751)    (16,210)
Provision for income taxes..................................                 (180)       (300)
                                                              -------    --------    --------
Net loss....................................................     (313)    (17,931)    (16,510)
Accretion to redemption value of mandatorily redeemable
  convertible preferred stock...............................     (611)
                                                              -------    --------    --------
Net loss applicable to common stockholders..................  $  (924)   $(17,931)   $(16,510)
                                                              =======    ========    ========
Net loss per share -- basic and diluted.....................  $ (0.12)   $  (1.65)   $  (1.47)
                                                              =======    ========    ========
Number of shares used in per share calculation..............    7,829      10,840      11,225
                                                              =======    ========    ========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
 
                                       33
<PAGE>   36
 
                                  VERITY, INC.
 
           CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
                FOR THE YEARS ENDED MAY 31, 1996, 1997 AND 1998
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                             NOTES      UNREALIZED                      TOTAL
                                            COMMON STOCK     ADDITIONAL   RECEIVABLE       GAIN                     STOCKHOLDERS'
                                           ---------------    PAID-IN        FROM        (LOSS) ON    ACCUMULATED     (DEFICIT)
                                           SHARES   AMOUNT    CAPITAL     STOCKHOLDER   INVESTMENTS     DEFICIT        EQUITY
                                           ------   ------   ----------   -----------   -----------   -----------   -------------
<S>                                        <C>      <C>      <C>          <C>           <C>           <C>           <C>
Balances May 31, 1995....................   1,581    $ 2      $ 1,271       $  (901)                   $(32,811)      $(32,439)
  Issuance of common stock:
    Upon exercise of stock options.......     561      1          726          (403)                                       324
    In exchange for services.............      21                  60                                                       60
    From public offerings, net of
      issuance costs of $1,361...........   3,500      3       49,011                                                   49,014
    Upon exercise of warrants............      17                  99                                                       99
    Under employee stock purchase plan...      82                 839                                                      839
  Conversion of mandatorily redeemable
    preferred............................   5,008      5       35,917                                                   35,922
  Payments on notes receivable from
    stockholder..........................                                        79                                         79
  Repurchase of common stock from
    stockholders.........................     (35)                (41)                                                     (41)
  Unrealized loss on investments.........                                                  $(125)                         (125)
  Accretion to redemption value of
    preferred stock......................                                                                  (611)          (611)
  Net loss...............................                                                                  (313)          (313)
                                           ------    ---      -------       -------        -----       --------       --------
Balances, May 31, 1996...................  10,735     11       87,882        (1,225)        (125)       (33,735)        52,808
  Issuance of common stock:
    Upon exercise of stock options.......      88                 199                                                      199
    Under employee stock purchase plan...     249               2,025                                                    2,025
    Net exercise of warrants.............       9
  Payments on notes receivable from
    stockholder..........................                                       135                                        135
  Repurchase of common stock from
    stockholders.........................     (63)                (94)                                                     (94)
  Unrealized gain on investments.........                                                    131                           131
  Net loss...............................                                                               (17,931)       (17,931)
                                           ------    ---      -------       -------        -----       --------       --------
Balances, May 31, 1997...................  11,018     11       90,012        (1,090)           6        (51,666)        37,273
  Issuance of common stock:
    Upon exercise of stock options.......     234                 883                                                      883
    Under employee stock purchase plan...     315      1        1,320                                                    1,321
  Payments on notes receivable from
    stockholder..........................                                     1,090                                      1,090
  Repurchase of common stock from
    stockholders.........................      (2)                 (3)                                                      (3)
  Unrealized gain on investments.........                                                      1                             1
  Net loss...............................                                                               (16,510)       (16,510)
                                           ------    ---      -------       -------        -----       --------       --------
Balances, May 31, 1998...................  11,565    $12      $92,212       $    --        $   7       $(68,176)      $ 24,055
                                           ======    ===      =======       =======        =====       ========       ========
</TABLE>
 
                                       34
<PAGE>   37
 
                                  VERITY, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                     YEAR ENDED MAY 31,
                                                              ---------------------------------
                                                                1996         1997        1998
                                                              ---------    --------    --------
<S>                                                           <C>          <C>         <C>
Cash flows from operating activities:
  Net loss..................................................  $    (313)   $(17,931)   $(16,510)
  Adjustments to reconcile net loss to net cash used in
     operating activities:
     Depreciation and amortization..........................      1,680       3,785       4,539
     Noncash restructuring charges..........................                                767
     Provision for doubtful accounts........................        455         350         699
     Amortization of discount on securities.................       (282)       (547)        (55)
     Realized gain on sale of investments...................       (761)
     Acquisition of in-process research and development and
      other.................................................        381      14,894
     Changes in operating assets and liabilities:
       Trade accounts receivable............................     (4,811)     (2,409)     (4,320)
       Prepaid and other current assets.....................       (838)     (1,294)        748
       Accounts payable.....................................        634       1,040        (665)
       Accrued compensation and other accrued liabilities...      1,453         741       1,607
       Deferred revenue.....................................      1,219         580       4,146
                                                              ---------    --------    --------
          Net cash used in operating activities.............     (1,183)       (791)     (9,044)
                                                              ---------    --------    --------
Cash flows from investing activities:
  Acquisition of equipment and leasehold improvements.......     (3,899)     (8,592)       (707)
  Capitalization of software development costs..............                 (1,411)       (198)
  Decrease in other assets..................................                     38
  Net cash paid in acquisitions.............................       (185)    (14,933)
  Purchases of investments..................................   (212,430)    (63,265)    (17,215)
  Maturity of investments...................................    142,145      42,800      10,856
  Proceeds from sale of investments.........................     25,712      44,441      16,217
                                                              ---------    --------    --------
          Net cash (used in) provided by investing
            activities......................................    (48,657)       (922)      8,953
                                                              ---------    --------    --------
Cash flows from financing activities:
  Borrowings under line of credit...........................        750       8,000       1,500
  Payments on line of credit................................     (1,645)     (8,000)     (1,500)
  Proceeds from the sale of mandatorily redeemable
     convertible preferred stock, net of issuance costs.....      3,242
  Proceeds from the sale of common stock, net of issuance
     costs..................................................     50,235       2,130       2,201
  Payments from stockholders on notes receivable............         79         135       1,090
  Proceeds from issuance of notes payable...................        150
  Proceeds from sales and lease backs of equipment..........        147
  Principal payments on notes payable and capital lease
     obligations............................................       (961)       (280)       (633)
                                                              ---------    --------    --------
          Net cash provided by financing activities.........     51,997       1,985       2,658
                                                              ---------    --------    --------
Effect of exchange rate changes on cash.....................          1         180           4
                                                              ---------    --------    --------
          Net increase in cash and cash equivalents.........      2,158         452       2,571
Cash and cash equivalents, beginning of period..............        324       2,482       2,934
                                                              ---------    --------    --------
Cash and cash equivalents, end of period....................  $   2,482    $  2,934    $  5,505
                                                              =========    ========    ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
  Cash paid during the period for interest..................  $     262    $    212    $    100
  Cash paid during the period for income taxes..............  $            $     58    $     35
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING
  ACTIVITIES:
  Accretion to redemption value of mandatorily redeemable
     convertible preferred stock............................  $     611
  Equipment purchases included in accounts payable..........  $     376
  Issuance of common stock for notes receivable.............  $     403
  Conversion of mandatorily redeemable preferred stock to
     common stock...........................................  $  35,922
  Assets acquired in acquisitions...........................  $     122    $    648
  Liabilities assumed in acquisitions.......................  $     208    $    670
  Insite acquisition consideration included in accrued
     liabilities............................................  $     110
  Issuance of common stock for net exercise of warrants.....               $     47
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       35
<PAGE>   38
 
                                  VERITY, INC.
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
 1. NATURE OF OPERATIONS:
 
     The Company develops, markets and supports software tools and applications
that enable individuals, enterprises and publishers to intelligently search,
filter, view and disseminate textual information residing on enterprise
networks, on-line services, the Internet, CD-ROM and other electronic media. The
Company markets and sells its software and services to commercial end users
across many industries and government entities through multiple distribution
channels, including direct sales and telesales organizations, primarily in the
United States and Europe and a worldwide network of value added resellers and
system integrators. The Company also licenses its software to original equipment
manufacturers for use in their applications sold to end users.
 
 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
 
  Basis of Consolidation:
 
     The consolidated financial statements include the accounts of Verity, Inc.
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated.
 
  Accounting Estimates:
 
     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amount of revenues and expenses during the reporting
period. Actual results could differ from those estimates.
 
  Cash and Cash Equivalents:
 
     Cash and cash equivalents consist of highly liquid investments with an
original or remaining maturity of 90 days or less as of the date of purchase.
 
  Investments:
 
     The Company has classified its investments as available-for-sale. Such
investments are recorded at fair value and unrealized gains and losses, if
material, are recorded as a separate component of stockholders' equity, net of
tax, until realized. Interest income is recorded using an effective interest
rate with the associated premium or discount amortized to investment income. The
cost of securities sold is based upon the specific identification method. As of
the balance sheet date, investments with maturity dates of one year or less are
classified as current, and those with maturity dates of greater than one year
are classified as long-term.
 
  Equipment and Leasehold Improvements:
 
     Equipment and leasehold improvements are stated at cost less accumulated
depreciation and amortization. Equipment is depreciated on a straight-line basis
over the estimated useful lives of the related assets, generally three to five
years. Leasehold improvements and leased assets are amortized on a straight-line
basis over the lesser of their estimated useful life or the lease term. Gains
and losses upon asset disposal are taken into income in the year of disposition.
 
  Intangible Assets:
 
     Intangible assets consist primarily of goodwill, purchased software and
capitalized software development costs. Goodwill and purchased software are
amortized on a straight-line basis over their estimated useful lives, generally
five years and three years, respectively. The Company periodically evaluates the
recoverability of
 
                                       36
<PAGE>   39
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)
  Intangible Assets: (continued)
goodwill and purchased software based upon estimated undiscounted future cash
flows from the related products and businesses acquired. Intangible assets are
included in other assets.
 
  Research and Development Costs:
 
     Costs related to research, design and development of products are charged
to research and development expense as incurred. Software development costs are
capitalized beginning when a product's technological feasibility has been
established and ending when a product is available for general release to
customers. Such costs are amortized using the greater of the amount computed
using the ratio that current gross revenues for a product bear to the total of
current and anticipated future gross revenues for that product, or on a straight
line basis over 12 to 18 months. The Company evaluates the estimated net
realizable value of costs capitalized for each product at each balance sheet
date and records write-downs to net realizable value for any product for which
the net book value is in excess of the net realizable value. During fiscal 1997
and 1998, the Company capitalized software development costs in the amounts of
$1,411,000 and $198,000, respectively, which have been fully amortized as of May
31, 1998. In fiscal 1996, the Company did not capitalize any software
development costs since such costs were not significant. Amortization is
included in costs of product revenue.
 
  Revenue Recognition:
 
     Revenues from the sale of software products are recognized upon delivery of
the product if remaining vendor obligations are insignificant and collection of
the resulting receivable is probable. Estimated sales returns and provisions for
insignificant vendor obligations are recorded upon shipment.
 
     Service and other revenues include software maintenance revenues and other
service revenues primarily from consulting and training. Software maintenance
revenues are deferred and recognized ratably over the life of the service
contract. Service revenues from consulting contracts are recognized on the
percentage of completion basis. Other service revenues are recognized as the
related services are performed.
 
  Income Taxes:
 
     Deferred tax assets and liabilities are determined based on the differences
between financial reporting and tax bases of assets and liabilities, measured at
tax rates that will be in effect when the differences are expected to reverse.
Valuation allowances are established when necessary to reduce deferred tax
assets to the amounts expected to be realized.
 
  Certain Risks and Concentrations:
 
     The Company's products are concentrated in the electronic information
search and retrieval software industry which is highly competitive and rapidly
changing. A number of companies offer competitive products addressing certain of
the Company's target markets and act as direct competitors of the Company. The
Company is dependent on the success of its strategic partners to obtain its
competitive edge, and the failure of the products of the Company's strategic
partners to achieve or maintain market acceptance could have a material adverse
effect on the Company's competitive position. Revenue is mainly derived from
relatively large sales to a limited number of customers. The loss of a major
customer or any reduction in orders by such customers, significant technological
changes in the industry, and the infringement or expropriation of proprietary
intellectual property rights or patents could affect operating results
adversely. In addition, a significant portion of the Company's revenue is
derived from international sales; therefore, fluctuation of the U.S. dollar
against foreign currencies or local economic conditions could adversely affect
operating results.
 
                                       37
<PAGE>   40
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)
  Certain Risks and Concentrations: (continued)
     Financial instruments which potentially subject the Company to a
concentration of credit risk principally consists of cash and cash equivalents,
investments and accounts receivable. The Company maintains the majority of its
cash and cash equivalents in demand accounts with two major financial
institutions.
 
     The Company maintains cash balances in excess of its operating requirements
in commercial paper securities issued by various corporate institutions, and
debt securities backed by the United States government. The Company has not
experienced any material losses in any of the instruments it has used for excess
cash balances.
 
     The Company sells products to companies in North America and Europe. The
Company performs ongoing credit evaluations of its customers' financial
condition and generally does not require collateral. The Company maintains
allowances for potential losses and such losses have been within management's
expectations. No single customer accounted for more than 10% of the accounts
receivable balance at May 31, 1997. One customer accounted for 25% of the
accounts receivable balance at May 31, 1998.
 
     Many currently installed computer systems are not capable of distinguishing
21st century dates from 20th century dates. As a result, in less than two years,
computer systems or applications used by many companies in a wide variety of
industries will experience operating difficulties unless the systems or
applications are modified to process information related to the century change
adequately. 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.
 
  Products:
 
     Although the Company's assessment of Year 2000 issues is not yet complete,
based on its assessment to date, the Company believes that the current versions
of its products are "Year 2000 compliant." In spite of the fact that the Company
has not been a party to any litigation or any proceedings to date involving its
products or services related to Year 2000 compliance issues, 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. The costs of defending and resolving Year
2000-related damages, including consequential damages, could have a material
adverse effect on the Company's business, results of operations and financial
condition.
 
  Operations:
 
     The Company is reviewing its internal management information and other
systems in order to identify and modify those products, services or systems that
are not Year 2000 compliant. The total cost of these Year 2000 compliance
activities has not been material to date. 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 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. 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 delivering products, services or systems
 
                                       38
<PAGE>   41
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)
  Operations: (continued)
required by the Company on a timely basis, the Company's business, results of
operations and financial condition could be materially and adversely affected.
 
  Foreign Currency Translation:
 
     The Company translates the accounts of its foreign branches and
subsidiaries using historical rates for nonmonetary assets and current rates for
monetary assets. Remeasurement gains and losses from the translation of these
branches and those that arise from exchange rate changes on transactions
denominated in a currency other than the local currency are included in the
statements of operations. The Company's foreign branches and subsidiaries use
the U.S. dollar as their functional currency as the U.S. parent exclusively
funds the branches and subsidiaries' operations with U.S. dollars. The net gain
(loss) on foreign currency remeasurement and exchange rate changes for fiscal
years 1996, 1997 and 1998, which is included in other income (expense) net on
the accompanying statements of operations, was $(24,000), $66,000 and $95,000,
respectively.
 
  Fair Value of Financial Instruments:
 
     Carrying amounts of certain of the Company's financial instruments,
including cash and cash equivalents, accounts receivable, accounts payable,
accrued expenses and other liabilities approximate fair value due to their short
maturities. Based upon borrowing rates currently available to the Company for
loans with similar terms, the carrying value of capital lease obligations and
notes payable approximate fair value. The fair value of the Company's
investments are set forth in Note 4.
 
  Computation of Net Loss Per Share:
 
     The Company has adopted Statement of Financial Accounting Standards No. 128
(SFAS No. 128), Earnings Per Share, which requires the dual presentation of
basic and diluted earnings per share. Basic earnings per share is computed using
the weighted average number of common shares outstanding during the period.
Diluted earnings per share is 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 all years presented, the
effects of outstanding stock options were excluded from the calculation of
diluted earnings per share because their effect was antidilutive. Accordingly,
no adjustments were required to previously reported earnings per share amounts.
 
  Recent 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. The
Company is evaluating alternative formats for presenting this information, but
does not expect this pronouncement to materially impact the Company's results of
operations.
 
     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
disclosure 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
 
                                       39
<PAGE>   42
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED)
  Recent Pronouncements: (continued)
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.
 
     During October 1997, the American Institute of Certified Public Accountants
issued Statement of Position 97-2 (SOP 97-2), Software Revenue Recognition. This
statement establishes requirements for revenue recognition for software
companies for fiscal years beginning after December 15, 1997. The Company is
currently evaluating the impact of SOP 97-2 and has not determined the result,
if any, on the Company's financial position, results of operations or cash
flows.
 
 3. ACQUISITIONS:
 
     During fiscal years 1996 and 1997, the Company acquired the following
entities described below which were accounted for as purchase transactions.
 
  Insite:
 
     In March 1996, the Company acquired substantially all the assets of Insite
Computer Technology Limited (Insite), a company which has focused on developing
groupware solutions, for a total cash purchase price of approximately $295,000
and assumed liabilities of $208,000. The purchase price has been allocated to
the fair value of the tangible assets and in-process research and development in
the amount of $122,000 and $381,000, respectively.
 
     During fiscal 1998, the Company discontinued operations of Insite.
 
  Cognisoft:
 
     In January 1997, the Company entered into an Agreement and Plan of
Reorganization and Merger with Cognisoft Corporation (Cognisoft) providing for
the acquisition of Cognisoft for a cash purchase price of approximately $10
million and assumed liabilities of $88,000. Cognisoft, a startup company located
in Bellevue, Washington, has developed and released in July 1997, an Intranet
application that enables corporations to "push" information to users from
multiple data sources. The purchase price plus direct costs incurred was
allocated to the tangible assets and in-process research and development in the
amounts of $49,000 and $10,000,000, respectively.
 
     During fiscal 1998, the Company determined that the push technology was not
part of its long-term strategy and, accordingly, discontinued the operations of
Cognisoft.
 
  64k:
 
     In May 1997, the Company completed its acquisition of all of the
outstanding stock of 64k Incorporated (64k) for a cash purchase price of $3.5
million and assumed liabilities of approximately $50,000. Since its inception in
1996, 64k, based in San Jose, California, focused on developing technology to
improve the speed and effectiveness of relational database searches. The
purchase price plus direct costs incurred was allocated to the tangible assets
and in-process research and development in the amounts of $491,000 and
$3,060,000, respectively.
 
     During fiscal 1998, the Company discontinued operations of 64k.
 
                                       40
<PAGE>   43
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 3. ACQUISITIONS: (CONTINUED)
  KeyView:
 
     In May 1997, the Company acquired substantially all of the assets of FTP
Software Inc.'s KeyView product line for a cash purchase price of approximately
$1.3 million and assumed liabilities of $489,000. KeyView, based in Calgary,
Canada, develops software utilities that allow users to view most file types
whether encountered on the Internet, corporate intranets, e-mail attachments or
found on a hard drive or network. The purchase price has been allocated to
purchased software products and in-process research and development in the
amounts of $184,000 and $1,065,000, respectively. The excess of the purchase
price plus direct costs incurred over the fair value of the assets acquired was
approximately $439,000 and has been recorded as goodwill, which is being
amortized on a straight line basis over four years.
 
     The operating results of these acquired businesses have been included in
the consolidated financial statements from the dates of acquisition. The
purchase prices in all of the above acquisitions have been allocated to assets
and liabilities assumed through established valuation techniques used in the
software industry. The amount of purchase price allocated to in-process research
and development in each of the acquisitions relates to products for which
technological feasibility has not been established and for which there is no
alternative future use. Consequently, these amounts were expensed at their
respective acquisition date. Also included in the expense line "Acquisition of
in-process research and development and other" for the year ended May 31, 1997
is $600,000 related to the write-off of prepaid license fees previously paid for
a product that was replaced by KeyView.
 
  Pro Forma Information:
 
     The following unaudited pro forma financial information for the Company
gives effect to the Cognisoft, KeyView and 64k acquisitions as if they had
occurred at the beginning of fiscal 1996. Because Cognisoft and 64k began
operations after June 1, 1995, their results of operations have been included in
the pro forma financial statements from their respective dates of inception.
 
     The pro forma information excludes the nonrecurring write-off of in-process
research and development for which there was no alternative future uses and
technological feasibility had not been established.
 
<TABLE>
<CAPTION>
                                                                FISCAL YEARS
                                                           ----------------------
                                                             1996         1997
                                                           ---------    ---------
                                                           (IN THOUSANDS, EXCEPT
                                                              PER SHARE DATA)
<S>                                                        <C>          <C>
Revenue..................................................   $31,088      $43,599
Net loss.................................................   $(2,917)     $(5,949)
Net loss applicable to common stockholders...............   $(3,528)     $(5,949)
Net loss per share.......................................   $ (0.45)     $ (0.55)
Shares used in calculation...............................     7,829       10,840
</TABLE>
 
     Such pro forma amounts are not necessarily indicative of what the actual
consolidated results of operations might have been if the acquisitions had been
effective at the beginning of fiscal 1996.
 
                                       41
<PAGE>   44
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 4. INVESTMENTS:
 
     As of May 31, 1997, available-for-sale securities consist of the following
(in thousands):
 
<TABLE>
<CAPTION>
                                                                   GROSS         GROSS
                                                    AMORTIZED    UNREALIZED    UNREALIZED     FAIR
                                                      COST         GAINS         LOSSES       VALUE
                                                    ---------    ----------    ----------    -------
<S>                                                 <C>          <C>           <C>           <C>
Corporate commercial paper -- short-term..........   $15,178        $14           $ (9)      $15,183
Corporate commercial paper -- long-term...........     7,006          8             (7)        7,007
Preferred stock...................................        50                                      50
                                                     -------        ---           ----       -------
Total investments.................................   $22,234        $22           $(16)      $22,240
                                                     =======        ===           ====       =======
</TABLE>
 
     As of May 31, 1998, available-for-sale securities consist of the following
(in thousands):
 
<TABLE>
<CAPTION>
                                                                   GROSS         GROSS
                                                    AMORTIZED    UNREALIZED    UNREALIZED     FAIR
                                                      COST         GAINS         LOSSES       VALUE
                                                    ---------    ----------    ----------    -------
<S>                                                 <C>          <C>           <C>           <C>
Corporate commercial paper -- short-term..........   $12,426         $7           $--        $12,433
Corporate commercial paper -- long-term...........         5                                       5
                                                     -------         --           ---        -------
                                                     $12,431         $7           $--        $12,438
                                                     =======         ==           ===        =======
</TABLE>
 
     At May 31, 1998, scheduled maturities of investments classified as
available-for-sale are as follows (in thousands):
 
<TABLE>
<S>                                                           <C>
Within one year.............................................  $12,426
After one year through five years...........................        5
                                                              -------
                                                              $12,431
                                                              =======
</TABLE>
 
 5. EQUIPMENT AND LEASEHOLD IMPROVEMENTS:
 
     As of May 31, 1997 and 1998, equipment and leasehold improvements consist
of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                                MAY 31,
                                                          -------------------
                                                           1997        1998
                                                          -------    --------
<S>                                                       <C>        <C>
Computer equipment......................................  $ 9,717    $ 10,442
Furniture and fixtures..................................    3,950       3,817
Leasehold improvements..................................    3,266       3,381
                                                          -------    --------
                                                           16,933      17,640
Less accumulated depreciation and amortization..........   (6,885)    (10,073)
                                                          -------    --------
                                                          $10,048    $  7,567
                                                          =======    ========
</TABLE>
 
     Depreciation expense for fiscal years 1996, 1997 and 1998 was $1,562,000,
$3,124,000 and $3,187,000, respectively.
 
                                       42
<PAGE>   45
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 5. EQUIPMENT AND LEASEHOLD IMPROVEMENTS: (CONTINUED)
     Assets acquired under capital leases included in equipment and leasehold
improvements above are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                                MAY 31,
                                                           ------------------
                                                            1997       1998
                                                           -------    -------
<S>                                                        <C>        <C>
Computer equipment.......................................  $ 1,839    $ 1,839
Furniture and fixtures...................................       29         29
                                                           -------    -------
                                                             1,868      1,868
Less accumulated depreciation and amortization...........   (1,653)    (1,778)
                                                           -------    -------
                                                           $   215    $    90
                                                           =======    =======
</TABLE>
 
 6. BANK LINE OF CREDIT:
 
     The Company has available a $5,000,000 line of credit under an agreement
with a bank which expires on September 30, 1998. 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 (8.5% at May
31, 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 May 31, 1998, no borrowings were
outstanding under the line of credit.
 
 7. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS:
 
     At May 31, 1998, the Company has long-term debt and capital lease
obligations as follows (in thousands):
 
<TABLE>
<S>                                                           <C>
Capital lease obligations...................................  $ 149
Equipment notes payable.....................................      2
                                                              -----
                                                                151
Less current portion........................................   (149)
                                                              -----
                                                              $   2
                                                              =====
</TABLE>
 
     The capital lease obligations, which expire through December 1999, are
collateralized by the related assets. Under the terms of the capital lease
obligations, the Company is responsible for property taxes, insurance and
maintenance costs.
 
     The equipment notes payable are due through July 1998, bear interest at a
rate of 16.4%, and are collateralized by the underlying equipment.
 
     Future minimum payments under long-term debt and capital lease obligations,
are as follows (in thousands):
 
<TABLE>
<CAPTION>
                 FISCAL YEAR ENDING MAY 31,
                 --------------------------
<S>                                                           <C>
1999........................................................  $156
2000........................................................     2
                                                              ----
                                                               158
Less amount representing interest...........................    (7)
                                                              ----
                                                              $151
                                                              ====
</TABLE>
 
                                       43
<PAGE>   46
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 8. COMMITMENTS:
 
     The Company leases various facilities and vehicles under noncancelable
operating leases expiring through September 2005. Under the terms of the leases,
the Company is responsible for taxes, insurance and normal maintenance costs.
Under its primary operating lease facility lease, the Company may extend the
lease term for an additional five years by providing written notice of its
exercise of this option no later than six months before the expiration of the
lease term. The Company has subleased certain of its space to other companies
for various periods through 2000.
 
     At May 31, 1998, future minimum rental payments and receipts under the
operating leases are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                             RENTAL     SUBLEASE
                FISCAL YEAR ENDING MAY 31,                  PAYMENTS     INCOME
                --------------------------                  --------    --------
<S>                                                         <C>         <C>
1999......................................................   $1,591      $1,321
2000......................................................    1,435         250
2001......................................................    1,253
2002......................................................    1,313
2003......................................................    1,322
Thereafter................................................    2,477
                                                             ------      ------
                                                             $9,391      $1,571
                                                             ======      ======
</TABLE>
 
     Rent expense, excluding sublease income, for fiscal years 1996, 1997 and
1998 was $1,070,000, $1,218,000, and $1,285,000, respectively.
 
 9. STOCKHOLDERS' EQUITY:
 
  Changes in and Conversion of Mandatorily Redeemable Convertible Preferred
Stock:
 
     In August 1995, the Company designated 500,000 shares of its preferred
stock as Series H mandatorily redeemable convertible preferred stock and issued
436,000 shares of such preferred stock at $7.50 per share for gross proceeds of
$3,267,000.
 
     In October 1995, all outstanding shares of Series A through H mandatorily
redeemable convertible preferred stock were converted to shares of the Company's
common stock in conjunction with its initial public offering.
 
  Initial Public Offering:
 
     In August 1995, the Company's Board of Directors authorized the
reincorporation of the Company in Delaware. As part of this reincorporation the
outstanding shares of the predecessor California corporation's common stock and
all classes of its mandatorily redeemable convertible preferred stock were
converted automatically into shares of the new Delaware corporation's common and
mandatorily redeemable convertible preferred stock. As a result of the
reincorporation, the Company's authorized common stock was increased to
30,000,000 shares, with a par value of $.001 per share, and upon the conversion
of all outstanding mandatorily redeemable convertible preferred stock and the
completion of the Company's initial public offering, the authorized preferred
stock was reduced to 2,000,000 shares with a par value of $.001.
 
     In October 1995, the Company successfully completed its initial public
offering of common stock. The Company sold 2,999,500 shares of common stock in
this offering, for $32,505,000, net of issuance costs of $961,000.
 
                                       44
<PAGE>   47
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 9. STOCKHOLDERS' EQUITY: (CONTINUED)
  Initial Public Offering: (continued)
     In January 1996, the Company successfully completed its second public
offering of common stock. The Company sold 500,000 shares of common stock in
this offering for $16,509,000, net of issuance costs of $400,000.
 
  1995 Stock Option Plan:
 
     In July 1995, the Company adopted the Amended and Restated 1995 Stock
Option Plan which amended and restated the 1988 Stock Option Plan. During fiscal
year 1996, the Company increased the number of shares reserved under the 1995
Stock Option Plan from the 1,300,000 shares initially reserved under the 1988
Stock Option Plan to 2,911,000 shares of the Company's common stock. In
September 1996, the Company's stockholders approved a further increase to the
number of shares reserved under the 1995 Stock Option Plan from 2,911,000 to
3,311,000 shares of the Company's common stock.
 
     Under the terms of the Plan, incentive options may be granted at prices not
lower than fair market value at the date of grant, while nonqualified options
may be granted at prices not lower than 85% of fair market value at the date of
grant as determined by the Board of Directors. Options granted under the Plan
are exercisable immediately and expire over periods of eight to ten years from
the date of grant.
 
     Common shares purchased under the Plan are subject to the Company's right
of repurchase, which generally lapses as to 12.5% of the shares six months from
the individual's date of employment and thereafter ratably over the remainder of
a 3 1/2 year period at the holder's original purchase price. Thereafter, the
Company has the right of first refusal to purchase such shares. At May 31, 1997
and 1998, 15,000 shares and zero shares, respectively, were subject to the
Company's right of repurchase. At May 31, 1998, 580,000 shares of common stock
were available for grant under the 1995 Stock Option Plan.
 
  1996 Nonstatutory Stock Option Plan:
 
     In February 1996, the Company's Board of Directors approved the 1996
Nonstatutory Stock Option Plan. The terms of the 1996 Nonstatutory Stock Option
Plan are substantially the same as those of the 1995 Stock Option Plan. In April
1997, the Company increased the number of shares reserved under the Plan from
300,000 to 600,000 shares of common stock for issuance to certain employees and
consultants of the Company. In March 1998, the Company raised the number of
shares to 1,860,000 shares of common stock for issuance to certain employees and
consultants of the Company. At May 31, 1998, 780,000 shares of common stock were
available for grant under the 1996 Nonstatutory Stock Option Plan.
 
  Outside Directors Plan:
 
     In July 1995, the Company's Board of Directors approved the 1995 Outside
Directors Plan and reserved 200,000 shares of common stock for issuance to
directors of the Company who are not employees of the Company. The Outside
Directors Plan provides for the automatic granting of nonqualified stock options
to directors of the Company who are not employees of the Company.
 
     At the initiation of the Plan, each current outside director was
automatically granted an option to purchase 20,000 shares of common stock at the
following annual meeting of stockholders. Each new outside director is
automatically granted an option to purchase 20,000 shares of the Company's
common stock at the annual meeting following their appointment. Thereafter at
each annual meeting of the stockholders, outside directors who have previously
received options will receive a new option to purchase 5,000 shares of the
Company's common stock. The exercise price of the options in all cases will be
equal to the fair market value of the Company's common stock at the date of
grant. Options granted under the Director's Plan are
 
                                       45
<PAGE>   48
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 9. STOCKHOLDERS' EQUITY: (CONTINUED)
  Outside Directors Plan: (continued)
immediately exercisable but vest over four years and generally must be exercised
within ten years. As of May 31, 1998, 30,000 options have been granted to
outside directors and 170,000 shares of common stock were available for grant
under this plan.
 
  1997 Stock Option Plan for Verity Canada:
 
     In May 1997, the Company's Board of Directors authorized the adoption of
the 1997 Stock Option Plan for Verity Canada. Under this plan, the Company has
reserved 150,000 shares of common stock for issuance to certain employees and
consultants of Verity Canada. The terms of the 1997 Stock Option Plan for Verity
Canada are substantially the same as those of the 1995 Stock Option Plan. In
March 1998, the Company increased the number of shares reserved under the Plan
from 150,000 to 390,000 shares of common stock for issuance to certain employers
and consultants of the Company. At May 31, 1998, 200,000 shares of common stock
were available for grant under the 1997 Stock Option Plan for Verity Canada.
 
  Activity Under Stock Option Plans:
 
Activity under the above stock option plans is set forth below:
 
<TABLE>
<CAPTION>
                                                                   OPTIONS OUTSTANDING
                                                         ----------------------------------------
                                                                        WEIGHTED
                                                                         AVERAGE
                                             SHARES                       PRICE
                                           AVAILABLE       SHARES       PER SHARE       TOTAL
                                           ----------    -----------    ---------    ------------
<S>                                        <C>           <C>            <C>          <C>
Balance, May 31, 1995....................     160,000        853,000     $ 1.13      $    965,000
  Shares reserved under plans............   2,111,000
  Options reinstated.....................      35,000
  Options granted........................  (1,709,000)     1,709,000     $23.20        39,644,000
  Options canceled.......................     554,000       (554,000)    $18.46       (10,229,000)
  Options exercised......................                   (561,000)    $ 1.30          (727,000)
                                           ----------    -----------                 ------------
Balances, May 31, 1996...................   1,151,000      1,447,000     $20.49        29,653,000
  Shares reserved under plans............     850,000
  Options reinstated.....................      63,000
  Options granted........................  (4,670,000)     4,670,000     $12.72        59,393,000
  Options canceled.......................   3,582,000     (3,582,000)    $19.28       (69,050,000)
  Options exercised......................                    (88,000)    $ 2.26          (199,000)
                                           ----------    -----------                 ------------
Balances, May 31, 1997...................     976,000      2,447,000     $ 8.09        19,797,000
  Shares reserved under plans............   1,500,000
  Options reinstated.....................       2,000         (2,000)
  Options granted........................  (2,665,000)     2,665,000     $ 5.31        14,141,000
  Options canceled.......................   1,921,000     (1,921,000)    $ 8.24       (15,826,000)
  Options exercised......................                   (232,000)    $ 3.79          (883,000)
                                           ----------    -----------                 ------------
Balances, May 31, 1998...................   1,734,000      2,957,000     $ 5.83      $ 17,229,000
                                           ==========    ===========                 ============
</TABLE>
 
     During fiscal year 1996, certain officers of the Company provided four year
recourse notes receivable totaling $403,000 bearing interest at approximately
6.5% in exchange for the purchase of a total of 284,000 shares of common stock
under option. As of May 31, 1998, the notes were repaid.
 
                                       46
<PAGE>   49
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 9. STOCKHOLDERS' EQUITY: (CONTINUED)
  Common Stock Option Plans:
 
     The following table summarizes information with respect to stock options
outstanding at May 31, 1998:
 
<TABLE>
<CAPTION>
                                                             OPTIONS NOT SUBJECT TO
                                                                 REPURCHASE UPON
                            OPTIONS OUTSTANDING                     EXERCISE
                  ---------------------------------------    -----------------------
                                   WEIGHTED
                    NUMBER         AVERAGE       WEIGHTED                  WEIGHTED
   RANGE OF       OUTSTANDING     REMAINING      AVERAGE     NUMBER AT      AVERAGE
   EXERCISE       AT MAY 31,     CONTRACTUAL     EXERCISE     MAY 31,      EXERCISE
    PRICE            1998        LIFE (YEARS)     PRICE         1998         PRICE
--------------    -----------    ------------    --------    ----------    ---------
<S>               <C>            <C>             <C>         <C>           <C>
$0.75 - $ 4.99       437,000         6.90         $3.49       224,000        $2.25
$5.00 - $ 5.99     1,626,000         7.44         $5.22       356,000        $5.24
$6.00 - $ 6.99       170,000         7.05         $6.51        41,000        $6.51
$7.00 - $19.50       724,000         6.88         $8.44       349,000        $8.19
                   ---------                                  -------
                   2,957,000         7.20         $5.82       970,000        $5.66
                   =========                                  =======
</TABLE>
 
     At May 31, 1997, options to purchase 568,000 shares of common stock at a
weighted average exercise price of $5.23, were not subject to the Company's
right of repurchase upon exercise.
 
     In March 1997, the Company offered employees the right to cancel certain
outstanding stock options and receive new options with an exercise price of
$7.75 per share, the closing price of the common stock on the date individual
employees agreed to cancel their original outstanding stock options. Options to
purchase a total of 1,333,000 shares at original exercise prices ranging from
$10.375 to $19.50 per share were canceled and new options were issued in March
1997. Vesting under the new options continues from the date of the original
option grant. The option term on the repriced options is eight years.
 
  Employee Stock Purchase Plan:
 
     In July 1995, the Company's Board of Directors approved the 1995 Employee
Stock Purchase Plan and reserved 250,000 shares of common stock for issuance to
eligible employees. In September 1996, the Company's stockholders approved an
increase to the number of shares reserved under the employee stock purchase plan
from 250,000 to 500,000 shares of common stock and in September 1997, the
Company's stockholders approved a further increase to 1,300,000 shares of common
stock. The Employee Stock Purchase Plan permits eligible employees to purchase
shares of the Company's common stock at 85% of the lesser of fair market value
of the common stock on the first day of the offering period or the last day of
the purchase period. The initial offering period commenced on the effective date
of the offering. At May 31, 1997 and 1998, 331,000 and 638,000 shares,
respectively, of the Company's common stock have been issued under the plan and
169,000 shares and 662,000 shares, respectively, remained available for
purchase.
 
  Pro forma Stock-Based Compensation:
 
     The Company has adopted the disclosure-only provisions of Statement of
Financial Accounting Standards No. 123 (SFAS No. 123), Accounting for
Stock-Based Compensation. Accordingly, no compensation cost has been recognized
for the Company's stock option plans or Employee Stock Purchase Plan. Had
compensation cost for the Company's stock option plans and Employee Stock
Purchase Plan been determined based on the fair value at the grant date for
awards in fiscal years 1996, 1997 and 1998 consistent with the provisions of
SFAS No. 123, the Company's net loss and net loss per share for fiscal years
1996, 1997 and
 
                                       47
<PAGE>   50
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 9. STOCKHOLDERS' EQUITY: (CONTINUED)
  Pro forma Stock-Based Compensation: (continued)
1998 would have been increased to the pro forma amounts indicated below (in
thousands, except per share mounts):
 
<TABLE>
<CAPTION>
                                                                      FISCAL YEARS
                                                              ----------------------------
                                                               1996      1997       1998
                                                              ------    -------    -------
<S>                                                           <C>       <C>        <C>
Net loss applicable to common stockholders -- as reported...  $  924    $17,931    $16,510
                                                              ======    =======    =======
Net loss applicable to common stockholders -- pro forma.....  $2,813    $23,174    $20,185
                                                              ======    =======    =======
Net loss per share -- basic and diluted -- as reported......  $ 0.12    $  1.65    $  1.47
                                                              ======    =======    =======
Net loss per share -- basic and diluted -- pro forma........  $ 0.36    $  2.14    $  1.80
                                                              ======    =======    =======
</TABLE>
 
     The above pro forma disclosures are not necessarily representative of the
effects on reported net income or loss for future years.
 
     The aggregate fair value and weighted average fair value of each option
granted in fiscal years 1996, 1997 and 1998 were $19.0 million, $22.0 million
and $7.1 million, and $11.10, $4.71 and $2.74, respectively. The fair value of
each option grant is estimated on the date of grant using the Black-Scholes
Option Pricing Model with the following weighted average assumptions for fiscal
years 1996, 1997 and 1998:
 
<TABLE>
<CAPTION>
                                                               1996       1997       1998
                                                              -------    -------    -------
<S>                                                           <C>        <C>        <C>
Expected volatility.........................................    60%        60%        60%
Risk-free interest rate.....................................   6.4%       6.4%       5.6%
Expected life...............................................  4 years    4 years    4 years
Expected dividend yield.....................................   0.0%       0.0%       0.0%
</TABLE>
 
     The Company has also estimated the fair value for the purchase rights under
the Employee Stock Purchase Plan using the Black-Scholes Model with the
following assumptions for fiscal years 1996, 1997 and 1998:
 
<TABLE>
<CAPTION>
                                                     1996              1997              1998
                                                --------------    --------------    --------------
<S>                                             <C>               <C>               <C>
Expected volatility...........................       60%               60%               60%
Risk-free interest rate.......................       6.4%              6.4%              5.6%
                                                   .48-1.48
Expected life.................................  years.........    .48-1.48 years    .50-1.00 years
Expected dividend yield.......................       0.0%              0.0%              0.0%
</TABLE>
 
  Stock Options Issued Outside of the Plan:
 
     In June 1993, the Company's Board of Directors granted an officer of the
Company an option outside of the Plan to purchase 365,000 shares of the
Company's common stock at $2.00 per share. Such shares upon purchase will be
subject to the Company's right of repurchase, which lapses ratably over four
years. In addition, the officer was granted an option outside of the Plan for an
additional 418,000 shares of the Company's common stock at $2.00 per share. Upon
purchase, these shares are also subject to the Company's right of repurchase,
which lapses the earlier of the achievement of certain specified Company
performance goals or after completion by the officer of seven years of
continuous employment. In December 1993, the exercise price for the shares under
these options was reduced to $1.15 per share. In August 1994, the officer
exercised his right to purchase all of the shares of common stock under option
in exchange for a recourse note receivable of $901,000 bearing interest at 7.05%
due August 2003. During fiscal year 1998, the note was repaid and none of the
stock is subject to repurchase as of May 31, 1998.
 
                                       48
<PAGE>   51
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 9. STOCKHOLDERS' EQUITY: (CONTINUED)
  Preferred Stock Purchase Rights Plan:
 
     In September 1996, the Company's Board of Directors adopted a Preferred
Stock Purchase Rights Plan designed to enable all Verity stockholders to realize
the full value of their investment and to provide for fair and equal treatment
for all Verity stockholders in the event that an unsolicited attempt is made to
acquire Verity. Under the Plan, stockholders will receive one Right to purchase
one one-hundredth of a share of a new series of Preferred Stock for each
outstanding share of Verity common stock held at the close of business on
October 2, 1996. The Rights expire on September 17, 2006.
 
10. INCOME TAXES:
 
     Income (loss) before taxes consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                       FISCAL YEARS
                                              -------------------------------
                                               1996        1997        1998
                                              -------    --------    --------
<S>                                           <C>        <C>         <C>
Domestic....................................  $(1,154)   $(20,532)   $(16,890)
Foreign.....................................      841       2,781         680
                                              -------    --------    --------
                                              $  (313)   $(17,751)   $(16,210)
                                              =======    ========    ========
</TABLE>
 
     Details of the income tax provision for fiscal year 1997 and 1998 consists
of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                                MAY 31,
                                                              ------------
                                                              1997    1998
                                                              ----    ----
<S>                                                           <C>     <C>
Current:
State.......................................................  $ 42    $108
Foreign.....................................................   138     192
                                                              ----    ----
                                                              $180    $300
                                                              ====    ====
</TABLE>
 
     During fiscal year 1996, the Company had a current provision for income
taxes of $401,000 which was substantially offset by a benefit derived from the
utilization of net operating loss carryforwards.
 
     The Company's effective tax rate differs from the statutory federal income
tax rate as shown in the following schedule:
 
<TABLE>
<CAPTION>
                                                           FISCAL YEARS
                                                      -----------------------
                                                      1996     1997     1998
                                                      -----    -----    -----
<S>                                                   <C>      <C>      <C>
Income tax benefit at statutory rates...............  (34.0)%  (35.0)%  (34.0)%
State income taxes net of federal benefit...........             0.2      0.7
Write-off of in-process research and development....            28.5
Non-deductible expenses.............................             1.6      1.0
Foreign taxes.......................................             0.8      1.3
Net operating loss not benefited....................   34.0      4.9     33.0
                                                      -----    -----    -----
Effective tax rate..................................     --%     1.0%     2.0%
                                                      =====    =====    =====
</TABLE>
 
                                       49
<PAGE>   52
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
10. INCOME TAXES: (CONTINUED)
     The components of the net deferred tax asset are (in thousands):
 
<TABLE>
<CAPTION>
                                                                    MAY 31,
                                                              --------------------
                                                                1997        1998
                                                              --------    --------
<S>                                                           <C>         <C>
Deferred tax assets:
  Accumulated depreciation..................................  $  1,657    $  1,980
  Accrued compensation......................................       259         348
  Other accruals and allowance for doubtful accounts........       469       1,543
  Research and development credits..........................     1,518       1,830
  Net operating loss carryforwards..........................     7,647      11,303
                                                              --------    --------
                                                                11,550      17,004
Deferred tax liabilities:
  Capitalized software......................................      (325)
                                                              --------    --------
                                                                11,225      17,004
Valuation allowance.........................................   (11,225)    (17,004)
                                                              --------    --------
          Net deferred tax asset............................  $     --    $     --
                                                              ========    ========
</TABLE>
 
     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 reduced.
 
     The Company's deferred tax asset related to its net operating loss
carryforwards includes the tax benefit derived from the disqualifying
dispositions of incentive stock options and the exercise of nonqualified stock
options. The benefit, which totaled $270,000 and $372,000, at May 31, 1997 and
1998, respectively, will be credited directly to additional paid-in capital when
the Company's deferred tax asset is recognized.
 
     As of May 31, 1998, the Company had approximately $31,000,000 and
$14,300,000 of net operating loss carryforwards for federal and California
purposes, respectively, to offset future taxable income. The Company also has
federal and state research and development tax credit carryforwards of
approximately $1,500,000 and $500,000, respectively, at May 31, 1998. These
carryforwards expire in the years 1999 to 2013 if not utilized. The Company's
net operating loss and tax credit carryforwards are subject to an annual
limitation of approximately $4,900,000 as a result of an ownership change, as
defined by tax laws.
 
11. RELATED PARTY TRANSACTIONS:
 
     During fiscal year 1996, the Company provided consulting services and sold
software products aggregating $54,000 to three stockholders. These revenues and
costs are included in the accompanying statements of operations.
 
12. EMPLOYEE BENEFIT PLAN:
 
     The Verity, Inc. 401(k) Plan, as allowed under Section 401(k) of the
Internal Revenue Code, provides tax deferred salary deductions for eligible
employees. Employees are eligible to participate immediately upon date of hire.
 
     Participants may make voluntary contributions to the plan up to 20% of
their compensation. The plan does not provide for Company contributions.
 
                                       50
<PAGE>   53
                                  VERITY, INC.
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
13. COMPUTATION OF NET LOSS PER SHARE:
 
     Basic and diluted loss per share are calculated as follows for fiscal years
1996, 1997 and 1998 (in thousands except per share amounts):
 
<TABLE>
<CAPTION>
                                                               1996       1997        1998
                                                              ------    --------    --------
<S>                                                           <C>       <C>         <C>
Basic and diluted:
  Weighted average common shares outstanding................   7,829      10,840      11,225
  Net loss applicable to common stockholders................  $ (924)   $(17,931)   $(16,510)
  Net loss per share........................................  $(0.12)   $  (1.65)   $  (1.47)
</TABLE>
 
     The calculation of diluted shares outstanding for fiscal 1996, 1997 and
1998 excludes 365,000, 506,000 and 387,000 stock options, respectively, as their
effect was antidilutive in each period.
 
14. BUSINESS SEGMENT, FOREIGN SALES AND OPERATIONS, AND MAJOR CUSTOMERS:
 
     The Company, whose operations consist of a single line of business,
develops, markets and supports software tools and applications that enable
individuals, enterprises and publishers to intelligently search, filter, view,
and disseminate textual information residing on enterprise networks, on-line
services, the Internet, CD-ROM and other electronic media.
 
     The Company has sales and marketing operations located outside the United
States in the Netherlands, United Kingdom, France, Germany and Canada. Foreign
branch and subsidiary revenues consist primarily of maintenance and consulting
services.
 
<TABLE>
<CAPTION>
          FINANCIAL DATA BY              UNITED                 OTHER
           GEOGRAPHIC AREA               STATES     EUROPE     FOREIGN    ELIMINATIONS     TOTAL
          -----------------             --------    -------    -------    ------------    --------
                                                              (IN THOUSANDS)
<S>                                     <C>         <C>        <C>        <C>             <C>
Revenues:
  1996................................  $ 28,309    $ 3,215     $552        $(1,358)      $ 30,718
  1997................................    40,417      5,459                  (3,205)        42,671
  1998................................    36,440      2,418                                 38,858
Income (loss) from operations:
  1996................................        70     (1,683)     222                        (1,391)
  1997................................   (17,603)     2,756      (54)        (4,581)       (19,482)
  1998................................   (13,752)       613       54         (4,578)       (17,663)
Identifiable assets:
  1997................................    45,521      3,516      406                        49,443
  1998................................    37,275      3,902      272                        41,449
</TABLE>
 
     Transfers between geographic areas are recorded at amounts generally above
cost and in accordance with the rules and regulations of the respective
governing tax authorities. Operating income consists of total net sales less
operating expenses, and does not include either interest and other income, net,
or income taxes. Identifiable assets of geographic areas are those assets used
in the Company's operations in each area.
 
     Included in software product revenues are export sales of approximately
$5,861,000, $10,144,000, and $10,317,000 in fiscal years 1996, 1997 and 1998,
respectively.
 
     No single customer accounted for 10% or more of the Company's revenue
during fiscal years 1996, 1997 and 1998. Revenues from the federal government
and its agencies were $3,230,000, $4,037,000 and $3,489,000 for fiscal years
1996, 1997 and 1998, respectively.
 
                                       51
<PAGE>   54
 
                                   SIGNATURES
 
     Pursuant to the requirements of Section 13 or 15(d) 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.
 
Date: August 12, 1998                     By: /s/ JAMES E. TICEHURST
                                            ------------------------------------
                                            James E. Ticehurst
                                            Vice President, Administration and
                                              Controller
                                            (Principal Financial Officer)
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.
 
<TABLE>
<CAPTION>
                       SIGNATURE                                     TITLE                   DATE
                       ---------                                     -----                   ----
<S>                                                       <C>                           <C>
/s/ GARY J. SBONA                                         President, Chief Executive    August 12, 1998
--------------------------------------------------------  Officer and Director
Gary J. Sbona                                             (Principal Executive
                                                          Officer)
 
/s/ JAMES E. TICEHURST                                    Vice President,               August 12, 1998
--------------------------------------------------------  Administration and
James E. Ticehurst                                        Controller (Principal
                                                          Financial Officer)
 
/s/ STEVEN M. KRAUSZ                                      Director                      August 12, 1998
--------------------------------------------------------
Steven M. Krausz
 
/s/ STEPHEN A. MACDONALD                                  Director                      August 12, 1998
--------------------------------------------------------
Stephen A. MacDonald
 
/s/ CHARLES P. WAITE, JR.                                 Director                      August 12, 1998
--------------------------------------------------------
Charles P. Waite, Jr.
</TABLE>
 
                                       52
<PAGE>   55
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
To the Board of Directors and Stockholders
Verity, Inc.:
 
     Our report on the consolidated financial statements of Verity, Inc. and
Subsidiaries is included on page 31 of this Form 10-K. In connection with our
audits of such financial statements, we have also audited the related financial
statement schedule listed in the index on page 30 of the Form 10-K.
 
     In our opinion, the financial schedule referred to above when considered in
relation to the basic financial statements taken as a whole, presents fairly, in
all material respects, the information required to be included herein.
 
                                            PricewaterhouseCoopers LLP
San Jose, California
June 19, 1998
 
                                       53
<PAGE>   56
 
                                  SCHEDULE II
 
                                  VERITY, INC.
                       VALUATION AND QUALIFYING ACCOUNTS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                  AMOUNTS
                                                   BALANCE AT    CHARGED TO                  BALANCE
                                                   BEGINNING     PROFIT AND                  AT END
                   DESCRIPTION                      OF YEAR         LOSS       DEDUCTIONS    OF YEAR
                   -----------                     ----------    ----------    ----------    -------
<S>                                                <C>           <C>           <C>           <C>
ALLOWANCE FOR BAD DEBTS:
Year ended May 31, 1996
  Allowance for doubtful accounts................   $   361        $  455        $(427)      $   389
Year ended May 31, 1997
  Allowance for doubtful accounts................   $   389        $  350        $(199)      $   540
Year ended May 31, 1998
  Allowance for doubtful accounts................   $   540        $  699        $(533)      $   706
ALLOWANCE FOR DEFERRED TAX ASSETS:
Year ended May 31, 1996
  Valuation Allowance............................   $ 9,025        $1,167        $  --       $10,192
Year ended May 31, 1997
  Valuation Allowance............................   $10,192        $1,033        $  --       $11,225
Year ended May 31, 1998
  Valuation Allowance............................   $11,225        $5,779        $  --       $17,004
</TABLE>
 
                                       54
<PAGE>   57
 
                               INDEX TO EXHIBITS
 
<TABLE>
<CAPTION>
EXHIBIT
  NO.                            DESCRIPTION
-------                          -----------
<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)
 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)
10.6     Security and Loan Agreement between Imperial Bank and the
         Company dated April 7, 1994, as amended.(2)
10.7     Series G Preferred Stock Purchase Agreement dated August 29,
         1994.(1)
10.8     Series H Preferred Stock Purchase Agreement dated August 1,
         1995.(1)
10.9     Sublease Agreement between Booz-Allen & Hamilton, Inc. and
         the Company dated April 1, 1988, as amended.(1)
10.10    Lease Agreement between The Trustees of the Roman Catholic
         Church of the Archdiocese of Canberra and Goulburn and the
         Company dated July 1, 1993 (Australia).(1)
10.11    Lease Agreement between Peel Investments (North) Limited and
         the Company dated 1994 (England).(1)
10.12    Lease Agreement between Le Centre D'Affaires Perinord and
         the Company dated November 26, 1992 (France).(1)
10.13    Lease Agreement between Oskam Vastgoed De Meern B.V. and the
         Company dated September 1, 1990 (The Netherlands).(1)
10.14    OEM Software Development and Run Time License Agreement
         between Adobe Systems, Inc. and the Company dated July 29,
         1994, as amended.(1),(5)
10.15    License Agreement between Frame Technology Corporation and
         the Company dated May 29, 1992.(1),(5)
10.16    OEM Development and License Agreement between the Company
         and Delphi Internet Services Corporation dated as of August
         23, 1995.(1),(5)
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)
</TABLE>
 
                                       55
<PAGE>   58
 
<TABLE>
<CAPTION>
EXHIBIT
  NO.                            DESCRIPTION
-------                          -----------
<S>      <C>
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 April 13,
         1998.
21.1     List of Subsidiaries.(1)
23.1     Consent of Independent Accountants.
27.1     Financial Data Schedule (available in EDGAR format only).
</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, 1996.
 
 (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 to the Company's report on
     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.
 
                                       56