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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549




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FORM 10-K/A







(Amendment No. 1)





(Mark One)



|  |                                                                                                                                        
|- | ---------------------------------------------------------------------------------------------------------------------------------------
|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE 
     SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED
    MARCH 31, 2004
| 
|o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934                                           

Commission File Number

1-15681




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webMethods, Inc.

(Exact name of Registrant as Specified in its
Charter)


|                                                                                 |  |                                                   
|-------------------------------------------------------------------------------- |  | --------------------------------------------------
|Delaware(State or Other Jurisdiction of
    Incorporation or Organization)       |  | 54-1807654(I.R.S. Employer
    Identification No.)
|                                                                                
|3930 Pender Drive, Fairfax, Virginia(Address of Principal Executive
    Offices) |  | 22030(Zip Code)                                   

Registrants telephone number, including
area code:  (703) 460-2500

Securities registered pursuant to
Section 12(b) of the Act: None

Securities registered pursuant to
Section 12(g) of the Act: Common Stock, $0.01 par value

Preferred Stock Purchase Rights




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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 o

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

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Exchange Act
Rule 12b-2).
Yes x     No o

As of September 30, 2003, there were
52,057,159 shares of the registrants Common Stock
outstanding. The aggregate market value of such shares held by
non-affiliates of the registrant, based upon the closing sale
price ($8.02) of such shares on the Nasdaq National Market for
such date, was approximately $266,180,100. Shares of the
registrants Common Stock held by each executive officer
and director of the registrant, and by each entity publicly
reporting that it owns 5% or more of the outstanding shares of
the registrants Common Stock, have been excluded, as such
persons may be deemed to be affiliates. This determination of
affiliate status is not necessarily a conclusive determination
for any other purpose.




As of August 4, 2004, there were outstanding
53,077,440 shares of the registrants Common Stock.




DOCUMENTS INCORPORATED BY REFERENCE




Certain portions of the definitive Proxy
Statement used in connection with the registrants 2004
Annual Meeting of Stockholders filed with the Securities and
Exchange Commission on July 19, 2004 are incorporated by
reference into Part III of this Form 10-K to the extent
stated.












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Explanatory Note







This Annual Report on Form 10-K/A (Amendment
No. 1) amends our Annual Report on Form 10-K for the year
ended March 31, 2004 that was filed with the Securities and
Exchange Commission on June 14, 2004 to correct errata in
the range of exercise prices in the table included in
Note 14 of the Notes to Consolidated Financial Statements
appearing at the bottom of page F-20 of this report. This
had no impact on any other reported amount or disclosure
referred to in the Note above.






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WEBMETHODS, INC.

FORM 10-K

TABLE OF CONTENTS

|           |  |                                                                                           |  |   
|---------- |  | ----------------------------------------------------------------------------------------- |  | --
|           |  |                                                                                           |  |   
|Part I     |  |                                                                                          
|Item 1.    |  | Business                                                                                  |  | 1 
|           |  | Overview                                                                                  |  | 1 
|           |  | Industry
    Background                                                                   |  | 3 
|           |  | The webMethods
    Solution                                                               |  | 4 
|           |  | webMethods
    Strategy                                                                  |  | 7 
|           |  | Customers                                                                                 |  | 8 
|           |  | Sales and
    Marketing                                                                   |  | 9 
|           |  | Partners and
    Strategic Relationships                                                  |  | 10
|           |  | Global Customer
    Services                                                              |  | 10
|           |  | Product
    Development                                                                   |  | 11
|           |  | Competition                                                                               |  | 11
|           |  | Intellectual
    Property and Other Proprietary Rights                                    |  | 12
|           |  | Corporate
    Information                                                                 |  | 14
|           |  | Available
    Information                                                                 |  | 15
|           |  | Employees                                                                                 |  | 15
|           |  | Executive
    Officers of webMethods                                                      |  | 15
|           |  | Factors That May
    Affect Future Operating Results                                      |  | 16
|Item 2.    |  | Properties                                                                                |  | 24
|Item 3.    |  | Legal Proceedings                                                                         |  | 25
|Item 4.    |  | Submission of Matters to a
    Vote of Security Holders                                   |  | 25
|Part II    |  |                                                                                          
|Item 5.    |  | Market for Registrants
    Common Stock and Related Stockholder Matters                  |  | 25
|Item 6.    |  | Selected Financial Data                                                                   |  | 27
|Item 7.    |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations |  | 28
|           |  | Overview                                                                                  |  | 28
|           |  | Results of
    Operations                                                                 |  | 32
|           |  | Liquidity and
    Capital Resources                                                       |  | 40
|           |  | Recently Issued
    Accounting Pronouncements                                             |  | 41
|Item 7A.   |  | Quantitative and Qualitative
    Disclosures about Market Risk                            |  | 42
|Item 8.    |  | Financial Statements and
    Supplementary Data                                           |  | 42
|Item 9.    |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosures |  | 43
|Item 9A.   |  | Controls and Procedures                                                                   |  | 43
|Part III   |  |                                                                                          
|Item 10.   |  | Directors and Executive
    Officers of the Registrant                                    |  | 44
|Item 11.   |  | Executive Compensation                                                                    |  | 44
|Item 12.   |  | Security Ownership of
    Certain Beneficial Owners and Management                        |  | 44
|Item 13.   |  | Certain Relationships and
    Related Transactions                                        |  | 44
|Item 14.   |  | Principal Accountant Fees
    and Services                                                |  | 44
|Part IV    |  |                                                                                          
|Item 15.   |  | Exhibits, Financial
    Statement Schedules and Reports on Form 8-K                       |  | 45
|Signatures |  | 47                                                                                       
|EX-21.1   
|EX-23.1   
|EX-31.1   
|EX-31.2   
|EX-32.1   
|EX-32.2   





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PART I



Item 1.     BUSINESS

This annual report on Form 10-K contains
forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended.
Examples of forward-looking statements include, but are not
limited to, (i) projections of revenue, costs or expense,
margins, income or loss, earnings or loss per share, capital
expenditures, cash requirements or other financial items,
sufficiency of working capital and projections regarding the
market for webMethods software and services,
(ii) statements of the plans, objectives or expectations of
webMethods, Inc. or its management, including the development or
enhancement of software, development and continuation of
strategic partnerships and alliances, contributions to
webMethods revenue by its business partners,
implementation and effect of sales and marketing initiatives by
webMethods, financial results of webMethods, Inc. and its
subsidiaries, financial results within geographic or specific
vertical markets and the allocation of resources to those
markets, predictions of the timing and type of customer or
market reaction to sales and marketing initiatives, the ability
to control expenses, future hiring, webMethods business
strategy and the execution on it and actions by customers and
competitors, (iii) statements of future economic
performance, economic conditions or the impact of recent or
anticipated changes in accounting standards and
(iv) assumptions underlying any of the foregoing. In some
instances, forward-looking statements can be identified by the
use of the words believes, anticipates,
plans, expects, intends,
may, will, should,
estimates, predicts,
continue, the negative thereof or similar
expressions. Although we believe that the expectations reflected
in the forward-looking statements are reasonable, our
expectations or the forward-looking statements could prove to be
incorrect, and actual results could differ materially from those
indicated by the forward-looking statements. Our future
financial condition and results of operations, as well as any
forward-looking statements, are subject to risks and
uncertainties, including (but not limited to) those discussed in
this Item 1 under the caption Factors That May Affect
Future Operating Results. Achieving the future results or
accomplishments described or projected in forward-looking
statements depends upon events or developments that are often
beyond our ability to control. All forward-looking statements
and all reasons why actual results may differ that are included
in this report are made as of the date of this report, and
webMethods disclaims any obligation to publicly update or revise
such forward-looking statements or reasons why actual results
may differ.




OVERVIEW

We are a leading provider of software and
services for end-to-end business integration solutions. We offer
a set of software products that enable organizations to run,
manage and optimize their business. Our software products and
related services give organizations the ability, seamlessly and
in real-time, to integrate disparate information resources, to
connect customers, vendors and business partners with the
organization and its employees, to view and manage the connected
information resources, data, business processes and human
workflows and to provide Web services at the enterprise level.

webMethods® completed three acquisitions in
October 2003 to significantly expand our portfolio of products
in the Service Oriented Architecture (SOA), Business Activity
Monitoring (BAM) and portal spaces. Taken individually, the
acquisitions were:



| |   |                                                                                                                                                                                                                                                                                                                                                                 
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The Mind Electric.webMethods acquired The Mind Electric,
    Inc., a privately-held provider of Web services and Service
    Oriented Architecture software that enables enterprise Service
    Oriented Architectures. The software products offered by
    webMethods that are derived from this acquisition are webMethods
    FabricTM and webMethods Glue®.
|
| |  | The Dante Group.webMethods acquired The Dante Group,
    Inc., a privately-held provider of Business Activity Monitoring
    software. The software product offered by webMethods that is
    derived from this acquisition is webMethods
    OptimizeTM.                                                                                                       

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| |   |                                                                                                                                                                                                                                                                                                                                                   
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | DataChannel Portal.webMethods acquired certain assets of
    DataChannel (recently marketed as PortalMinder by Netegrity), a
    portal platform for creating secure, identity-driven portals
    within a scalable architecture. The software product offered by
    webMethods that is derived from this acquisition is webMethods
    PortalTM.

With the addition of the products from these
acquisitions, continued organic development from our product
development team, and several key partnerships, webMethods
offers a solution that represents the next generation of
integration technology and provides our customers with a breadth
of functionality that we believe is compelling. And while each
one of the technologies represented in our solution is, in and
of itself, significant and important to our customers, it is the
combined breadth and strength of these technologies and the
natural synergies among them that drive further value and return
on investment for our customers.

The webMethods solution starts with the strength
of our foundational integration capabilities. Introduced in the
first quarter of webMethods fiscal year 2005, the
webMethods Enterprise Services PlatformTM combines
proven, mature enterprise application integration
technology  incorporating the offering formerly known
as the webMethods Integration PlatformTM 
with the Service Oriented Architecture capabilities of
webMethods FabricTM and webMethods
highly-scalable and event-driven messaging capabilities. The
result is an integration solution for linking business
processes, enterprise and legacy application software products,
databases, and Web services, both within and across business
enterprises and government organizations. Further, the Service
Oriented Architecture capabilities provided by webMethods Fabric
enable customers to implement Web services-based integration on
an enterprise scale. The webMethods Integration Platform now
incorporated into the webMethods Enterprise Services Platform
has enabled customers to achieve quantifiable return on their
investment within a comparably brief timeframe by linking
business processes and seamlessly integrating enterprise and
legacy applications and databases.

To this strong foundation, webMethods brings
value-added functions for end-to-end Business Process
Management, integrated Business Activity Monitoring and greatly
simplified Composite Application creation. These functions both
complement and extend the functionality of the webMethods
Enterprise Services Platform, allowing customers to leverage
their integration efforts to realize broader value for their
enterprise. It is the sum of these functions that enable
customers to create an integrated, real-time view of their
enterprise, establish real-time visibility into business
processes and optimize existing business processes or create
entirely new business processes as the pressures of competitive
business dictate. We believe these capabilities result in
enhanced adaptability and agility for our customers.

By deploying webMethods solutions,
customers can reduce costs, create new revenue opportunities,
strengthen relationships with their customers, vendors and
business partners and establish real-time visibility and control
of their business processes. webMethods solutions enable
our customers to rapidly and cost-effectively meet the full
range of their business integration requirements with a single,
highly-scalable infrastructure. webMethods solutions
enable our customers to create an integrated, real-time view of
their customers, vendors and business partners, projects,
orders, assets, business processes, human workflows, information
system resources and data.

We had more than 1,100 customers as of
March 31, 2004, including many major business enterprises
included in the top 2,000 business enterprises worldwide (the
Global 2000) and government organizations. Our
customers include leaders in manufacturing, process industries
(such as chemicals, oil and gas, life sciences, metals, paper
and plastics), financial services, telecommunications, consumer
goods manufacturing and retail, utilities and transportation and
logistics. We license our software primarily through our direct
sales force. In Japan and the Asia Pacific region and, to a
lesser extent, in Europe, we also license our software through
resellers. We pursue joint promotional and selling efforts with
strategic partners who provide enterprise application software
products, many of whom embed our software directly into their
application products. We also pursue joint promotional and
selling efforts through strategic alliances with major systems
integrators. Through these joint efforts with our strategic
partners, we leverage our direct sales force, and, indirectly,
the sales forces of our partners, to reach a broader range of

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prospective customers and create opportunities to
upsell our products to customers already using limited-use
implementations of our software embedded in their enterprise
application products.


Our goal is to continue extending our technology
and product leadership in business integration and Service
Oriented Architecture solutions. Our strategy is based on
driving the success of our customers and partners, making our
software ubiquitous among the Global 2000 and government
organizations by expanding and maximizing our strategic software
vendor partnerships, leveraging our sales force and technical
services team by expanding our strategic alliances with major
systems integrators and providing a compelling business
integration and Service Oriented Architecture solution.




INDUSTRY BACKGROUND

We believe that there are three major trends
shaping our industry, and those trends are the basis for our
strategy.

First, there is the continued demand for business
integration software.

Integration is routinely rated as the top
strategic priority for most Global 2000 companies and government
organizations due to the benefits available from the integration
of information resources. The reason is clear. Computers are
being applied to ever more aspects of customers
businesses. But with the widespread proliferation of packaged
application software, custom applications, databases, Web
services, and various other computing technologies, as well as
proliferation of these same information resources and
technologies throughout an organizations chain of vendors,
customers, affiliates and business partners, the ability to
integrate these disparate systems and applications has become a
strategic part of an organizations information systems
infrastructure. In addition, the need for integration software
is driven by the widespread adoption of enterprise resource
planning (ERP), supply chain management (SCM), financial
management, and customer relationship management
(CRM) software application products, whose strategic value
to the customer is largely dependent on integration with other
information systems and software products within the
organization. Organizations that have purchased such software or
systems often seek to streamline internal processes and enable
communication and collaboration internally and with their
customers, vendors and partners to increase productivity, create
new revenue opportunities, reduce costs and strengthen
relationships with their customers, vendors and business
partners.

Second, in parallel with the continued demand for
integration software, there has been an increase in the need for
more sophisticated integration technology.

Integration systems today require the ability not
only to integrate the numerous disparate information resource
types (databases, legacy mainframe applications, packaged
application software, custom applications, trading partners,
people and Web services), but also to manage the business
processes that govern the interactions between these resources.
This Business Process Management capability is the foundation
that allows an organization or enterprise to manage its business
with its information systems. In many cases, the deployment of
Business Process Management capability has revealed that many
critical business processes involve activities that people must
perform manually. Consequently, customers are pressuring
integration vendors to provide fully-integrated manual workflow
capabilities that allow users to define business processes that
include manual steps and to manage the complete business process
with their integration technology. Customers are also
increasingly demanding software toolsets that allow for the
rapid creation of user interfaces to support these human
workflow steps.

More recently, integration technology has further
evolved to include technologies that enable enterprises to
access and analyze real-time data flowing through the integrated
information systems associated with business transactions and to
govern the interactions between the many information resources
that comprise the enterprise information technology environment.
This Business Activity Monitoring capability enables enterprises
to realize real-time visibility into their business operations
and provides them with the ability to effect more timely changes
to their business operations resulting in the ability to
optimize those operations to best meet the needs of the
enterprise.

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The ability of integration technology solutions
to define business processes and Business Activity Monitoring
schemas in a minimal amount of time and with a minimum of custom
software coding is increasingly becoming an expectation of
prospective customers. This demand for ease-of-use has caused a
fundamental shift in demand for integration technology away from
complex software programming techniques to a more intuitive,
highly-graphical configuration approach. It has also driven the
demand for integrated software tools that allow users to solve a
wide variety of integration requirements without having to learn
multiple software products or writing custom software code. A
natural extension of this expectation is the ability to deliver
personalized Composite Applications  applications
that integrate functionality from multiple related, but
stove-pipe, information systems  using a common
presentation, delivery and collaboration framework.

The third significant trend in our industry is
the growing acceptance among customers and prospects of Service
Oriented Architecture and Web services as the preferred basis
for implementing business integration, business process
optimization and Composite Application functionality.

Service Oriented Architecture is an approach to
software architecture and deployment that allows enterprises to
more easily assemble, integrate, and modify software
applications and business processes in response to market
requirements. Service Oriented Architecture offers flexibility
in the way information systems can be configured, and has the
potential to lower implementation costs of multiple new software
applications by increasing reusability. While not a novel
concept in itself, Service Oriented Architecture is becoming
more broadly accepted among customers and prospects given the
growing acceptance and adoption of Web services methodology and
is now generally viewed among customers and prospects as the
best-practice approach for integration infrastructure software.

Complementing Service Oriented Architecture is
the expanding interest in Web services. The appeal of Web
services is the prospect of enforcing cross-platform
standardization of the low-level integration points across a
wide range of computing resources, thereby allowing a user or
computing resource to seamlessly access functionality or
business processes provided by other software products operating
within the enterprise. The expected benefit is lower services
costs associated with integration. Although a number of
companies outside the integration software industry promote
their offerings as a solution for Web services-based
integration, many industry analysts agree that this
functionality will be most capably delivered by established
integration software companies, given their experience in
seamlessly and securely linking enterprise and legacy
applications and databases using standards-based technologies
and protocols, and managing the operation of that infrastructure.




THE WEBMETHODS SOLUTION

We believe that the webMethods solution offers a
compelling suite of capabilities to integrate information
resources and provide Web services at the enterprise level to
make Global 2000 companies and government organizations more
agile. With webMethods solution, customers are able to
more rapidly deploy information technology capabilities as they
pursue competitive advantages, seek to secure more value from
their existing information technology resources and strive to
take advantage of standards-based technologies in their
information technology infrastructure.

The strength of the webMethods solution derives
from both the strength of our individual solutions and the
synergies enabled by our combination of Service Oriented
Architecture, business integration, Business Process Management,
Business Activity Monitoring and Composite Application Framework
functionality. Historically, companies may have selected
different products from different vendors to achieve these
various capabilities, only to suffer from lack of integration
between the different selected products. By combining these
best-of-breed capabilities into one infrastructure, we offer
customers the ability to lower their total cost of ownership and
to streamline the overall implementation process.

The following are the core elements of
webMethods solution:

webMethods Enterprise Services
Platform

At the foundation of webMethods solution is
the webMethods Enterprise Services Platform, a set of software
capabilities that enable customers to implement a powerful,
reliable Service Oriented Architecture. webMethods calls this an
Enterprise Service Oriented Architecture (ESOA). ESOA goes

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beyond simple Web services standards with
features that enable the widespread deployment of Web services
in a mission-critical business setting.


The webMethods Enterprise Services Platform
includes the following features:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Proven business integration
    functionality inherited
    from our previous flagship offering, the webMethods Integration
    Platform  which allows companies to not only
    integrate existing applications and establish electronic
    communications with trading partners, but to incorporate these
    resources seamlessly into the Enterprise Service Oriented
    Architecture. The webMethods Integration Server, which unites
    enterprise application integration and business-to-business
    functionality under a common architecture, is the basis for this
    capability. As a foundation for business integration and
    Composite Application development, the webMethods Integration
    Server allows the customers information technology
    resources to be published, managed and orchestrated as Web
    services in a Service Oriented Architecture. With so much
    investment tied up in existing information technology systems,
    this is the most expedient and cost-effective path to populating
    a Service Oriented Architecture with the Web services that
    higher-level software tools, portals, and other service-based
    applications can leverage. The move to Web services also
    benefits downstream business integration initiatives through
    reusability and the reduced cost and complexity resulting from
    standardization.
|
| |  | A robust, scalable, high performance
    event-driven messaging capabilitythat allows the webMethods
    Enterprise Services Platform to support real-time,
    message-oriented interactions in addition to the Web services
    request/reply style of interaction. Enabled by the webMethods
    Broker, event-driven processing naturally complements Web
    services by providing the real-time capabilities that are needed
    for Business Activity Monitoring and other applications. The
    webMethods BrokerTM offers reliable message delivery
    and a scalable publish/subscribe architecture that is capable of
    processing thousands of messages per second. The webMethods
    Broker is also the basis of webMethods JMS+TM, a Java
    Message Service-compliant messaging solution that is offered as
    a standalone product.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|
| |  | Enables implementation of an
    enterprise-caliber service-oriented infrastructure.
    Delivered by webMethods Fabric, the webMethods Enterprise
    Services Platform enables enterprises to go from small, static,
    brittle, ad hoc networks of unmanaged Web services to larger,
    dynamic, robust, coordinated networks of managed Web services.
    webMethods Fabric can be deployed as an intermediary or in
    conjunction with either the Web service producer or Web service
    consumer or both. webMethods Fabric coordinates the use of Web
    services in a Service Oriented Architecture regardless of what
    technology was used to create those services including, but not
    limited to, webMethods software, J2EE application servers,
    .NET-based applications, other packaged applications or
    mainframe environments. With this flexible deployment
    architecture, customers can reduce network latency and create a
    more secure and robust environment for deploying a Service
    Oriented Architecture. These include capabilities such as Web
    services monitoring and management, service discovery, dynamic
    binding, failover and load-balancing, and intelligent message
    processing.                                                                                                                                               
|
| |  | An extensive library of adaptersso that
    the webMethods Enterprise Services Platform can integrate the
    numerous proprietary interfaces presented by a broad variety of
    enterprise applications (e.g., supply chain management software
    from i2 Technologies, inter-enterprise software solutions from
    SAP AG, sales, marketing and customer relationship management
    software from Siebel Systems, customer relationship management
    and enterprise management software from PeopleSoft). The
    webMethods Enterprise Services Platform can also be extended by
    customers and partners through the use of webMethods software
    toolkits that allow them to develop interfaces to integrate
    custom applications or other software with the webMethods
    Enterprise Services Platform.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|
| |  | Support for a wide range of electronic
    commerce protocolsthat enable our customers to automate and
    integrate their commercial transactions generated by their
    information technology resources with the information systems of
    their customers and business partners. Examples of these types
    of transactions include purchasing and procurement, supply chain
    management, collaborative product                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | design and vendor-managed inventory. Our software
    supports a broad range of capabilities to support these and
    other initiatives of an enterprise to integrate its information
    resources with those of its customers and business partners.
    These protocols include XML, traditional and Internet EDI,
    Commerce Ones xCBL, RosettaNet, Chem eStandards and ebXML.                                                                                                                                                                     
|
| |  | A high-performance Java Web services platformwith webMethods Glue. webMethods Glue eliminates the
    traditional complexity of Web services development. Targeted at
    the Java developer, webMethods Glue provides the fastest and
    easiest way to turn ordinary Java objects into Web services with
    very little incremental effort. By using webMethods Glue,
    developers can publish any Java object as a Web service using
    just a few lines of code, while remote Web services can be
    invoked as if they were local Java objects.
|
| |  | Capabilities targeted at J2EE and .NETdevelopers to make it easier for users of those technologies
    to connect their application into the Enterprise Service
    Oriented Architecture.                                                                                                                                                                                                                                                                                                                                                                

Business Process Management
(BPM)

webMethods Business Process Management
solution facilitates business process management, first, by
providing capabilities for orchestrating both automated and
manual processes; second, by promoting the creation of
business-oriented services that can be reused across different
processes; and, third, by providing a level of abstraction from
the underlying systems that makes the task of orchestrating
business processes accessible to the non-technical user. The
webMethods Business Process Management tools also provide an
intuitive design and development environment for incorporating
manual workflows and custom user-interfaces into business
process flows, allowing the webMethods solution to manage
automated and manual tasks. The webMethods Business Process
Management solution provides two core capabilities: an
easy-to-use graphical tool for modeling business processes and
orchestrating services, and a codeless design environment that
allows organizations to create workflow solutions, including
associated user interfaces, to monitor and manage manual
processes.

Business Activity Monitoring
(BAM)

webMethods Business Activity Monitoring
solution enables customers to achieve new levels of agility by
monitoring their business operations on their information
systems in real-time, identifying opportunities and diagnosing
problems as they occur, and responding instantly to changes in
business activity. The webMethods Business Activity Monitoring
solution, webMethods Optimize, combines real-time awareness
about business events with the ability to correlate information
surrounding these events into meaningful feedback along the
decision chain. This solution provides further value when the
customer extends this correlation capability to the point of
recommending responses or even predicting failures before they
occur. With webMethods Optimize, companies are able to improve
the speed and effectiveness of their decision-making by gaining
complete real-time visibility into their business processes.
webMethods offers a set of service offerings to support our
customers implementation of our Business Activity
Monitoring solution. These include the webMethods BAM Workshop,
a facilitated on-site session which helps companies identify the
business processes most appropriate for an initial Business
Activity Monitoring implementation; a Business Process Report
Card detailing the as is state of a business process
with regard to its ability to meet its business commitments and
identified Key Performance Indicators (KPIs); and a BAM
Assessment providing an in-depth analysis of a companys
key business processes with regard to their applicability and
associated return on investment for Business Activity Monitoring.

Composite Application
Framework

From the services and resources that are made
available through the webMethods infrastructure, the webMethods
Composite Application Framework enables customers to assemble a
new breed of application. With minimal development, these
composite business applications are able to deliver personalized
access to other application software, data and business
processes from across the enterprise. Instead of developing

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traditional client/server or Web applications
using monolithic (and sometimes proprietary) technologies, the
webMethods Composite Application Framework enables a process of
assembly, using the inventory of Web services available within
the webMethods-enabled Enterprise Service Oriented Architecture.
As the key component of the webMethods Composite Application
Framework, webMethods PortalTM provides the primary
delivery mechanism for user interaction with these composite
applications. webMethods Portal allows people  both
inside and outside the customer  to be provided with
personalized access to the information, business processes, and
applications that are relevant to their job function or
relationship to the organization. By promoting contextual views
of business situations, the webMethods Composite Application
Framework can enable webMethods customers to achieve
significant gains in business efficiency, customer satisfaction,
and decision-making capabilities.





WEBMETHODS STRATEGY

We believe our focused business strategy enables
us to be a leading provider of business integration and Service
Oriented Architecture solutions. Our strategy is based on
investing our efforts in our customers and business partners to
ensure their success with our solutions, developing and
delivering what we believe to be the next generation of
integration technology, and then extending our customers
investments in business integration and Web services enablement
with business-focused, value-added capabilities for Business
Process Management, Business Activity Monitoring and Composite
Application construction. By executing on our strategy, we
believe we are helping to ensure the success of our customers
and business partners with our solutions. The key elements of
our strategy include the following:

Focus on Customer Success.A core part of our strategy is a
tremendous focus on customers to ensure their success with our
solutions and referenceability. We invest in resources and
programs to improve our customers success rates with our
solutions by reducing their time to deploy our software,
minimizing their runtime costs and assisting them in maximizing
their return on investment for their integration projects. We
attempt to accomplish this by working closely with customers to
understand their business needs, timelines and associated
project risks, and then supporting them to ensure they achieve
their goals. Our satisfied customers often assist with
references and site visits for prospective customers.

Expand and Maximize Our Strategic Software
Vendor Partnerships.We have
relationships with enterprise application software vendors,
including American Management Systems (AMS), Hewlett-Packard
Company, Informatica, i2 Technologies, Microsoft, PeopleSoft and
Siebel Systems, some of whom embed a limited-use implementation
of webMethods software into their solution and may then sell
both the integrated solution as well as other webMethods
products. As a result, any customer of our partner who licenses
its product in which our software is embedded receives a
license-limited version of webMethods software. We believe these
customers will be good candidates to purchase additional
webMethods integration software.

We believe these relationships distinguish us
from other integration software providers and provide a
competitive advantage for webMethods. These relationships
leverage our direct sales force and, we believe, provide us with
an incumbency advantage that positions webMethods as the lowest
risk option for customers of these software products.

Concentrate on Major Systems Integrators.We continue to expand and strengthen
our alliances with major system integrators to provide services
and sales leverage to our software product-based business model.
We have established a series of formal alliance relationships
with major system integrators, such as Accenture, American
Management Systems (AMS), Atos Origin, BearingPoint, Cap Gemini
Ernst & Young Group (CGE&Y), Computer Sciences
Corporation (CSC), Deloitte, Electronic Data Systems Corporation
(EDS) and Tata Consulting Services (TCS). Many of these
partners have established a formal webMethods practice, thus
increasing dramatically the number of webMethods-trained
resources available through our system integrator partners.

As a result of this expanded knowledge-base, as
well as implementation successes on which the systems integrator
partner and webMethods have worked jointly, these alliances have
resulted in a virtual extension of our direct sales force. This
results in the third-party introduction and subsequent
endorsement

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of webMethods solutions in opportunities of
which we may not otherwise be aware, or with customers or
prospects of the partner with which we may not otherwise already
be engaged.


Extend Technology and Product Leadership to
Provide the Most Compelling Integration Solution.We believe that we have developed one
of the broadest and most comprehensive business integration
solutions currently available, supporting more
application-to-application, business-to-business, mainframe
integration and Web services protocols and data format standards
than any competing product. We have integrated workflow
technology to allow our customers and their business partners to
automate not only the unattended business process but also those
critical business functions where a person plays a key role. The
products we introduced in the December 2003 quarter further
extended our portfolio to include innovative Service Oriented
Architecture technology, business activity monitoring technology
and a portal capability. We believe that while each one of our
products individually brings value and shows technical
leadership, it is the combination of these capabilities in one
solution that differentiates us from our competition.

Continue to Demonstrate Leadership in Web
Services and Service Oriented
Architecture.webMethods was an early
pioneer in Web services, demonstrated by our role in the
application of extensible markup language (XML), Web Interface
Definition Language (WIDL) and Java technologies for all
areas of integration and e-commerce. We believe that we have
successfully built upon our heritage and positioned webMethods
as a leader in Web services and Service Oriented Architecture.
The webMethods Enterprise Services Platform combines the
extensive integration capabilities of the webMethods Integration
Platform with the Service Oriented Architecture capabilities of
webMethods Fabric, resulting in a platform for delivering Web
services technology which we believe is unparalleled in the
industry. This solution is standards-based and vendor neutral,
and bridges J2EE and .NET technologies. The webMethods
Enterprise Services Platform unifies proven integration
technology with innovative Web services and Service Oriented
Architecture capabilities to help our customers apply Web
services to solving integration problems throughout their
enterprise. As further validation of our leadership in Web
services, webMethods currently serves on the Board of Directors
of the Web Services Interoperability organization (WS-I).

Extend the Value of Integration to the
Business Users at Our Customers and
Prospects.Integration solves very
important problems for our customers, but the role of
integration has historically been viewed as technical in nature
and the principal domain of information technology personnel.
Through our solutions for Business Process Management and
Business Activity Monitoring, webMethods can demonstrate and
deliver value that directly touches the business users within
the enterprise. BPM provides businesses the ability to capture
business processes and integrate necessary human interaction
directly into those processes. BAM provides real-time visibility
into those processes, providing business users with the ability
to not only track key performance indicators (KPIs), but
actually predict when those KPIs might trend out of the range
for acceptable values. Taken together, BPM and BAM create a
continuous cycle of visibility and control, with BAM providing
the feedback necessary to tune these processes through the
integrated BPM functions to maximize process efficiencies.

We believe that our capabilities in BPM and BAM
help to differentiate webMethods, and provide us with important
new selling opportunities. These capabilities elevate the value
of webMethods into the heart of the processes critical to the
health of our customers enterprises, and give the
webMethods sales force the opportunity to help our customers and
prospects address specific business issues that help them create
differentiation in their respective markets. We expect that our
sales force will be able to leverage this message to generate
new customers, including those prospects that may be using a
competitive product. Our BPM and BAM capabilities also enable
our existing customers to extend the value of their existing
integration investment with webMethods, creating upsell
opportunities within our customer base.




CUSTOMERS

As of March 31, 2004, we had more than
1,100 customers. Many of our customers are Global
2000 companies and represent a broad spectrum of vertical
markets. We also have a number of government organizations as
customers. Our customers include leaders in manufacturing,
process industries

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(such as chemicals, oil and gas, life sciences,
metals, paper and plastics), financial services,
telecommunications, consumer goods manufacturing and retail,
utilities and transportation and logistics.


In each of the fiscal years ended March 31,
2004, 2003 and 2002, no individual customer accounted for more
than 10% of our total revenue.




SALES AND MARKETING

We license our software and sell our services
primarily through our direct sales organization augmented by
other sales channels, including our strategic software vendor
partners, major systems integrators with whom we have strategic
alliances, other partners and distributors and, to a lesser
extent, resellers. Our strategic software vendor partners and
system integrator partners actively assist us in selling the
full webMethods product line to their customers, often giving us
an incumbency advantage when the customer implements an
enterprise-wide integration initiative. Information on our
strategic partners is included in this section under the
captions webMethods Strategy and
Partners and Strategic Relationships.

Our direct sales organization consists of sales
representatives and pre-sales consultants supported by personnel
with experience within the industries we serve. At
March 31, 2004, our sales and marketing personnel serving
North America were located in our headquarters in Fairfax,
Virginia, and in approximately 25 other offices in the United
States and Canada. At that date, our sales and marketing
personnel in Europe were located in nine countries, and our
sales and marketing personnel in Asia Pacific were located in
Australia, Japan and six other countries. Information on revenue
we derived from our Americas, Europe, Japan and Asia Pacific
operations, as well as long lived assets located in those
geographic areas, is included in Note 18 of the Notes to
Consolidated Financial Statements of webMethods, Inc. included
elsewhere in this report. We expect to continue expanding our
sales and marketing group through targeted recruitment of
qualified individuals.

We continued to focus on key vertical markets
with specialized teams during our fiscal year ended
March 31, 2004. Those teams focus on customers, prospective
customers and business partners in vertical markets such as
manufacturing, process industries (such as chemicals, oil and
gas, life sciences, metals, paper and plastics), financial
services, telecommunications, government, consumer goods
manufacturing and retail, utilities and transportation and
logistics.

We license our software primarily on a perpetual
basis and, to a lesser extent, on a renewable term basis. At the
end of the renewable license term, customers can either pay a
new license fee or their license will terminate.

The sales cycle for our software typically ranges
from 90 to 270 days. A prospective customers decision
to use our products may involve a substantial financial
commitment, which may require a significant evaluation period
and approval of the customers senior management. A
customers decision to license certain of our products may
also involve significant user education and deployment costs, as
well as substantial involvement of the customers
personnel. Due to the nature of our business, we have no
inventory.

We have experienced quarterly fluctuations in our
operating results and anticipate fluctuations in the future. We
experience certain general seasonal factors, such as: revenue in
our second fiscal quarter (ending September 30) can be
positively impacted by budgeting cycles of the US Government,
and can be negatively impacted because businesses often defer
purchase decisions during summer months. In addition, revenue in
our third fiscal quarter (ending December 31) can be
positively impacted by the end-of-year budgeting cycles of many
Global 2000 companies, and revenue in our fourth fiscal
quarter (ending March 31) can be positively impacted, as
revenue in our first fiscal quarter (ending June 30) can be
negatively impacted, by the annual nature of our sales
compensation plans. Quarterly revenue and operating results
depend on the volume and timing of orders received, which may be
affected by large individual transactions that sometimes are
difficult to predict.

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PARTNERS AND STRATEGIC RELATIONSHIPS

We believe that our strategic relationships
represent a significant advantage over our competition. As
described above in webMethods Strategy, we
utilize our strategic partnerships with enterprise application
software vendors, such as American Management Systems (AMS),
Hewlett-Packard Company, Informatica, i2 Technologies,
Microsoft, PeopleSoft and Siebel Systems, to provide a
differentiator when selling to a prospective customer that owns
or plans to purchase one or more products from these companies
in which a license-limited version of our software is embedded
or utilized. We believe that this provides us with an incumbency
advantage for many of the new business opportunities in which we
compete. We also utilize our strategic partnerships with
software vendors, such as Informatica, JBoss Group and Defywire
Inc., to provide real-time visibility, analytic and reporting
capabilities to data flowing through the webMethods Integration
Platform, a J2EE-based application server and the capability of
delivering real-time information over wireless networks to
cellular phones, PDAs and laptops. We also expect to
continue to benefit from these relationships through their
promotion of our products. We are also building a base of
independent software vendors, original manufacturers and device
manufacturers embedding webMethods Glue to provide Web
services-enabled solutions.

We believe that our multiple strategic alliances
with major systems integrators also constitute a significant
advantage over some competitors. As described above in
webMethods Strategy, we work very closely with
many major systems integrators, including Accenture, AMS, Atos
Origin, Bearing Point, CGE&Y, CSC, Deloitte, EDS and TCS, to
support our customers integration needs. We invest in
partner education to assist our partners in staying
knowledgeable of the latest integration technology and
proficient with webMethods product functionality. We
believe that our investment in these relationships is important
because they augment our direct sales force by promoting our
products as the most appropriate solution for their clients and
increase our implementation capabilities.

In Japan and the Asia Pacific region and, to a
lesser extend in Europe, we license our software through
resellers and distributors, who may also sell our consulting and
implementation services. We have relationships with a number of
resellers or distributors with expertise in certain industry
sectors or countries in which we do not currently have a
significant number of direct sales personnel.

We believe our partners influenced, directly or
indirectly, a significant portion of our license revenue during
fiscal years ended March 31, 2004 and March 31, 2003,
and we expect this to continue in future periods. During our
fiscal year 2004, we expanded our relationship with PeopleSoft
as its partner for certain embedded integration technology, and
we implemented joint selling and integrated global customer
support. In April 2004, we formed a partnership with Microsoft
Corporation based upon the availability of the webMethods for
Microsoft PackageTM that enables enterprise customers
to benefit from the integration of webMethods and Microsoft
Video Studio .NET technologies.

As part of the effort to expand support for
customers in Asia Pacific, webMethods partnered with
Hewlett-Packard Company and established an integration
competency center in Hong Kong to offer resources and expertise
that enable customers to develop and test applications before
deploying them in production environments.

Under certain partnerships with our enterprise
application software vendor partners, the partner may embed or
otherwise utilize our software with their applications under
limited use licenses for a license fee or royalty fee. Under
certain partnership arrangements, we may share license fees
derived from joint selling opportunities with our partner. In
systems integrator and other partnership arrangements, we may
pay a sales assistance fee to a partner who performs or assists
in certain sales activities, and that fee usually is paid once
payment from the joint customer of license fees is received.




GLOBAL CUSTOMER SERVICES

We offer our customers a variety of software
support and maintenance options designed to meet their varied
needs. Our most sophisticated enterprise customers may choose
options that include 24-hour coverage, seven days per week. We
have established a follow-the sun support model with
integrated,

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major support centers in Virginia and California
in the United States and in Australia, Japan and the
Netherlands. Our resellers and distributors generally provide
initial software support to their customers, and we provide
support on more complicated support issues. Our customers and
business partners can also receive support from our webMethods
AdvantageTM support limited access extranet, which
includes extensive discussion groups and technical advisory
papers and provides online access to our customer service
management system so that our customers and business partners
can submit and monitor the status of any technical issues.


Many of our customers purchase consulting
services from us to support their full range of integration
initiatives. We may provide all of these services directly or we
may augment the efforts of a systems integration partner in
performing these services. We offer these professional services
both during the initial deployment of our products and
thereafter to address our customers needs through the
entire project lifecycle. We provide professional services
ranging from initial software infrastructure architectural
planning to the complete deployment of our products. We also
offer training courses and other education products at our
facilities, as well as on-site at our customers and
partners facilities. All of these offerings have been
expanded to include the products and capabilities derived from
the acquisitions we completed in October 2003 and the new
products delivered by our product development staff in fiscal
year 2004.

We believe our strong focus and track record of
ensuring that our software is successfully put into production
(production event) is a strong competitive advantage
and differentiator. During fiscal year 2004, our global customer
services group reported and documented more than 497 separate
production events as compared to 340 such events in fiscal year
2003 and 178 such events in fiscal year 2002. Ensuring that our
customers successfully implement our software in a timely manner
enables them to achieve a greater return on their investment
and, in many cases, encourages them to purchase additional
software for other business integration projects and serve as a
reference customer for us in our future sales efforts.




PRODUCT DEVELOPMENT

We pursue a judicious mix of building, acquiring
and partnering to allow us to offer an optimal mix of strategic
technologies to meet the needs of our market. This has allowed
us to bring a business integration solution to market more
quickly than our competitors.

We focus our ongoing product development efforts
on a combination of enhancing, broadening and deepening the
functionality of our core products and services to address new
software alliances, industries, marketplaces and geographic
markets as well as new product development to meet emerging
opportunities based on new technologies. During our fiscal year
ended March 31, 2004, we released the latest version of our
flagship integration platform, webMethods 6.1, and a new
product, webMethods JMS+ for event-driven, high speed JMS
messaging. During the period between the acquisitions in October
2003 and the end of fiscal year 2004, we also released new
production versions of all of the products derived from the
three acquisitions: webMethods Fabric, webMethods Glue,
webMethods Portal and webMethods Optimize. Significant work to
integrate and unify the acquired products with our core
integration platform was either completed or was well underway
at the completion of fiscal year 2004.

Our product development staff has developed our
products utilizing project teams focused on independent
components of the software under development. We maintain
product release planning procedures to ensure integration,
testing and version control among the different project
development teams. We maintain our primary development centers
in Fairfax, Virginia and Sunnyvale, California and have special
development teams in Denver, Colorado, Seattle, Washington and
Westborough, Massachusetts. The development teams represented by
the acquisitions in October 2003 have been integrated into the
development methodology and product lifecycle management process
used by webMethods.




COMPETITION

The market for our software and services is
extremely competitive and subject to rapid change. We offer a
suite of capabilities for business integration, Business Process
Management, Business Activity Monitoring, Composite Application
delivery, and Service Oriented Architecture infrastructure that

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represents the next generation of integration
technology and provides our customers with a breadth of
functionality that we believe is compelling. We are not aware of
any competitor that can demonstrate the breadth of capabilities
that we can with our in-depth expertise in trading partner
integration and management, our long history of Web services
experience, our deep knowledge of legacy IBM mainframe
integration and our broad expertise in Enterprise Application
Integration (EAI). We compete primarily with providers of
integration software products, including International Business
Machines Corporation (IBM) and TIBCO Software, Inc. We also
compete with BEA Systems, Inc., Microsoft Corporation, SeeBeyond
Technology Corporation, SAP AG, Sterling Commerce Inc. and a
wide-range of companies that are emerging in this category. We
expect additional competition primarily from other emerging
companies. In addition, we may face pricing pressures from our
current competitors and new market entrants in the future. We
believe that the competitive factors affecting the market for
our software and services are numerous and the specific
importance of any one of these factors varies significantly for
each specific customer environment. These competitive factors
include product functionality and features; performance and
price; ease and cost of product implementation; vendor and
product reputation; quality of customer support services;
financial strength; customer training and documentation; and
quality of professional services offerings. Although we believe
that our software and services currently compete favorably with
respect to such factors, we may not be able to maintain our
competitive position against current and potential competitors.


Some of our current and potential competitors
have longer operating histories, significantly greater
financial, technical, product development and marketing
resources, greater brand recognition and larger installed
customer bases than we do. Our present or future competitors may
be able to develop software similar to or even superior in
functionality to what we offer, some may be able to adapt more
quickly than we do to new technologies, evolving industry trends
or new customer requirements, or devote greater resources to the
marketing, design and development, and sale of their products
than we do. Accordingly, it is possible that we may not be able
to compete effectively in our markets, which may harm our
business and operating results. If we are not successful in
developing new software and enhancements to our existing
software or in achieving customer acceptance, our gross margins
may decline, and our business and operating results may suffer.




INTELLECTUAL PROPERTY AND OTHER PROPRIETARY
RIGHTS

Our success is heavily dependent upon the
technological and creative skills of our personnel and how
successfully we can safeguard their efforts in developing and
enhancing our software and related technology through the
protection of our intellectual property rights, brand name, and
associated goodwill. We depend upon our ability to develop and
protect our proprietary technology and intellectual property
rights to distinguish our software from our competitors
products. We rely on a combination of confidentiality
agreements, confidentiality procedures and contractual
provisions, as well as trade secret, copyright, trademark and
patent laws, to establish and protect our proprietary rights and
accomplish these goals.

For example, we take measures to avoid disclosure
of our trade secrets, including, but not limited to, requiring
all employees and certain consultants, customers, prospective
customers, and others with which we have business relationships
to execute confidentiality agreements that prohibit the
unauthorized use and disclosure of our trade secrets and other
proprietary materials and information. Further, we enter into
license agreements with our customers, business partners,
resellers and distributors that limit the unauthorized access
to, use and distribution of our software, documentation and
other proprietary information. Our license agreements with our
customers, business partners, resellers and distributors impose
restrictions on the use of our technology, including prohibiting
the reverse engineering or de-compiling of our software, impose
restrictions on the licensees ability to utilize the
software and provide for specific remedies in the event of a
breach of these restrictions. We also restrict access to our
source code. While some of our license agreements require us to
place the source code for our software in escrow for the benefit
of the licensee, these agreements generally provide these
licensees with a limited, non-exclusive license to use this code
in the event we cease to do business without a successor or
there is a bankruptcy proceeding by or against webMethods;
certain agreements may provide that the licensee can use the
escrowed source code if we fail to provide the necessary
software maintenance and support.

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We also seek to protect our technology, software,
documentation and other proprietary information under the
copyright, trademark and patent laws. We assert copyright in our
software, documentation and other works of authorship, and
periodically register copyrights with the U.S. Copyright Office
in qualifying works of authorship. We assert trademark rights in
and to our name, product names, logos and other markings that
are designed to permit consumers to identify our goods and
services. We routinely file for and have been granted trademark
protection from the U.S. Patent and Trademark Office for
qualifying marks. We currently hold a trademark registration in
the United States for the webMethods and B2B
Integration Server marks, a trademark registration in
certain other countries and the European Union for the
webMethods mark, a trademark registration in the
United States for the Glueware and
Glueprints marks and a pending application for the
registration of the Glue mark in the United States.
We have a patent issued in the United States and several patent
applications pending for technology related to our software. We
may file additional patent applications in the United States or
other countries in the future.

Despite our efforts to protect our proprietary
rights, contractual provisions, licensing restrictions and
existing laws and remedies afford us only limited protection.
The steps we have taken to protect our proprietary rights and
intellectual property may not be adequate to deter
misappropriation of our technology, and the protections we have
may not prevent our competitors from developing products with
functionality or features similar to our software. The use by
others of our proprietary rights could materially harm our
business.

It is possible that the copyrights, trademarks or
patent held by us could be challenged and invalidated. For
example, we cannot be certain that the patent we hold, those
that we have applied for, if issued, or our potential future
patents will not be successfully challenged. Further, we cannot
be certain that we will be able to develop proprietary products
or technologies that are patentable, that any patent issued to
us will provide us with any competitive advantage or that the
patents of others will not seriously limit or harm our ability
to do business.

We may not be able to detect unauthorized use of
our proprietary information or take appropriate steps to enforce
our intellectual property rights effectively, and the use by
others of our proprietary rights could materially harm our
business. Policing the unauthorized use of our products and
other proprietary rights is difficult and expensive,
particularly given the global nature and reach of the Internet.
In the event we increase our international operations in the
future, effective protection of intellectual property rights may
be unavailable or limited in certain countries because the laws
of some foreign countries do not protect proprietary rights to
the same extent as do the laws of the United States. For more
information regarding our proprietary rights, see Factors
That May Affect Future Operating Results  If we are unable
to protect our intellectual property, we may lose a valuable
asset, experience reduced market share, or incur costly
litigation to protect our rights.

Despite our efforts to protect our proprietary
rights, parties may breach confidentiality agreements or other
protective licenses and contracts into which we have entered,
and we may not be able to enforce our rights effectively in the
event of these breaches. There can be no assurance that we will
be able to prevent unauthorized attempts to copy or reverse
engineer aspects of our software or to obtain and use
information that we regard as proprietary. Further, unauthorized
parties may attempt to copy or otherwise obtain and use software
or technology that we consider proprietary, and third parties
may attempt to develop similar technology independently. It is
possible that our competitors will adopt similar product or
service names, impeding our ability to protect our intellectual
property and possibly leading to customer confusion. The
unauthorized reproduction or other misappropriation of our
proprietary technology could enable third parties to benefit
from the technology developed by us without paying for it.

The software industry is characterized by the
existence of a large number of patents and frequent litigation
based on allegations of patent infringement and the violation of
other intellectual property rights. We believe that software
developers in our market will increasingly be subject to
infringement claims as the number of products in different
software industry segments overlap. Although we attempt to avoid
infringing known proprietary rights of third parties in our
product development efforts, a third party has

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claimed that the use of our software in certain
situations infringed on its intellectual property rights. Third
parties may in the future claim that we have infringed on their
intellectual property rights (including those intellectual
property rights currently existing or developed in the future)
or the use our software in certain situations infringes on their
intellectual property rights. We may increasingly be subject to
infringement claims as the number of products and competitors in
our industry grows and functionalities of products overlap.
Furthermore, former employers of our current and future
employees may assert that their employees have improperly
disclosed confidential or proprietary information to us.


Expensive litigation may be necessary in the
future to enforce our intellectual property rights. We have
been, and may in the future be, subject to legal proceedings and
claims for alleged infringement by us or our licensees of
third-party proprietary rights, such as copyrights, trademarks,
patents or trade secrets, from time to time in the ordinary
course of our business. While we do not currently believe that
any of our software, documentation, copyrights, trademarks,
patents, or other proprietary rights infringe the proprietary
rights of third parties, third parties have claimed, and may in
the future claim, that we have infringed their current or future
products, technology or intellectual property rights or that use
of our software in certain situations may infringe on their
intellectual property rights. Any infringement claims, with or
without merit, brought by such third parties may be
time-consuming, result in costly litigation, prevent product
shipment, cause delays, distract us from managing our business
or require us to enter into royalty or licensing agreements
which are not advantageous to us, any of which could materially
harm our business. Patent litigation in particular has complex
technical issues and inherent uncertainties, and is commonly
quite expensive.

Parties making claims against us could secure
substantial damages, as well as injunctive or other equitable
relief that could effectively block our ability to license our
software in the United States or abroad. Such a judgment could
materially harm our business. In the event an infringement claim
against us was successful and we could not obtain a license on
acceptable terms, license a substitute technology or redesign to
avoid infringement, our business would be harmed materially. In
addition, parties making these claims may be able to obtain an
injunction, which could prevent us from selling our software in
the United States or abroad. Any of these results could harm our
business materially.

For more information regarding our proprietary
rights, see Factors That May Affect Future Operating
Results  Third-party claims that we infringe upon
their intellectual property rights may be costly to defend or
settle and could damage our business.

In addition, we license technology from third
parties that is incorporated into our software, and we bundle
technology from third parties with our software. We also
incorporate into our software certain open source
software code or software tools, the use of which in commercial
software products, such as ours, may be prohibited or restricted
now or in the future. Any significant interruption in the supply
or support of any technology we license from third parties, or
our inability to continue to use open source
software in our products, could adversely affect our business,
unless and until we can replace the functionality provided by
the licensed technology or open source software. Our
use of licensed technology or open source software
could cause our products to infringe the intellectual property
rights of others, causing costly litigation and the loss of
significant rights.




CORPORATE INFORMATION

webMethods, Inc. was organized in Delaware in
1996. We completed our initial public offering in February 2000.
In August 2000, webMethods, Inc. acquired Active Software, Inc.,
a publicly-held software company that developed and delivered
enterprise application integration software. In February 2001,
we acquired IntelliFrame Corporation, its workflow technology
and its research and development team. In October 2003, we
acquired The Mind Electric, Inc., The Dante Group, Inc. and
certain assets of Datachannel. References to
webMethods, we, us or
our include webMethods, Inc. and its subsidiaries
unless a statement specifically refers to webMethods, Inc. Our
executive offices are located at 3930 Pender Drive, Fairfax,
Virginia 22030, and our main telephone number is
(703) 460-2500. We operate in a single segment of software
and related services.

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AVAILABLE INFORMATION

Our internet address is
www.webMethods.com. Our Investor Relations page of our
web site provides a link to a service giving access to our
securities filings as soon as reasonably practical after we
electronically file with the Securities and Exchange Commission
(SEC) our annual reports, quarterly reports, current reports and
any amendments to those reports filed or furnished pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of
1934, and as soon as reasonably practical after any of our
directors or executive officers electronically file with the
Securities and Exchange Commission any reports pursuant to
Section 16 of the Securities Exchange Act of 1934. We do
not charge for access to and viewing of those filings. Other
information on our Investor Relations page and our web site is
not part of this Form 10-K or any other webMethods
securities filing unless specifically incorporated. In addition,
our reports, proxy statements and other information are filed
with the SEC through the SECs Electronic Data Gathering,
Analysis and Retrieval system and are publicly available through
the SECs site on the World Wide Web, at
www.sec.gov. All statements made in any of our securities
filings, including all forward-looking statements or
information, are made as of the date of that document in which
the statement is included, and we do not assume or undertake any
obligation to update any of those statements or documents unless
we are required to do so by law.




EMPLOYEES

As of March 31, 2004, we employed
approximately 860 full-time employees. These included
approximately 300 in sales and marketing, 200 in professional
services and technical support, approximately 240 in research
and development and approximately 120 in other administrative
areas, including accounting, finance, human resources,
facilities and information technology. Our future success will
depend in part on our ability to attract, retain and motivate
highly qualified technical and management personnel, for whom
competition is intense. From time to time, we have employed, and
will continue to employ, independent contractors and consultants
to support research and development, marketing and sales, and
business development. Our employees are not represented by a
collective bargaining agreement and we have never experienced a
strike or similar work stoppage. We consider relations with our
employees to be good.




EXECUTIVE OFFICERS OF WEBMETHODS

Our executive officers and their ages and
positions as of May 31, 2004 are as follows:

|                  |  |     |    |          |  |                                                                    
|----------------- |  | --- | -- | -------- |  | -------------------------------------------------------------------
|Name              |  | Age |    | Position
|                  |  |     |    |         
|Phillip Merrick   |  |     | 41 |          |  | Chairman of the Board and Chief Executive Officer                  
|David Mitchell    |  |     | 39 |          |  | President and Chief Operating Officer                              
|Richard Chiarello |  |     | 51 |          |  | Executive Vice President, Worldwide Operations                     
|Mary Dridi        |  |     | 43 |          |  | Chief Financial Officer, Executive Vice President
    and Treasurer
|Douglas W. McNitt |  |     | 39 |          |  | General Counsel, Executive Vice President and
    Secretary        
|Kristin A. Weller |  |     | 33 |          |  | Executive Vice President, Product Development                      

Phillip Merrickthe
founder of webMethods, has served as Chairman of the Board and
Chief Executive Officer since its inception in June 1996; he
served as President of webMethods from inception in June 1996 to
August 2000. Before founding webMethods, he served from December
1994 to February 1996 as Vice President of Engineering at Open
Software Associates, an Internet and graphic user interface
tools company. From 1990 to 1994, Mr. Merrick was Director
of Development at Magna Software Corporation. Mr. Merrick
holds a B.S. in Computer Science from the University of
Melbourne in Australia.

David Mitchelljoined webMethods in December 1997 as
Vice President, Sales, became Chief Operating Officer in January
2000 and became President in January 2001. Mr. Mitchell
served as Vice President of Worldwide Sales from September 1999
to December 1999. From 1995 to 1997, Mr. Mitchell

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served as Director of Worldwide Sales for the
help desk and network management group at McAfee Software, now
Network Associates, Inc. From 1993 to 1995, Mr. Mitchell
was President and Chief Executive Officer of VYCOR Corporation,
a vendor of help desk and customer interactivity software, which
was acquired in 1995 by McAfee Software. Mr. Mitchell
served as Vice President of Sales of VYCOR from 1989 to 1993.
Mr. Mitchell holds a B.S. in Marketing from Virginia
Commonwealth University.


Richard Chiarellojoined webMethods in April 2004 as
Executive Vice President, Worldwide Operations. From October
2002 to 2004, he served as Senior Vice President, Worldwide
Sales, of Siebel Systems, Inc., where he managed all aspects of
the companys worldwide sales operations. From December
1998 to September 2002, he served as President of ATL LLC
Consulting, a private sales consulting company founded by
Mr. Chiarello to serve clients in the information
technology industry. He also served as President and Chief
Operating Officer of AMC Computer Corporation, a hardware and
professional services company, from October 2000 to June 2001.
From December 1985 to December 1998, Mr. Chiarello held
several sales, marketing and executive management positions at
Computer Associates International, Inc., the most recent of
which was Executive Vice President and General Manager,
Worldwide Sales and Channels. Prior to joining Computer
Associates International, Inc., Mr. Chiarello served in a
variety of sales positions with IBM Corporation from 1977 to
1985. Mr. Chiarello holds a B.A. from Queens College in New
York and has completed executive management training in the IBM
Management Training program and with Babson Business School,
Boston, Massachusetts.

Mary Dridijoined
webMethods in May 1998 as Chief Financial Officer and Treasurer.
She became an Executive Vice President in January 2002. From
July 1991 to April 1998, she served as the Controller and Vice
President of Finance for SRA International, Inc., an information
technology company. From 1987 to 1991, Ms. Dridi served as
the Director of Finance at Geostar Corporation, a mobile
satellite communications company. From 1983 to 1987,
Ms. Dridi provided audit and other business services with
the accounting firm of Peat Marwick. Ms. Dridi holds a B.S.
in Commerce and Accounting from the University of Virginia.

Douglas W. McNittjoined webMethods in October 2000 as
General Counsel, became an Executive Vice President in January
2002, and became Secretary in May 2003. Mr. McNitt served
in various capacities, including Senior Counsel and Assistant
General Counsel for America Online, Inc. during his service
there from December 1997 to September 2000. From May 1996 to
December 1997, he was an associate with the law firm of Tucker,
Flyer & Lewis, a professional corporation, and was an
associate with the law firm of McDermott, Will & Emery from
April 1994 to May 1996. Mr. McNitt holds a B.A. from
Stanford University and a J.D. from Notre Dame Law School.

Kristin A. Wellerjoined webMethods as Vice President of
Professional Services and Customer Care in September 1998. She
became Vice President of Product Development in January 2000,
Senior Vice President of Product Development in October 2001 and
Executive Vice President of Product Development in March 2003.
From 1994 to September 1998, Ms. Weller served as Senior
Manager for Deloitte & Touche Consulting Group, where she
participated in the development of their enterprise resource
planning (ERP) implementation methodology. Ms. Weller
holds a B.A. in Economics from Rhodes College.




FACTORS THAT MAY AFFECT FUTURE OPERATING
RESULTS

You should consider the following factors when
evaluating our statements in this report and elsewhere.
webMethods is subject to risks in addition to those described
below, which, at the date of this report, we may not be aware of
or which we may not consider significant. Those risks may
adversely affect our business, financial condition, results of
operations or the market price of webMethods common stock.

Unanticipated fluctuations in our quarterly
revenue or operating results, or failure to return to and
maintain profitability, could significantly affect the price of
webMethods common stock.

We believe that quarter-to-quarter or
year-to-year comparisons of our financial results are not
necessarily meaningful indicators of our future revenue or
operating results and should not be relied on as

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an indication of our future performance. If our
quarterly or annual revenue or operating results fail to meet
the guidance we provide publicly or the expectations of
investors or analysts, that could have a material adverse effect
on the market price of webMethods common stock. Our quarterly
operating results have varied substantially in the past and may
vary substantially in the future depending upon a number of
factors, including the changes in demand for our products and
services, the timing and terms of large transactions with
customers, competitive pressures, our ability to execute on our
business plans, the amount and timing of operating costs, the
timing and amount of revenue from acquired technology and
businesses, delays in the availability of new products or new
releases of existing products and changes that we may make in
our business, operations and infrastructure. In addition,
economic conditions and other events beyond our control, such as
economic uncertainties, geopolitical developments or
uncertainties, travel limitations, infectious outbreaks like
SARS, terrorist acts and other major, unanticipated events may
have significant negative impact on our quarterly operating
results and delay our ability to return to and maintain
profitability on a basis determined in accordance with
accounting principles generally accepted in the United States
(GAAP). Further, the expensing of stock options in the future,
the costs of compliance with the Sarbanes-Oxley Act and other
legal and compliance requirements could add significant costs
that may impede or delay our ability to return to and maintain
profitability on a GAAP basis. If our quarterly revenue or
operating results are adversely impacted, that could have a
material adverse effect on the market price of webMethods common
stock.


We generally close a substantial number of
license transactions in the last month of each quarter, which
makes it more difficult to gauge the level of license revenue we
will have in any quarter until near to, or after, its
conclusion. We expect to continue devoting resources to our
sales and marketing operations and our research and development
activities. Our operating expenses, which include sales and
marketing, research and development and general and
administrative expenses, are based on our expectations of future
revenue and are relatively fixed in the short term. If revenue
falls below our expectations in a quarter or our operating costs
increase in a quarter and we are not able to quickly reduce our
spending in response, our operating results for that quarter
could be significantly below the guidance we provide publicly or
expectations of investors or analysts. It is possible that our
revenue or operating results in the future may be below the
guidance we provide publicly and the expectations of investors
or analysts and, as a result, the market price of webMethods
common stock may fall significantly. In addition, the stock
market, particularly the stock prices of independent
infrastructure software companies, has been very volatile. This
volatility is often not related to the operating performance of
the companies. From our initial public offering in
February 2000 until June 1, 2004, the closing price of
webMethods stock on the Nasdaq National Market has ranged
from a high of $336.25 to a low of $4.32.

Growth of our sales may slow from time to
time, causing our quarterly operating results to fluctuate and
possibly resulting in significant volatility in the market price
of webMethods common stock.

Due to customer demand, economic conditions, the
timing and terms of large transactions with customers,
competitive pressures, our ability to execute on our business
plan, seasonal factors or major, unanticipated events, we may
experience a lower growth rate for, no growth in, or a decline
in quarterly or annual revenue from sales of our software and
services in some or all of the geographic regions in which we
operate. For example, the growth rate for revenue from sales of
our software and services during summer months may be lower than
at other times during the year, particularly in European
markets, and may be impacted by the annual nature of our sales
compensation plans.

We also may experience declines in expected
revenue due to patterns in the capital budgeting and purchasing
cycles of our current and prospective customers, changes in
demand for our software and services, the timing and amount of
revenue from acquired technology and business, economic
uncertainties, geopolitical developments or uncertainties,
travel limitations, infectious outbreaks like SARS, terrorist
acts or other major unanticipated events. These periods of
slower or no growth may lead to lower revenue, which could cause
fluctuations in our quarterly operating results. In addition,
variations in sales cycles may have an impact on the timing of
our revenue, which in turn could cause our quarterly operating
results to fluctuate. To successfully sell our software and
services, we generally must educate our potential customers

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regarding their use and benefits, which can
require significant time and resources. Any misperception by us
in the needs of our customers and prospective customers, or any
delay in sales of our software and services could cause our
revenue and operating results to vary significantly from quarter
to quarter, which could result in significant volatility in the
market price of webMethods common stock.


We are a relatively young company and have
a relatively limited operating history with which to evaluate
our business and the prospects of achieving our anticipated
growth and our forecasts of operating results.

We commenced operations in September 1996.
Active Software, with which we completed a merger in
August 2000, was incorporated in September 1995. We
have been operating as a combined company since
August 2000. In addition, we have acquired several
businesses and technologies with limited operating histories.
During much of our history, we have sustained losses from
operations. For a number of reasons described in other factors
listed here, we may not be able to achieve our anticipated
revenue growth, and control costs of operations, to achieve our
forecasts of operating results, including returning to and
maintaining profitability on a GAAP basis. That situation could
have a material adverse effect on the market price of webMethods
common stock. If we do not generate sufficient revenue to
achieve and maintain income from operations, our growth could be
limited unless we are willing to incur operating losses that may
be substantial and are able to fund those operating losses from
our available assets or, if necessary, from the sale of
additional capital through public or private equity or debt
financings. If we are unable to grow as planned, our chances of
returning to and maintaining profitability and the anticipated
or forecasted results of operations could be reduced, which, in
turn, could have a material adverse effect on the market price
of webMethods common stock.

Our target markets are highly competitive,
and we may not be able to compete effectively.

The markets for business integration solutions,
Service Oriented Architecture capabilities, Business Activity
Monitoring and Business Process Management solutions and
Composite Application framework capabilities are rapidly
changing and intensely competitive. There are a variety of
methods available to integrate software applications, monitor
and optimize business processes and workflows, provide Service-
Oriented Architectures, enable Web services and provide
customers the capabilities to run, manage and optimize their
enterprise. We expect that competition will remain intense as
the number of entrants and new technologies increases. We do not
know if our target markets will widely adopt and deploy our
Service Oriented Architecture technology, our Enterprise
Services Platform solution, our Business Process Management
solution, our Business Activity Monitoring solution, our
Composite Application Framework or other solutions we offer or
have announced. If our technology, software and solutions are
not widely adopted by our target markets or if we are not able
to compete successfully against current or future competitors,
our business, operating results and financial condition may be
harmed. Our current and potential competitors include, among
others, large software vendors; companies that develop their own
integration software or Web services technology; software
vendors offering business integration software, Service Oriented
Architecture technology, Web services capabilities, Business
Process Management software and Business Activity Monitoring
software; electronic data interchange vendors; vendors of
proprietary enterprise application integration; vendors of
portal products; and application server vendors. We also face
competition from providers of various technologies to enable Web
services. Further, we face competition for some aspects of our
software and service offerings from major system integrators,
both independently and in conjunction with corporate in-house
information technology departments, which have traditionally
been the prevalent resource for application integration. In
addition, application software vendors with whom we currently
have or have had strategic relationships sometimes offer
competitive solutions or may become or are competitors. Some of
our competitors or potential competitors may have more
experience developing technologies or solutions competitive with
ours, larger technical staffs, larger customer bases, more
established distribution channels, greater brand recognition and
greater financial, marketing and other resources than we do. Our
competitors may be able to develop products and services that
are superior to our solutions, that achieve greater customer
acceptance or that have significantly improved functionality or
performance as compared to our existing solutions and future
software and services. In addition, negotiating and maintaining
favorable customer and strategic relationships is critical

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to our business. Our competitors may be able to
negotiate strategic relationships on more favorable terms than
we are able to negotiate. Many of our competitors may also have
well-established relationships with our existing and prospective
customers. Increased competition may result in reduced margins,
loss of sales, decreased market share or longer sales cycles or
sales processes involving more extensive demonstrations of
product capabilities, which in turn could harm our business,
operating results and financial condition.


We rely on strategic partnerships with
software vendors, alliances with major system integrators and
other similar relationships to promote and implement our
software and, if these relationships diminish or terminate, we
may lose important deals and marketing
opportunities.

We have established strategic relationships with
enterprise application software vendors and system integration
partners. These strategic partners provide us with important
sales and marketing opportunities, create opportunities to
license our solutions, upsell our products to customers already
using license-limited versions of our software embedded in their
enterprise application products, and greatly increase our
implementation capabilities. We also have similar relationships
with resellers, distributors and other technology leaders.
During fiscal year 2004, our enterprise application and systems
integrator partners directly or indirectly influenced a
significant portion of our license revenue, and we expect that
leverage to continue in future periods. If our relationships
with our strategic business partners diminished or terminated or
if we failed to work effectively with our partners or to grow
our base of strategic partners, resellers and distributors, we
might lose important opportunities, including sales and
marketing opportunities, our business may suffer and our
financial results could be adversely impacted. In general, our
partners are not required to market or promote our software and
generally are not restricted from working with vendors of
competing software or solutions or offering their own solutions
providing similar capabilities. Accordingly, our success will
depend on their willingness and ability to devote sufficient
resources and efforts to marketing our software and solutions
rather than the products of competitors or that they offer
themselves. If these relationships are not successful or if they
terminate, our revenue and operating results could be materially
adversely affected, our ability to increase our penetration of
our target markets could be impaired, we may have to devote
substantially more resources to the distribution, sales and
marketing, implementation and support of our software than we
would otherwise, and our efforts may not be as effective as
those of our partners, which could harm our business, our
operating results and the market price of webMethods common
stock.

Recent and future acquisitions of companies
or technologies may result in disruptions to our business,
dilution or other adverse effects on future financial results or
the distraction of our management.

In October 2003, we acquired businesses and
technologies, and we may acquire or make investments in other
complementary businesses and technologies in the future.
Although the October 2003 acquisitions produced results at
or above our expectations through the end of fiscal year 2004,
we may not be able to realize benefits or results in the future
that we expect to achieve from those businesses and technologies.

We may make investments in, or acquisitions of,
technology, products or companies in the future to maintain or
improve our competitive position. We may not be able to identify
future suitable acquisition or investment candidates, and even
if we identify suitable candidates, may not be able to make
these acquisitions or investments on commercially acceptable
terms, or at all. With respect to our potential future
acquisitions, we may not be able to realize future benefits we
expected to achieve at the time of entering into the
transaction, or our recognition of those benefits may be
delayed. In such acquisitions, we will likely face many or all
of the risks inherent in integrating corporate cultures, product
lines, operations and businesses. We will be required to train
our sales, professional services and customer support staff with
respect to acquired software products, which can detract from
executing against goals in the current period, and we may be
required to modify priorities of our product development,
customer support, systems engineering and sales organizations.
Further, we may have to incur debt or issue equity securities to
pay for any future acquisitions or investments, the issuance of
which could be dilutive to our stockholders.

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Treating stock options and employee stock
purchase plan participation as a compensation expense could
significantly impair our ability to return to and maintain
profitability.

The Financial Accounting Standards Board has
proposed requiring companies to record compensation expense
regarding stock options and participation in employee stock
purchase plans. We grant stock options to our employees,
officers and directors and we administer an employee stock
purchase plan (ESPP). Information on our stock option plan and
ESPP, including the shares reserved for issuance under those
plans, the terms of options granted, the terms of ESPP
participation, and the shares subject to outstanding stock
options, is included in Note 14 of the Notes to
Consolidated Financial Statements of webMethods, Inc. included
elsewhere later this report. If we choose, or are required, to
record an expense for our stock-based compensation plans, we
could incur a significant compensation expense, and any such
expense could significantly impair our ability to return to and
maintain profitability on a GAAP basis. That impact on our
ability to return to and maintain profitability on a GAAP basis
could have a material adverse effect on the market price of
webMethods common stock.

Third-party claims that we infringe upon
their intellectual property rights may be costly to defend or
settle or could damage our business.

We cannot be certain that our software and the
services do not infringe issued patents, copyrights, trademarks
or other intellectual property rights of third parties.
Litigation regarding intellectual property rights is common in
the software industry, and we have been subject to, and may be
increasingly subject to, legal proceedings and claims from time
to time, including claims of alleged infringement of
intellectual property rights of third parties by us or our
licensees concerning their use of our software products,
technologies and services. Although we believe that our
intellectual property rights are sufficient to allow us to
market our software without incurring liability to third
parties, third parties have brought, and may bring in the
future, claims of infringement against us or our licensees.
Because our software is integrated with our customers
networks and business processes, as well as other software
applications, third parties may bring claims of infringement
against us, as well as our customers and other software
suppliers, if the cause of the alleged infringement cannot
easily be determined. We have agreed, and may agree in the
future, to indemnify certain of our customers against claims
that our software infringes upon the intellectual property
rights of others. Furthermore, former employers of our current
and future employees may assert that our employees have
improperly disclosed confidential or proprietary information to
us. Such claims may be with or without merit.

Claims of alleged infringement, regardless of
merit, may have a material adverse effect on our business in a
number of ways. Claims may discourage potential customers from
doing business with us on acceptable terms, if at all.
Litigation to defend against claims of infringement or contests
of validity may be very time-consuming and may result in
substantial costs and diversion of resources, including our
managements attention to our business. In addition, in the
event of a claim of infringement, we, as well as our customers,
may be required to obtain one or more licenses from third
parties, which may not be available on acceptable terms, if at
all. Furthermore, a party making such a claim could secure a
judgment that requires us to pay substantial damages, and also
include an injunction or other court order that could prevent us
from selling our software or require that we re-engineer some or
all of our products. Five of our customers have been subject to
such claims and litigation, and we or other customers may in the
future be subject to additional claims and litigation. We have
settled one such claim and may in the future settle any other
such claims with which we may be involved, regardless of merit,
to avoid the cost and uncertainty of continued litigation.
Defense of any lawsuit or failure to obtain any such required
licenses could significantly harm our business, operating
results and financial condition and the price of webMethods
common stock. Although we carry general liability insurance, our
current insurance coverage may not apply to, and likely would
not protect us from, all liability that may be imposed under
these types of claims. Our current insurance programs do not
cover claims of patent infringement.

We are trying to increase our sales to the
US Government and to others in the public sector, and we may
face difficulties in our attempts to procure new contracts with
them and risks unique to government contracts that may have a
detrimental impact on our business or operating
results.

We are attempting to expand our customer base to
include more entities and agencies within the US Government,
state, local and foreign governments. Developing new business in
the public sector often

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requires companies to develop capabilities in
government bidding and contracting and to develop relationships
with government contractors providing information technology
solutions. If we are unable to develop or sustain those
capabilities and relationships, we may be unable to procure new
contracts within the timeframe we expect, and our business and
financial results may be adversely affected. Contracting with
the U.S. Government and other governments also requires
businesses to participate in a highly competitive bidding
process to obtain new contracts. We may be unable to bid
competitively if our software and services are improperly priced
or if we are incapable of providing our software and services at
a competitive price. Further, some agencies within the U.S.
Government may also require some of our personnel to obtain a
security clearance or may require us to add features or
functionality to our software. If our key personnel are unable
to obtain or retain this clearance or if we cannot or do not
provide required features or functionality, we may be
unsuccessful in our bid for some government contracts.


Contracts with the U.S. Government or with many
state, local, and foreign governments also frequently include
provisions not found in the private sector and are often
governed by laws and regulations that do not affect private
contracts. These differences permit the public sector customer
to take action not available to customers in the private sector.
This may include termination of current contracts for
convenience or due to a default. If any of these events occur,
they may negatively affect our business and financial results.
In order to maintain contracts with the U.S. Government,
webMethods must also comply with many rules and regulations that
may affect our relationship with other customers or result in
increased costs or an inability to take advantage of certain
opportunities that may present themselves in the future. U.S.
Government agencies may audit our performance and our pricing,
and review our compliance with rules and regulations. An
unfavorable audit could result in a reduction of revenue, and
may result in civil or criminal liability if the audit uncovers
improper or illegal activities. This could harm our business,
financial results and reputation.

Our operating results may decline and our
customers may become dissatisfied if we do not provide
professional services or maintain our record of successful
production events concerning our solutions or if we are unable
to establish and maintain relationships with third-party
implementation providers.

Customers that license our software typically
engage our professional services staff or third-party
consultants to assist with support, training, consulting and
implementation, and we believe our strong focus on ensuring that
our software is successfully put into production is a strong
competitive advantage and differentiator. We believe that many
of our software sales depend, in part, on our ability to provide
our customers with these services and to attract and educate
third-party consultants to provide similar services. New
professional services personnel and service providers require
training and education and take time to reach full productivity.
Competition for qualified personnel and service providers is
intense. Our business may be harmed if we are unable to provide
professional services to our customers or maintain our record of
successful production events concerning our solutions of if we
are unable to establish and maintain relationships with
third-party implementation providers.

Our executive officers and certain key
personnel are critical to our business, and these officers and
key personnel may not always remain with us.

Our success depends upon the continued service of
our executive officers and other key employees, and none of
these officers or key employees is bound by an employment
agreement for any specific term. If we lose the services of one
or more of our executive officers or key employees, our
business, operating results and financial condition could be
harmed. In particular, Phillip Merrick, our Chairman of the
Board and Chief Executive Officer, would be particularly
difficult to replace. Our future success will also depend in
large part on our ability to attract and retain experienced
technical, sales, marketing and management personnel.

We may not be able to increase market
awareness and sales of our software if we do not maintain our
sales and distribution capabilities.

We need to maintain and further develop our
direct and indirect sales and distribution efforts, both
domestically and internationally, in order to increase market
awareness and sales of our software and the related services we
offer. Our software and solutions require a sophisticated sales
effort targeted at multiple

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departments within an organization. Competition
for qualified sales and marketing personnel is intense, and we
might not be able to hire and retain adequate numbers of such
personnel. Our competitors have attempted to hire employees away
from us, and we expect that they will continue such attempts in
the future. We also plan to expand our relationships with system
integrators, enterprise software vendors and other third-party
resellers to further develop our indirect sales channel. As we
continue to develop our indirect sales channel, we will need to
manage potential conflicts between our direct sales force and
third-party reselling efforts, which may impact our business and
operating results.


We intend to continue expanding our
international sales efforts, and our inability to do so could
harm our business and operating results.

We have been, and intend to continue, expanding
our international sales efforts. We have relatively limited
experience in marketing, selling and supporting our software and
services abroad. Expansion of our international operations will
require a significant amount of attention from our management
and substantial financial resources. If we are unable to
continue expanding our international operations successfully and
in a timely manner, our business and operating results could be
harmed. In addition, doing business internationally involves
additional risks, particularly: the difficulties and costs of
staffing and managing foreign operations; unexpected changes in
regulatory requirements, taxes, trade laws and tariffs;
differing intellectual property rights; differing labor
regulations; and changes in a specific countrys or
regions political or economic conditions.

We currently do not engage in any currency
hedging transactions. Our foreign sales generally are invoiced
in the local currency, and, as we expand our international
operations or if there is continued volatility in exchange
rates, our exposure to gains and losses in foreign currency
transactions may increase when we determine that foreign
operations are expected to repay intercompany debt in the
foreseeable future. Moreover, the costs of doing business abroad
may increase as a result of adverse exchange rate fluctuations.
For example, if the United States dollar declines in value
relative to a local currency and we are funding operations in
that country from our U.S. operations, we could be required
to pay more for salaries, commissions, local operations and
marketing expenses, each of which is paid in local currency. In
addition, exchange rate fluctuations, currency devaluations or
economic crises may reduce the ability of our prospective
customers to purchase our software and services.

If we experience delays in developing
solutions, or if our software contains defects, we could lose
partners, customers and revenue.

We expect that the rapid evolution of business
integration software, Service Oriented Architecture technology,
Business Process Management solutions, Business Activity
Monitoring solutions, Composite Application technologies, and
related standards and technologies and protocols, as well as
general technology trends such as changes in or introductions of
operating systems or enterprise applications, will require us to
adapt our software and solutions to remain competitive. Our
software and solutions could become obsolete, unmarketable or
less desirable to prospective customers if we are unable to
adapt to new technologies or standards. Many serious defects are
frequently found during the period immediately following
introduction of new software or enhancements to existing
software. Internal quality assurance testing and customer
testing may reveal product performance issues or desirable
feature enhancements that could lead us to postpone the release
of new versions of our software. The reallocation of resources
associated with any postponement could cause delays in the
development and release of future enhancements to our currently
available software, could require significant additional
professional services work to address operational issues and
could damage the reputation of our software in the marketplace.
Although we attempt to resolve all errors that we believe would
be considered serious by our partners and customers, our
software is not error-free. Undetected errors or performance
problems may be discovered in the future, and known errors that
we consider minor may be considered serious by our partners and
customers. This could result in lost revenue or delays in
customer deployment and would be detrimental to our reputation,
which could harm our business, operating results and financial
condition. If our software experiences performance problems or
ceases to demonstrate technology leadership, we may have to
increase our product development costs and divert our product
development resources to address the

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problems. In addition, because our customers and
certain partners depend on our software for their critical
systems and business functions, any interruptions in operation
of our software or solutions could cause our customers and
certain partners to initiate warranty or product liability suits
against us.


Because our software could interfere with
the operations of our partners and customers other
software applications, we may be subject to potential product
liability and warranty claims by these partners and customers,
which may be time consuming, costly to defend and may not be
adequately covered by insurance.

Our software enables customers and certain
partners software applications to provide Web services, or
to integrate with networks and software applications, and is
often used for mission critical functions or applications.
Errors, defects, other performance problems in our software or
failure to provide technical support could result in financial
or other damages to our partners and customers. Partners and
customers could seek damages for losses from us, which, if
successful, could have a material adverse effect on our
business, operating results or financial condition. In addition,
the failure of our software and solutions to perform to
partners and customers expectations could give rise
to warranty claims. Although our license agreements typically
contain provisions designed to limit our exposure to potential
product liability claims, existing or future laws or unfavorable
judicial decisions could negate these limitation of liability
provisions. Although we have not experienced any product
liability claims to date, sale and support of our software
entail the risk of such claims. The use of our software to
enable partners and customers software applications
to provide Web services, and the integration of our software
with our partners and customers networks and
software applications, increase the risk that a partner or
customer may bring a lawsuit against several suppliers if an
integrated computer system fails and the cause of the failure
cannot easily be determined. Even if our software is not at
fault, a product liability claim brought against us, even if not
successful, could be time consuming and costly to defend and
could harm our reputation. In addition, although we carry
general liability insurance, our current insurance coverage
would likely be insufficient to protect us from all liability
that may be imposed under these types of claims.

We may not have sufficient resources
available to us in the future to take advantage of certain
opportunities.

In the future, we may not have sufficient
resources available to us to take advantage of growth,
acquisition, product development or marketing opportunities. We
may need to raise additional funds in the future through public
or private debt or equity financings in order to: take advantage
of opportunities, including more rapid international expansion
or acquisitions of complementary businesses or technologies;
developing new software or services; or responding to
competitive pressures. Additional financing needed by us in the
future may not be available on terms favorable to us, if at all.
If adequate funds are not available, not available on a timely
basis, or are not available on acceptable terms, we may not be
able to take advantage of opportunities, develop new software or
services or otherwise respond to unanticipated competitive
pressures. In such case, our business, operating results and
financial condition could be harmed.

If we are unable to protect our
intellectual property, we may lose a valuable asset, experience
reduced market share, or incur costly litigation to protect our
rights.

Our success depends, in part, upon our
proprietary technology and other intellectual property rights.
To date, we have relied primarily on a combination of copyright,
trade secret, trademark and patent laws, and nondisclosure and
other contractual restrictions on copying and distribution to
protect our proprietary technology. We have one patent and
several pending patent applications for technology related to
our software, but we cannot assure you that this patent is valid
or that these applications will be successful. A small number of
our agreements with customers and system integrators contain
provisions regarding the rights of third parties to obtain the
source code for our software, which may limit our ability to
protect our intellectual property rights in the future. Despite
our efforts to protect our proprietary rights, unauthorized
parties may copy aspects of our software and obtain and use
information that we regard as proprietary. In

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addition, other parties may breach
confidentiality agreements or other protective contracts we have
entered into, and we may not be able to enforce our rights in
the event of these breaches. Furthermore, we expect to continue
increasing our international operations in the future, and the
laws of certain foreign countries may not protect our
intellectual property rights to the same extent as do the laws
of the United States.


Our means of protecting our intellectual property
rights in the United States or abroad may not be adequate to
fully protect our intellectual property rights. Litigation to
enforce our intellectual property rights or protect our trade
secrets could result in substantial costs, may not result in
timely relief and may not be successful. Any inability to
protect our intellectual property rights could seriously harm
our business, operating results and financial condition.

Because market participants in some markets
have adopted industry specific technologies, we may need to
expend significant resources in order to address specific
markets.

Our strategy is to continue developing our
integration software to be broadly applicable to many
industries. However, in some markets, market participants have
adopted core technologies that are specific to their markets.
For example, many companies in the financial services industries
and consumer goods manufacturing and retail industries have
adopted industry-specific protocols for the interchange of
information. In order to successfully sell our software to
companies in these markets, we may need to expand or enhance our
software to adapt to these industry-specific technologies, which
could be costly and require the diversion of engineering
resources.

We adopted a shareholder rights plan in
October 2001, and previously implemented certain provisions
in our certificate of incorporation and bylaws, that may have
anti-takeover effects.

Our Board of Directors adopted a shareholder
rights plan and declared a dividend distribution of one right
for each outstanding share of webMethods stock. Each
right, when exercisable, entitles the registered holder to
purchase certain securities at a specified purchase price,
subject to adjustment. The rights plan may have the
anti-takeover effect of causing substantial dilution to a person
or group that attempts to acquire webMethods on terms not
approved by our Board of Directors. The existence of the rights
plan could limit the price that certain investors might be
willing to pay in the future for shares of webMethods
stock and could discourage, delay or prevent a merger or
acquisition of webMethods, Inc. that stockholders may consider
favorable. In addition, provisions of the current certificate of
incorporation and bylaws of webMethods, Inc., as well as
Delaware corporate law, could make it more difficult for a
third-party to acquire us without the support of our Board of
Directors, even if doing so would be beneficial to our
stockholders.




Item 2.     PROPERTIES

Our principal administrative, sales, marketing
and research and development facility is located in Fairfax,
Virginia, and consists of approximately 126,000 square feet of
office space held under leases that expire in March 2005 and
July 2007. We maintain offices for sales and research and
development in Sunnyvale, California, Westborough,
Massachusetts, Denver, Colorado and Bellevue, Washington. We
also maintain small offices for sales personnel in the United
States in California, Colorado, Georgia, Illinois, Indiana,
Massachusetts, Michigan, Minnesota, New York, New Jersey, North
Carolina, Ohio, Pennsylvania and Texas. We maintain offices
outside the United States for sales and administrative personnel
in Australia, Canada, Hong Kong, France, Germany, Japan,
Malaysia, the Netherlands, Peoples Republic of China, Singapore,
South Korea, Taiwan and the United Kingdom.

We provide customer technical support from our
facilities in Virginia and California in the United States and
in Australia, Japan and the Netherlands. We regularly evaluate
the suitability and adequacy of our existing facilities and the
availability of space for facilities in new locations, and we
believe that suitable space for new, replacement or expanded
facilities, as needed, generally will be available on
commercially reasonable terms.

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Item 3.     LEGAL
PROCEEDINGS

On November 30, 2001, a purported class
action lawsuit was filed in the Southern District of New York
naming webMethods, several of its executive officers at the time
of our initial public offering (IPO) and the managing
underwriters of our initial public offering as defendants. The
amended complaint alleges, among other things, that underwriters
of webMethods IPO solicited and received excessive
commissions and demanded tie-in arrangements from the
underwriters customers in connection with their allocation
of shares in webMethods IPO, and that those activities
allegedly undertaken by the underwriters of webMethods IPO
were not disclosed in the registration statement and final
prospectus for webMethods IPO or disclosed to the public
after webMethods IPO. The amended complaint also alleges
that false analysts reports were issued by the
underwriters. The amended complaint seeks unspecified damages on
behalf of a purported class of purchasers of webMethods
common stock between February 10, 2000 and December 6,
2000. This case has been consolidated as part of In Re Initial
Public Offering Securities Litigation (SDNY). Claims against
webMethods executive officer defendants have been
dismissed without prejudice. webMethods has considered and
conditionally agreed to enter into a proposed settlement with
representatives of the plaintiffs in the consolidated
proceeding. Under the proposed settlement, the plaintiffs would
dismiss and release their claims against webMethods in exchange
for a contingent payment guaranty by the insurance companies
collectively responsible for insuring the issuers in the
consolidated action and assignment or surrender to the
plaintiffs by the settling issuers of certain claims that may be
held against the underwriter defendants. We believe that any
material liability on behalf of webMethods or its executive
officers that may accrue under that settlement offer would be
covered by our insurance policies. Until that settlement is
fully effective, we intend to defend against the amended
complaint vigorously.

On March 30, 2004, we entered into a
settlement agreement with a private company that had made claims
against five of our customers, whom we had agreed to indemnify,
at least in part, for business reasons against infringement
claims relating to our products. The private company claimed
that those customers implementation of application
integration systems and methods supported by certain of our
products allegedly infringed a U.S. patent. The private company
did not make infringement claims directly against webMethods or
claim that any of our products infringed that patent. Under the
settlement agreement, we paid $2.25 million to the private
company in April 2004 to secure a complete release of all claims
against the five customers, and we obtained a license to that
patent that we can pass through to our past, present and future
customers with respect to their use of webMethods products.

From time to time, webMethods is involved in
other disputes and litigation in the normal course of business.




Item 4.     SUBMISSION
OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security
holders during the fourth quarter of the fiscal year covered by
this report.



PART II





|        |                                                                         
|------- | ------------------------------------------------------------------------
|Item 5. | MARKET FOR REGISTRANTS COMMON STOCK AND
    RELATED STOCKHOLDER MATTERS

webMethods common stock has been publicly
traded on the Nasdaq National Market under the symbol
WEBM since our initial public offering on
February 11, 2000. The high and low sales prices of
webMethods common stock as reported by the Nasdaq National
Market during the last two fiscal years are shown below:

|                           |                                           |      |   |       |  |  |   |      | 
|-------------------------- | ----------------------------------------- | ---- | - | ----- |  |  | - | ---- | 
|                           |                                           | High |   | Low  
|                           |                                           |      |   |      
|Year ended March 31, 2003: |                                           |      |   |       |  |  |   |     
|                           | First Quarter (ended June 30, 2002)       |      | $ | 18.64 |  |  | $ | 7.61 | 
|                           | Second Quarter (ended September 30, 2002) |      |   | 11.83 |  |  |   | 4.71 | 
|                           | Third Quarter (ended December 31, 2002)   |      |   | 10.24 |  |  |   | 4.25 | 
|                           | Fourth Quarter (ended March 31, 2003)     |      |   | 12.82 |  |  |   | 8.07 | 

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|                           |                                           |      |  |       |  |  |  |      | 
|-------------------------- | ----------------------------------------- | ---- |  | ----- |  |  |  | ---- | 
|                           |                                           | High |  | Low  
|                           |                                           |      |  |      
|Year ended March 31, 2004: |                                           |      |  |       |  |  |  |     
|                           | First Quarter (ended June 30, 2003)       |      |  | 10.91 |  |  |  | 8.02 | 
|                           | Second Quarter (ended September 30, 2003) |      |  | 10.25 |  |  |  | 7.24 | 
|                           | Third Quarter (ended December 31, 2003)   |      |  | 10.15 |  |  |  | 7.41 | 
|                           | Fourth Quarter (ended March 31, 2004)     |      |  | 12.17 |  |  |  | 8.76 | 

As of June 10, 2004, there were
approximately 380 holders of record, and approximately 13,000
beneficial owners, of webMethods common stock. The number of
holders of record of webMethods common stock does not reflect
the number of beneficial holders whose shares are held by
depositories, brokers or other nominees. As of June 10,
2004, the closing price of webMethods common stock was
$8.29.

webMethods has never declared or paid any cash
dividends on its common stock. We currently intend to retain
earnings, if any, to support our growth strategy and do not
anticipate paying cash dividends in the foreseeable future.

The following table provides information
concerning webMethods securities authorized for issuance under
equity compensation plans at March 31, 2004.

Equity Compensation Plan Information

|                                                                 |  |                      |            |                      |  |                                |         |     |  |  |           |    
|---------------------------------------------------------------- |  | -------------------- | ---------- | -------------------- |  | ------------------------------ | ------- | --- |  |  | --------- | ---
|                                                                 |  | Number of securities |            |                      |  | Number of securities remaining
|                                                                 |  | to be issued upon    |            | Weighted-average     |  | available for future issuance 
|                                                                 |  | exercise of          |            | exercise price of    |  | under equity compensation     
|                                                                 |  | outstanding options, |            | outstanding options, |  | plans (excluding securities   
|Plan category                                                    |  | warrants and rights  |            | warrants and rights  |  | reflected in column (a))      
|                                                                 |  |                      |            |                      |  |                               
|                                                                 |  | (a)                  |            | (b)                  |  | (c)                           
|Equity compensation plans approved by security
    holders       |  |                      | 16,619,841 | (1)                  |  | $                              | 15.0218 | (1) |  |  | 2,647,357 | (1)
|Equity compensation plans not approved by
    securities holders |  |                      | 171,619    | (2)                  |  |                                | 42.1032 | (2) |  |  |          |    
|                                                                 |  |                      |            |                      |  |                                |         |     |  |  |           |    
|Total                                                            |  |                      | 16,791,460 |                      |  | $                              | 15.3001 |     |  |  | 2,647,357 |    
|                                                                 |  |                      |            |                      |  |                                |         |     |  |  |           |    



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Excludes webMethods Employee Stock Purchase
    Plan, under which, as of March 31, 2004, a total of
    4,500,000 shares of webMethods common stock have been
    reserved for issuance, 1,081,624 shares had been issued at
    an average purchase price of $11.6835 and 3,418,376 shares
    remained available for future issuance. Also excludes an
    additional 2,462,195 shares of webMethods common stock that
    were reserved for issuance under the webMethods, Inc. Amended
    and Restated Stock Option Plan as of April 1, 2004.                                                                           
|   
|(2) | Consists only of shares of webMethods common
    stock to be issued upon the exercise of stock options issued by
    Active Software under its 1999 Stock Option Plan, its 1996 and
    1996A Stock Option Plans and its 1999 Director Option Plan, and
    stock options assumed by Active Software that had been granted
    by the respective company under the TransLink Software, Inc.
    Stock Option Plan, Alier, Inc. 1997 Stock Option Plan and Alier,
    Inc. 1996 Stock Option Plan, all such options having been
    granted prior to the acquisition of Active Software by
    webMethods, Inc. in August 2000.

When webMethods, Inc. acquired Active Software in
August 2000, webMethods, Inc. assumed stock options granted by
Active Software prior to the completion of that acquisition
under Active Softwares 1999 Stock Option Plan and 1996 and
1996A Stock Option Plans. Options granted under those plans
generally had exercise prices not less than the fair market
value of Active Softwares common stock on the date of
grant, vested over 50 months and expire 10 years from
the date of grant. In connection with that acquisition,
webMethods, Inc. also assumed stock options granted by Active
Software prior to the completion of that acquisition under
Active Softwares 1999 Director Option Plan, under which
each newly elected director of Active Software was eligible to
receive an option to purchase a fixed number of shares of Active
Software common stock and each non-employee director was
eligible to receive an option to purchase a fixed number of
shares at each annual meeting of stockholders of Active Software
commencing in 2000; all such options vested immediately upon
grant and expire 10 years from the date of grant.

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##### Table of Contents






Item 6.     SELECTED
FINANCIAL DATA

The following selected historical consolidated
financial data for webMethods should be read in conjunction with
the consolidated financial statements of webMethods and
Managements Discussion and Analysis of Financial
Condition and Results of Operations, which are included
elsewhere in this report. The historical consolidated statement
of operations data for the years ended March 31, 2004, 2003
and 2002 and the historical consolidated balance sheet data as
of March 31, 2004 and 2003 are derived from the
consolidated financial statements of webMethods, which have been
audited by PricewaterhouseCoopers LLP, independent accountants
for webMethods, and are included elsewhere in this report. The
historical consolidated statement of operations data for the
years ended March 31, 2001 and 2000 and the historical
consolidated balance sheet data as of March 31, 2002, 2001
and 2000 are derived from consolidated financial statements of
webMethods not contained in this report. Historical results are
not necessarily indicative of future results.

|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |        |        |        | 
|------------------------------------------------------------------------------------- | ------------------------------------------ | ------------------------------------------- | ------------------------ | ------ | ------ | ------- | ------- | ------- | ------ | ------- | ------- | ------- | ------- | ------- | -------- | ------- | ------- | ------- | ------- | ------ | ------ | ------ | 
|                                                                                      |                                            |                                            
|                                                                                      |                                            | Year Ended March 31,                       
|                                                                                      |                                            |                                            
|                                                                                      |                                            | 2004                                        |                          | 2003   |        | 2002    |         | 2001    |        | 2000   
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |        
|                                                                                      |                                            |                                            
|                                                                                      |                                            | (In thousands, except per share data)      
|Consolidated Statements of Operations
    Data:                                       |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|Revenue:                                                                              |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|                                                                                      | License                                    |                                             | $                        | 97,282 |        |         | $       | 117,066 |        |         | $       | 121,803 |         |         | $        | 143,514 |         |         | $       | 42,822 |       
|                                                                                      | Professional services                      |                                             |                          | 43,923 |        |         |         | 33,378  |        |         |         | 35,800  |         |         |          | 34,945  |         |         |         | 11,699 |       
|                                                                                      | Maintenance                                |                                             |                          | 53,320 |        |         |         | 46,310  |        |         |         | 38,393  |         |         |          | 23,498  |         |         |         | 5,624  |       
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|                                                                                      |                                            |                                             | Total revenue            |        |        | 194,525 |         |         |        | 196,754 |         |         |         | 195,996 |          |         |         | 201,957 |         |        |        | 60,145 | 
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|Cost of revenue:                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|                                                                                      | Amortization of intangibles                |                                             |                          | 1,199  |        |         |         |        |        |         |         |        |         |         |          |        |         |         |         |       |       
|                                                                                      | License                                    |                                             |                          | 2,211  |        |         |         | 1,937   |        |         |         | 2,335   |         |         |          | 5,189   |         |         |         | 2,612  |       
|                                                                                      | Professional services and maintenance:     |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |        |       
|                                                                                      |                                            | Stock based compensation                    |                          |        | 56     |         |         |         | 251    |         |         |         | 436     |         |          |         | 1,188   |         |         |        | 560    |       
|                                                                                      |                                            | Other professional services and maintenance |                          |        | 53,332 |         |         |         | 41,937 |         |         |         | 42,124  |         |          |         | 46,304  |         |         |        | 16,102 |       
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|                                                                                      |                                            |                                             | Total cost of revenue    |        |        | 56,798  |         |         |        | 44,125  |         |         |         | 44,895  |          |         |         | 52,681  |         |        |        | 19,274 | 
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|Gross profit                                                                          |                                            |                                             | 137,727                  |        |        |         | 152,629 |         |        |         | 151,101 |         |         |         | 149,276  |         |         |         | 40,871  |       
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|Operating expenses:                                                                   |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|                                                                                      | Sales and marketing:                       |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |        |       
|                                                                                      |                                            | Stock based compensation and warrant charge |                          |        | 2,769  |         |         |         | 3,761  |         |         |         | 2,865   |         |          |         | 4,813   |         |         |        | 1,471  |       
|                                                                                      |                                            | Other sales and marketing costs             |                          |        | 91,325 |         |         |         | 92,958 |         |         |         | 106,377 |         |          |         | 100,154 |         |         |        | 44,033 |       
|                                                                                      | Research and development:                  |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |        |       
|                                                                                      |                                            | Stock based compensation                    |                          |        | 15     |         |         |         | 97     |         |         |         | 12,526  |         |          |         | 12,447  |         |         |        | 1,250  |       
|                                                                                      |                                            | Other research and development costs        |                          |        | 45,045 |         |         |         | 47,441 |         |         |         | 49,634  |         |          |         | 45,158  |         |         |        | 14,780 |       
|                                                                                      | General and administrative:                |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |        |       
|                                                                                      |                                            | Stock based compensation                    |                          |        | 7      |         |         |         | 47     |         |         |         | 433     |         |          |         | 1,640   |         |         |        | 307    |       
|                                                                                      |                                            | Other general and administrative costs      |                          |        | 17,873 |         |         |         | 17,831 |         |         |         | 19,372  |         |          |         | 20,837  |         |         |        | 9,753  |       
|                                                                                      | Restructuring and related charges          |                                             |                          | 3,920  |        |         |         | 2,155   |        |         |         | 7,243   |         |         |          |        |         |         |         |       |       
|                                                                                      | Acquisition related expenses               |                                             |                          |       |        |         |         |        |        |         |         |        |         |         |          | 34,039  |         |         |         |       |       
|                                                                                      | Amortization of goodwill and intangibles   |                                             |                          |       |        |         |         |        |        |         |         | 38,697  |         |         |          | 41,395  |         |         |         | 1,305  |       
|                                                                                      | In-process research and development        |                                             |                          | 4,284  |        |         |         |        |        |         |         |        |         |         |          | 34,910  |         |         |         | 2,737  |       
|                                                                                      | Settlement of intellectual property matter |                                             |                          | 2,250  |        |         |         |        |        |         |         |        |         |         |          |        |         |         |         |       |       
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|                                                                                      |                                            |                                             | Total operating expenses |        |        | 167,488 |         |         |        | 164,290 |         |         |         | 237,147 |          |         |         | 295,393 |         |        |        | 75,636 | 
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|Operating loss                                                                        |                                            |                                             | (29,761                  | )      |        |         | (11,661 | )       |        |         | (86,046 | )       |         |         | (146,117 | )       |         |         | (34,765 | )     
|Interest income                                                                       |                                            |                                             | 2,851                    |        |        |         | 4,732   |         |        |         | 9,116   |         |         |         | 14,894   |         |         |         | 3,507   |       
|Interest expense                                                                      |                                            |                                             | (205                     | )      |        |         | (674    | )       |        |         | (553    | )       |         |         | (503     | )       |         |         | (145    | )     
|Other income (expense)                                                                |                                            |                                             | (473                     | )      |        |         | 18      |         |        |         | (26     | )       |         |         | 112      |         |         |         | (47     | )     
|Impairment of equity investments in private
    companies                             |                                            |                                             |                         |        |        |         | (1,000  | )       |        |         | (5,200  | )       |         |         |         |         |         |         |        |       
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|Loss before income taxes                                                              |                                            |                                             | (27,588                  | )      |        |         | (8,585  | )       |        |         | (82,709 | )       |         |         | (131,614 | )       |         |         | (31,450 | )     
|Provision for income taxes                                                            |                                            |                                             | 323                      |        |        |         |        |         |        |         |        |         |         |         |         |         |         |         |        |       
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|Net loss                                                                              |                                            |                                             | (27,911                  | )      |        |         | (8,585  | )       |        |         | (82,709 | )       |         |         | (131,614 | )       |         |         | (31,450 | )     
|Accretion and accrued dividends related to
    mandatorily redeemable preferred stock |                                            |                                             |                         |        |        |         |        |         |        |         |        |         |         |         |         |         |         |         | (10,223 | )     
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|Net loss attributable to common shareholders                                          |                                            | $                                           | (27,911                  | )      |        | $       | (8,585  | )       |        | $       | (82,709 | )       |         | $       | (131,614 | )       |         | $       | (41,673 | )     
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|Basic and diluted net loss per share                                                  |                                            | $                                           | (0.54                    | )      |        | $       | (0.17   | )       |        | $       | (1.67   | )       |         | $       | (2.81    | )       |         | $       | (2.23   | )     
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       
|Shares used in computing basic and diluted net
    loss per common share              |                                            |                                             | 52,137                   |        |        |         | 51,282  |         |        |         | 49,493  |         |         |         | 46,860   |         |         |         | 18,717  |       
|                                                                                      |                                            |                                             |                          |        |        |         |         |         |        |         |         |         |         |         |          |         |         |         |         |       

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|                                                                                                 |  |                |         |      |  |      |         |      |  |      |         |  |  |   |         |  |  |   |         | 
|------------------------------------------------------------------------------------------------ |  | -------------- | ------- | ---- |  | ---- | ------- | ---- |  | ---- | ------- |  |  | - | ------- |  |  | - | ------- | 
|                                                                                                 |  |               
|                                                                                                 |  | March 31,     
|                                                                                                 |  |               
|                                                                                                 |  | 2004           |         | 2003 |  | 2002 |         | 2001 |  | 2000
|                                                                                                 |  |                |         |      |  |      |         |      |  |     
|                                                                                                 |  |               
|                                                                                                 |  | (In thousands)
|Consolidated Balance Sheet Data:                                                                 |  |                |         |      |  |      |         |      |  |      |         |  |  |   |         |  |  |   |         | 
|Cash, cash equivalents and short-term and
    long-term marketable securities available for sale |  | $              | 155,947 |      |  | $    | 201,626 |      |  | $    | 211,842 |  |  | $ | 206,389 |  |  | $ | 196,972 | 
|Working capital                                                                                  |  |                | 95,845  |      |  |      | 149,424 |      |  |      | 178,909 |  |  |   | 190,722 |  |  |   | 181,355 | 
|Total assets                                                                                     |  |                | 284,122 |      |  |      | 304,436 |      |  |      | 324,063 |  |  |   | 375,288 |  |  |   | 299,187 | 
|Long-term liabilities                                                                            |  |                | 4,175   |      |  |      | 7,267   |      |  |      | 21,653  |  |  |   | 25,409  |  |  |   | 6,208   | 
|Total stockholders equity                                                                       |  |                | 202,554 |      |  |      | 218,559 |      |  |      | 215,544 |  |  |   | 265,609 |  |  |   | 252,169 | 






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF
    FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This item of our annual report on Form 10-K
contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as
amended. A cautionary paragraph at the very beginning of
Item 1, Business, of this report provides
examples of forward-looking statements and indications of
forward-looking statements. Although we believe that the
expectations reflected in the forward-looking statements are
reasonable, our expectations or the forward-looking statements
could prove to be incorrect, and actual results could differ
materially from those indicated by the forward-looking
statements. Our future financial condition and results of
operations, as well as any forward-looking statements, are
subject to risks and uncertainties, including (but not limited
to) those discussed in Item 1 of this report under the
caption Factors That May Affect Future Operating
Results. Achieving the future results or accomplishments
described or projected in forward-looking statements depends
upon events or developments that are often beyond our ability to
control. All forward-looking statements and all reasons why
actual results may differ that are included in this report are
made as of the date of this report, and webMethods disclaims any
obligation to publicly update or revise such forward-looking
statements or reasons why actual results may differ.




OVERVIEW

Background

We are a leading provider of software and
services for end-to-end business integration solutions. We offer
a set of software products that enable organizations to run,
manage and optimize their business. Our software products and
related services give organizations the ability, seamlessly and
in real-time, to integrate disparate information resources, to
connect customers, vendors and business partners with the
organization and its employees, to view and manage the connected
information resources, data, business processes and human
workflows and to provide Web services at the enterprise level.

In August 2000, webMethods acquired Active
Software, Inc. (Active Software) in a transaction
that was accounted for as a pooling of interests. We have
combined our financial statements for prior periods as if the
merger had occurred at the beginning of all prior periods
presented.

We completed acquisitions of business and
technology in October 2003 to significantly expand our portfolio
of products in the Service Oriented Architecture (SOA), Business
Activity Monitoring (BAM) and portal spaces. The aggregate
acquisition cost for these three acquisitions was approximately
$32.4 million in cash. From the technology acquired in
those acquisitions, we introduced webMethods Fabric, webMethods
Glue, webMethods Optimize and webMethods Portal. With the
addition of those products, continued organic development from
our product development team, and several key partnerships,
webMethods offers a solution that represents the next generation
of integration technology and provides our customers with a
breadth of functionality that we believe is compelling. And
while each one of the technologies represented in our solution
is, in and of itself, significant and important to our
customers, it is the combined breadth and strength of these
technologies and the natural synergies between them that drive
further value and return on investment to our customers.

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We license our software and sell our services
primarily through our direct sales organization augmented by
other sales channels, including our strategic software vendor
partners, major system integrators with whom we have strategic
alliances, other partners and distributors and, to a lesser
extent, resellers. We license our software primarily on a
perpetual basis and, to a lesser extent, on a renewable term
basis. As of March 31, 2004, we had over 1,100 customers,
compared to over 925 customers as of March 31, 2003.

We believe one of our competitive differentiators
is our strategic partnerships with enterprise application
software companies and system integrators. Under our
partnerships with enterprise application software vendors, the
partner may resell or, in some instances, embed or otherwise
utilize our software with their applications under limited use
licenses for a license or royalty fee. Enterprise application
software vendors with whom we have relationships include
American Management Systems (AMS), Hewlett-Packard Company,
Informatica, i2 Technologies, Microsoft, Peoplesoft and Siebel
Systems. We believe our partners influenced, directly or
indirectly, a significant portion of our license revenue during
fiscal year 2004, and we expect this leverage to continue in
future periods. Under certain partnership arrangements, we may
share license fees derived from joint selling opportunities with
our partner. In systems integrator and other partnership
arrangements, we may pay a sales assistance fee to a partner who
performs or assists in certain sales activities, and that fee
usually is paid once payment from the joint customer of license
fees is received.

We believe our strong focus and track record of
ensuring that our software is successfully put into production
(production event) is a strong competitive advantage
and differentiator. During fiscal year 2004, our global customer
services group reported and documented more than 497 separate
production events as compared to 340 such events in fiscal year
2003 and 178 such events in fiscal year 2002. Ensuring that our
customers successfully implement our software in a timely manner
enables them to achieve a greater return on their investment
and, in many cases, encourages them to purchase additional
software for other business integration projects and serve as a
reference customer for us in our future sales efforts.

Critical Accounting Policies and
Estimates

Our discussion and analysis of our financial
condition and results of operations are based upon our
consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the
United States of America. The preparation of these financial
statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenue and
expenses, and related disclosures. We evaluate our estimates, on
an on-going basis, including those related to allowances for bad
debts, investments, intangible assets, income taxes,
contingencies and litigation. We base our estimates on
historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results
of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent
from other sources. Actual results may differ for these
estimates under different assumptions or conditions.

We believe the following critical accounting
policies affect the more significant judgments and estimates
used in the preparation of our consolidated financial statements.

Revenue Recognition

We enter into arrangements, which may include the
sale of licenses of our software, professional services and
maintenance or various combinations of each element. We
recognize revenue based on

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Statement of Position (SOP) 97-2,
Software Revenue Recognition, as amended, and
modified by SOP 98-9, Modification of SOP 97-2,
Software Revenue Recognition, With Respect to Certain
Transactions. SOP 98-9 modified SOP 97-2 by
requiring revenue to be recognized using the residual
method if certain conditions are met. Revenue is
recognized based on the residual method when an agreement has
been signed by both parties, the fees are fixed or determinable,
collection of the fees is probable, delivery of the product has
occurred, vendor specific objective evidence of fair value
exists for any undelivered element, and no other significant
obligations remain. Revenue allocated to the undelivered
elements is deferred using vendor-specific objective evidence of
fair value of the elements and the remaining portion of the fee
is allocated to the delivered elements (generally the software
license). See Note 2 in the Consolidated Financial
Statements for a more comprehensive discussion of our revenue
recognition policies. Judgments we make regarding these items,
including collection risk, can materially impact the timing of
recognition of license revenue.


Policies related to revenue recognition require
difficult judgments on complex matters that are often subject to
multiple sources of authoritative guidance. These sources may
publish new authoritative guidance which might impact current
revenue recognition policies. We continue to evaluate our
revenue recognition policies as new authoritative
interpretations and guidance are published, and where
appropriate, may modify our revenue recognition policies.
Application of our revenue recognition policy requires a review
of our license and professional services agreements with
customers and may require management to exercise judgment in
evaluating whether delivery has occurred, payments are fixed and
determinable, collection is probable, and where applicable, if
vendor-specific objective evidence of fair value exists for
undelivered elements of the contract. In the event judgment in
the application of our revenue recognition policies is
incorrect, the revenue recognized by webMethods could be
impacted.

Allowance for Doubtful
Accounts

We maintain allowances for doubtful accounts for
estimated losses which may result from the inability of our
customers to make required payments to us. These allowances are
established through analysis of the credit-worthiness of each
customer with a receivable balance, determined by credit reports
from third parties, published or publicly available financial
information, customers specific experience including payment
practices and history, inquiries, and other financial
information from our customers. The use of different estimates
or assumptions could produce materially different allowance
balances. If the financial condition of our customers were to
deteriorate, resulting in an impairment of their ability to make
payments, additional allowances may be required. At
March 31, 2004 and 2003, the allowance for doubtful
accounts was $2,103,000 and $2,850,000 respectively.

Business Combinations

We are required to allocate the purchase price of
acquired companies to the tangible and intangible assets
acquired, liabilities assumed, as well as in-process research
and development (IPR&D) based on their estimated fair
values. We engaged independent third-party appraisal firms to
assist us in determining the fair values of assets acquired and
liabilities assumed. Such a valuation requires management to
make significant estimates and assumptions, especially with
respect to intangible assets.

Critical estimates in valuing certain of the
intangible assets include but are not limited to: future
expected cash flows from license sales, maintenance agreements,
consulting contracts, customer contracts, and acquired developed
technologies and IPR&D projects, and discount rates.
Managements estimates of fair value are based upon
assumptions believed to be reasonable, but which are inherently
uncertain and unpredictable. Assumptions may be incomplete or
inaccurate, and unanticipated events and circumstances may occur.

Other estimates associated with the accounting
for these acquisitions may change as additional information
becomes available regarding the assets acquired and liabilities
assumed.

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Goodwill and Intangibles
Assets

We record goodwill and intangible assets when we
acquire other businesses. The allocation of acquisition cost to
intangible assets and goodwill involves the extensive use of
managements estimates and assumptions, and the result of
the allocation process can have a significant impact on our
future operating results. Financial Accounting Standards Board
No. 142, Goodwill and Other Intangible Assets
(SFAS 142), which was issued during fiscal year 2002 and
adopted by us on April 1, 2002, eliminated the amortization
of goodwill and indefinite lived intangible assets. Intangible
assets with finite lives are amortized over their useful lives
while goodwill and indefinite lived assets are not amortized
under SFAS 142, but are periodically tested for impairment. In
accordance with SFAS 142, all of our goodwill is associated with
our corporate reporting unit, as we do not have multiple
reporting units. On an annual basis, we will evaluate whether an
impairment of the goodwill may exist. Goodwill is tested for
impairment using a two-step process. The first step is to
identify a potential impairment and the second step measures the
amount of the impairment loss, if any. Goodwill is deemed to be
impaired if the carrying amount of the asset exceeds its
estimated fair value.

Acquired In-process Research and
Development

Costs to acquire in-process research and
development technologies which have no alternative future use
and which have not reached technological feasibility at the date
of acquisition are expensed as incurred (see Note 12,
Business acquisitions).

Foreign Currency Effects

The functional currency for our foreign
operations is the local currency. The financial statements of
foreign subsidiaries have been translated into United States
dollars. Asset and liability accounts have been translated using
the exchange rate in effect at the balance sheet date. Revenue
and expense accounts have been translated using the average
exchange rate for the period. The gains and losses associated
with the translation of the financial statements resulting from
the changes in exchange rates from period to period have been
reported in other comprehensive income or loss. To the extent
assets and liabilities of the foreign operations are realized or
the foreign operations are expected to pay back the intercompany
debt in the foreseeable future, amounts previously reported in
other comprehensive income or loss would be included in net
income or loss in the period in which the transaction occurs.
Transaction gains or losses are included in net income or loss
in the period in which they occur.

Accounting for Income Taxes

We have recorded a tax valuation allowance to
reduce our deferred tax assets to the amount that is expected to
be realized. While we have considered future taxable income and
ongoing prudent and feasible tax planning strategies in
assessing the need for the valuation allowance, in the event we
were to determine that we would be able to realize our deferred
tax assets in the future in excess of its net recorded amount,
an adjustment to the deferred tax asset would increase income in
the period such determination was made. Likewise, should we
determine that we would not be able to realize all or part of
our net deferred tax asset in the future, an adjustment to the
deferred tax asset would be charged to income in the period such
determination was made.

Restructuring and Related
Charges

We have recorded restructuring costs to align our
cost structure with changing market conditions. These
restructuring plans resulted in a reduction in headcount and
consolidation of facilities through the closing of excess
offices. Our restructuring costs included accruals for the
estimated loss on facilities that we intend to sublease based on
estimates of the timing and amount of sublease income. We
reassess this liability each period based on market conditions.
Revisions to our estimates of this liability could materially
impact our operating results and financial position in future
period if anticipated events and key

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assumptions, such as the timing and amounts of
sublease rental income, either change or do not materialize.


Litigation and Contingencies

We are subject to the possibility of various loss
contingencies arising in the ordinary course of business. We
consider the likelihood of loss or impairment of an asset or the
incurrence of a liability, as well as our ability to reasonably
estimate the amount of loss in determining loss contingencies.
An estimated loss contingency is accrued when it is probable
that an asset has been impaired or a liability has been incurred
and the amount of loss can be reasonably estimated. We regularly
evaluate current information available to us to determine
whether such accruals should be adjusted.

RESULTS OF OPERATIONS

The following table summarizes the results of our
operations for each of the past three fiscal years (all
percentages are calculated using the underlying data in
thousands):

|                         |  |                  |         |            |  |           |        |            |  |           |         |    |  |  |       |    |  |  |         |   
|------------------------ |  | ---------------- | ------- | ---------- |  | --------- | ------ | ---------- |  | --------- | ------- | -- |  |  | ----- | -- |  |  | ------- | --
|                         |  | March 31,        |         | Percentage |  | March 31, |        | Percentage |  | March 31,
|                         |  | 2004             |         | Change     |  | 2003      |        | Change     |  | 2002     
|                         |  |                  |         |            |  |           |        |            |  |          
|                         |  |                 
|                         |  | ($ in thousands)
|Total revenue            |  |                  | 194,525 |            |  |           | (1.1   | )%         |  |           | 196,754 |    |  |  | 0.4   | %  |  |  | 195,996 |   
|Gross profit             |  |                  | 137,727 |            |  |           | (9.8   | )%         |  |           | 152,629 |    |  |  | 1.0   | %  |  |  | 151,101 |   
|% of total revenue       |  |                  | 70.8    | %          |  |           |        |            |  |           | 77.6    | %  |  |  |       |    |  |  | 77.1    | % 
|Total operating expenses |  |                  | 167,488 |            |  |           | 2.0    | %          |  |           | 164,290 |    |  |  | (30.7 | )% |  |  | 237,147 |   
|% of total revenue       |  |                  | 86.1    | %          |  |           |        |            |  |           | 83.5    | %  |  |  |       |    |  |  | 121.0   | % 
|Operating loss           |  |                  | (29,761 | )          |  |           | (155.2 | )%         |  |           | (11,661 | )  |  |  | (86.4 | )% |  |  | (86,046 | ) 
|% of total revenue       |  |                  | (15.3   | )%         |  |           |        |            |  |           | (5.9    | )% |  |  |       |    |  |  | (43.9   | )%
|Net loss                 |  |                  | (27,911 | )          |  |           | (221.4 | )%         |  |           | (8,585  | )  |  |  | (89.6 | )% |  |  | (82,709 | ) 
|% of total revenue       |  |                  | (14.3   | )%         |  |           |        |            |  |           | (4.4    | )% |  |  |       |    |  |  | (42.2   | )%

During fiscal year 2004, our total revenue
decreased slightly to $194.5 million from $196.8 million in
fiscal year 2003, and $196.0 million in fiscal year 2002.
Our fiscal year 2004 license revenue was negatively impacted by
the continued uncertainty in information technology spending and
lower-than-anticipated Americas license revenue. Additionally,
we entered the first quarter of fiscal year 2004 with our quota
bearing sales headcount down approximately 10%, which resulted
in lower than anticipated Americas license revenue, particularly
in the first half of the year. The decrease in license revenue
in fiscal year 2004 was partially offset by an increase in
maintenance and professional services revenue. In addition,
during the last three quarters of fiscal 2004, license and total
revenue increased sequentially in each quarter, both in the
Americas and on a worldwide consolidated basis.

Our net loss increased to $27.9 million in
fiscal year 2004 from $8.6 million in fiscal year 2003 due,
primarily, to a decrease in license revenue, an increase in
professional services costs, the addition of in-process research
and development and intangibles amortization related to the
acquisitions in October 2003 and the settlement of an
intellectual property matter in March 2004. Our net loss
decreased from $82.7 million in fiscal year 2002 to
$8.6 million in fiscal year 2003 due, primarily, to the
cessation of amortization of goodwill and indefinite lived
intangibles, reduced sales and marketing costs, lower charges
for impairment of equity investments and reduced restructuring
and related charges.

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Revenue

The following table summarizes webMethods
revenue for each of the past three fiscal years:

|                      |  |                  |         |            |  |           |       |            |  |           |         |  |  |  |      |    |  |   |         | 
|--------------------- |  | ---------------- | ------- | ---------- |  | --------- | ----- | ---------- |  | --------- | ------- |  |  |  | ---- | -- |  | - | ------- | 
|                      |  | March 31,        |         | Percentage |  | March 31, |       | Percentage |  | March 31,
|                      |  | 2004             |         | Change     |  | 2003      |       | Change     |  | 2002     
|                      |  |                  |         |            |  |           |       |            |  |          
|                      |  |                 
|                      |  | ($ in thousands)
|License               |  | $                | 97,282  |            |  |           | (16.9 | )%         |  | $         | 117,066 |  |  |  | (3.9 | )% |  | $ | 121,803 | 
|Professional services |  |                  | 43,923  |            |  |           | 31.6  | %          |  |           | 33,378  |  |  |  | (6.8 | )% |  |   | 35,800  | 
|Maintenance           |  |                  | 53,320  |            |  |           | 15.1  | %          |  |           | 46,310  |  |  |  | 20.6 | %  |  |   | 38,393  | 
|                      |  |                  |         |            |  |           |       |            |  |           |         |  |  |  |      |    |  |   |         | 
|Total revenue         |  | $                | 194,525 |            |  |           | (1.1  | )%         |  | $         | 196,754 |  |  |  | 0.4  | %  |  | $ | 195,996 | 
|                      |  |                  |         |            |  |           |       |            |  |           |         |  |  |  |      |    |  |   |         | 

The following table summarizes webMethods
net revenue by geographic region for each of the past three
fiscal years:




|              |  |                  |         |            |  |           |       |            |  |           |         |  |  |  |       |    |  |   |         | 
|------------- |  | ---------------- | ------- | ---------- |  | --------- | ----- | ---------- |  | --------- | ------- |  |  |  | ----- | -- |  | - | ------- | 
|              |  | March 31,        |         | Percentage |  | March 31, |       | Percentage |  | March 31,
|              |  | 2004             |         | Change     |  | 2003      |       | Change     |  | 2002     
|              |  |                  |         |            |  |           |       |            |  |          
|              |  |                 
|              |  | ($ in thousands)
|Americas      |  | $                | 114,507 |            |  |           | (14.4 | )%         |  | $         | 133,756 |  |  |  | (6.5  | )% |  | $ | 143,003 | 
|Europe        |  |                  | 44,965  |            |  |           | 23.7  | %          |  |           | 36,351  |  |  |  | 1.9   | %  |  |   | 35,666  | 
|Japan         |  |                  | 20,456  |            |  |           | 33.9  | %          |  |           | 15,274  |  |  |  | 130.3 | %  |  |   | 6,632   | 
|Asia Pacific  |  |                  | 14,597  |            |  |           | 28.4  | %          |  |           | 11,373  |  |  |  | 6.3   | %  |  |   | 10,695  | 
|              |  |                  |         |            |  |           |       |            |  |           |         |  |  |  |       |    |  |   |         | 
|Total revenue |  | $                | 194,525 |            |  |           | (1.1  | )%         |  | $         | 196,754 |  |  |  | 0.4   | %  |  | $ | 195,996 | 
|              |  |                  |         |            |  |           |       |            |  |           |         |  |  |  |       |    |  |   |         | 




Our total revenue decreased by $2.2 million,
or 1%, in fiscal year 2004 from fiscal year 2003, and increased
by $758,000 or less than 1% in fiscal year 2003 from fiscal year
2002. Our ability to maintain our software license revenue, a
major component of revenue, continued to be impacted by the
economic downturn and uncertainty in information technology
spending, particularly in the Americas, as well as the impact of
our quota bearing sales representatives in the Americas being
down approximately 10% at the beginning of fiscal year 2004 and
lower-than-anticipated license revenue in the Americas,
particularly in the first half of fiscal year 2004. Many
enterprises continue to be cautious and subject information
technology (IT) purchases to more rigorous internal reviews and
approvals, which often result in longer sales cycles, the
postponement of IT projects or customers placing smaller orders.
Total revenue included a $9.2 million positive foreign
currency impact from certain international markets in fiscal
year 2004, which had minimal impact on operating margins because
total cost of revenue and operating expenses in fiscal year 2004
were negatively impacted by approximately $9.2 million due to
foreign currency fluctuations. In addition, license revenue and
total revenue increased sequentially in each of the last three
quarters of our fiscal year, both in the Americas and on a
worldwide consolidated basis. These increases in the last two
quarters of fiscal year 2004 were due in part to sales of the
products we acquired in connection with the three acquisitions
completed in October 2003.

Professional services revenue increased by
$10.5 million, or 32%, to $43.9 million, for fiscal
year 2004 compared to $33.4 million for fiscal year 2003.
This increase was primarily due to an increase in the volume
and/or size of customer engagements, the increased use of
subcontractors and, to a lesser extent, a $2.0 million
positive foreign currency impact. In fiscal year 2003,
professional services revenue decreased 7%, to
$33.4 million, from $35.8 million in fiscal year 2002.

Maintenance revenue increased $7.0 million,
or 15%, from $46.3 million to $53.3 million in fiscal
year 2004, and $7.9 million, or 21%, from
$38.4 million to $46.3 million in fiscal year 2003.
This increase is due primarily to the increase in customers
licensing our software and the cumulative effect of agreements
for post-contract maintenance and support, which is recognized
as revenue ratably over the term of the contract. Additionally,
more customers have moved to our 24x7 support plans given the
mission critical nature of their integration projects.
Furthermore, the increase in maintenance revenue was partially
due to a $2.1 million foreign currency impact.

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In fiscal year 2004, revenue from the Americas
declined $19.3 million, or 14%, from $133.8 million to
$114.5 million due primarily to the uncertainty in
information technology spending as well as the lower number of
quota bearing sales representatives at the beginning of the
first quarter of fiscal year 2004, as described above. Total
revenue from Europe, Asia Pacific and Japan (international
revenue) increased $17.0 million to
$80.0 million and included a $9.2 million positive
foreign currency impact. International revenue accounted for 41%
of our total revenue in fiscal year 2004 as compared to 32% and
27% in 2003 and 2002, respectively.

Gross Profit

The following table summarizes our gross profit,
excluding stock based compensation, by type of revenue for each
of the past three fiscal years:

|                                      |  |                   |    |           |  |           |    |   |  |  |    |  
|------------------------------------- |  | ----------------- | -- | --------- |  | --------- | -- | - |  |  | -- | -
|                                      |  |                  
|                                      |  | Fiscal Year Ended
|                                      |  |                  
|                                      |  | March 31,         |    | March 31, |  | March 31,
|                                      |  | 2004              |    | 2003      |  | 2002     
|                                      |  |                   |    |           |  |          
|License                               |  |                   | 96 | %         |  |           | 98 | % |  |  | 98 | %
|Professional services and maintenance |  |                   | 45 | %         |  |           | 47 | % |  |  | 43 | %
|Total revenue                         |  |                   | 71 | %         |  |           | 78 | % |  |  | 77 | %

Our total gross profit, excluding stock based
compensation, decreased to 71% in fiscal year 2004 from 78% and
77% in fiscal years 2003 and 2002, respectively. This decrease
was primarily due to a decrease in license revenue as a percent
of total revenue, an increase in the total cost of professional
services and maintenance as compared to fiscal year 2003 and an
increase in cost of revenue due to amortization of intangibles
of $1.2 million related to the October 2003
acquisitions.

Our cost of license revenue consists of royalties
for products embedded in our software licensed from third
parties. In addition, we acquired certain technology in fiscal
year 2004 that resulted in amortization of intangibles in the
amount of $1.2 million, which is included in our license
margin. Accordingly, our gross profit on license revenue was
approximately 96% in fiscal year 2004, as compared to 98% in
fiscal years 2003 and 2002.

Our cost of professional services and maintenance
consists primarily of costs related to internal professional
services and support personnel, and subcontractors hired to
provide implementation and support services. Our gross profit on
maintenance and services, excluding stock based compensation,
was 45%, 47% and 43% in fiscal years 2004, 2003 and 2002,
respectively. Our gross profit, excluding stock based
compensation, in fiscal year 2004 was negatively impacted by an
increase in subcontractor activity and nonbillable travel,
training and other activities as well as a decrease in billing
rates. Our gross profit, excluding stock based compensation, in
fiscal year 2002 was negatively impacted due to increases in the
number of professional service and technical support personnel,
and, to a lesser extent, an increase in subcontractor and travel
expenses.

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Operating Expenses

The following table presents certain information
regarding webMethods operating expenses during each of the
past three fiscal years:

|                                              |  |                   |         |                  |  |           |       |            |  |           |         |   |  |  |        |    |  |   |         |  
|--------------------------------------------- |  | ----------------- | ------- | ---------------- |  | --------- | ----- | ---------- |  | --------- | ------- | - |  |  | ------ | -- |  | - | ------- | -
|                                              |  |                  
|                                              |  | Fiscal Year Ended
|                                              |  |                  
|                                              |  | March 31,         |         | Percentage       |  | March 31, |       | Percentage |  | March 31,
|                                              |  | 2004              |         | Change           |  | 2003      |       | Change     |  | 2002     
|                                              |  |                   |         |                  |  |           |       |            |  |          
|                                              |  |                   |         |                  |  |           |       |           
|                                              |  |                   |         | ($ in thousands) |  |           |       |           
|Operating Expenses:                           |  |                   |         |                  |  |           |       |            |  |           |         |   |  |  |        |    |  |   |         |  
|Sales and marketing*                          |  | $                 | 91,325  |                  |  |           | (1.2  | )%         |  | $         | 92,958  |   |  |  | (12.6  | )% |  | $ | 106,377 |  
|% of total revenue                            |  |                   | 47.0    | %                |  |           |       |            |  |           | 47.2    | % |  |  |        |    |  |   | 54.3    | %
|Research and development*                     |  |                   | 45,045  |                  |  |           | (5.1  | )%         |  |           | 47,441  |   |  |  | (4.4   | )% |  |   | 49,634  |  
|% of total revenue                            |  |                   | 23.2    | %                |  |           |       |            |  |           | 24.1    | % |  |  |        |    |  |   | 25.3    | %
|General and administrative*                   |  |                   | 17,873  |                  |  |           | 0.2   | %          |  |           | 17,831  |   |  |  | (8.0   | )% |  |   | 19,372  |  
|% of total revenue                            |  |                   | 9.2     | %                |  |           |       |            |  |           | 9.1     | % |  |  |        |    |  |   | 9.9     | %
|Stock based compensation and warrant charge** |  |                   | 2,791   |                  |  |           | (28.5 | )%         |  |           | 3,905   |   |  |  | (75.3  | )% |  |   | 15,824  |  
|% of total revenue                            |  |                   | 1.4     | %                |  |           |       |            |  |           | 2.0     | % |  |  |        |    |  |   | 8.1     | %
|Restructuring and related charges             |  |                   | 3,920   |                  |  |           | (81.9 | )%         |  |           | 2,155   |   |  |  | (70.2  | )% |  |   | 7,243   |  
|% of total revenue                            |  |                   | 2.0     | %                |  |           |       |            |  |           | 1.1     | % |  |  |        |    |  |   | 3.7     | %
|Amortization of goodwill and intangibles      |  |                   |        |                  |  |           | 0.0   | %          |  |           |        |   |  |  | (100.0 | )% |  |   | 38,697  |  
|% of total revenue                            |  |                   | 0.0     | %                |  |           |       |            |  |           | 0.0     | % |  |  |        |    |  |   | 19.7    | %
|In-process research and development           |  |                   | 4,284   |                  |  |           | 100.0 | %          |  |           |        |   |  |  | 0.0    | %  |  |   |        |  
|% of total revenue                            |  |                   | 2.2     | %                |  |           |       |            |  |           | 0.0     | % |  |  |        |    |  |   | 0.0     | %
|Settlement of intellectual property matter    |  |                   | 2,250   |                  |  |           | 100.0 | %          |  |           |        |   |  |  | 0.0    | %  |  |   |        |  
|% of total revenue                            |  |                   | 1.2     | %                |  |           |       |            |  |           | 0.0     | % |  |  |        |    |  |   | 0.0     | %
|Operating expense                             |  | $                 | 167,488 |                  |  |           | 2.0   | %          |  | $         | 164,290 |   |  |  | (30.7  | )% |  | $ | 237,147 |  
|% of total revenue                            |  |                   | 86.1    | %                |  |           |       |            |  |           | 83.5    | % |  |  |        |    |  |   | 121.0   | %



---



|   |                                                                                                                                                                                                                                       
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*  | Excludes stock based compensation and warrant
    charge if applicable.                                                                                                                                                               
|  
|** | Includes stock based compensation that would be
    included in sales and marketing, research and development and
    general and administrative expense and warrant charge that would
    be included in sales and marketing expense.

Our operating expenses are primarily classified
as sales and marketing, research and development and general and
administrative. Each category includes related expenses for
compensation, employee benefits, professional fees, travel,
communications and allocated facilities, recruitment and
overhead costs. Our sales and marketing expenses also include
expenses which are specific to the sales and marketing
activities, such as commissions, trade shows, public relations,
business development costs, promotional costs and marketing
collateral. Also included in our operating expenses is the
amortization of deferred stock compensation and deferred warrant
charge, restructuring and related charges, amortization of
goodwill and intangibles, settlement of intellectual property
matter and in-process research and development. Total cost of
revenue and operating expenses for fiscal year 2004 were
negatively impacted by approximately $9.2 million due to
foreign currency fluctuations. This negative expense impact was
offset by an approximately $9.2 million positive foreign
currency impact to total revenue, resulting in minimal impact to
operating margins in fiscal year 2004.

Operating expenses, excluding stock based
compensation and warrant charge, in-process research and
development, settlement of intellectual property matter and
restructuring and related charges, totaled $154.2 million
in fiscal year 2004, a decrease of $4.0 million, or 3%,
from fiscal year 2003 due to our continued focus on expense
management despite a $5.1 million negative foreign currency
impact.

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Operating expenses, excluding stock based
compensation and warrant charge, amortization of goodwill and
intangibles and restructuring and related charges, totaled
$158.2 million in fiscal year 2003, as compared to
$175.4 million in fiscal year 2002. The 10% decrease in
those operating expenses from fiscal year 2002 to fiscal year
2003 was primarily due to our intense focus on expense
management following a restructuring in fiscal year 2003. We
increasingly focused on expense management and reduced our
quarterly fiscal year 2003 operating expenses, excluding stock
based compensation and warrant charge and restructuring and
related charges, by 15%, from $49.4 million in the first
fiscal quarter to $42.2 million in the fourth fiscal
quarter.


Sales and marketing expense, excluding stock
based compensation and warrant charge, was 47%, 47% and 54% of
total revenue in fiscal years 2004, 2003 and 2002, respectively.
In fiscal year 2004, sales and marketing expense, excluding
stock based compensation and warrant charge, decreased to
$91.3 million from $93.0 million in fiscal year 2003.
This decrease was primarily due to a decrease in personnel
costs, commission expense, travel expense and sales assistance
fees paid to partners offset by increases in marketing program
costs, professional services and recruiting expenses. In
addition, these decreases were further offset by a
$4.7 million increase in expenses due to the foreign
currency impact. In fiscal year 2003, sales and marketing
expense, excluding stock based compensation and warrant charge,
decreased to $93.0 million from $106.0 million in
fiscal year 2002. This decrease was primarily due to a decrease
in the employee compensation and benefit expense arising from
decreased average headcount, and decreases in sales assistance
fees paid to partners, marketing program costs, recruiting
expenses and commission expense.

Research and development expense, excluding stock
based compensation, was 23%, 24% and 25% of total revenue in
fiscal years 2004, 2003 and 2002, respectively. In fiscal year
2004, research and development expense, excluding stock based
compensation, decreased $2.4 million primarily due to
continued reduction in the use of outside contractors and
reduced personnel costs offset by an increase in recruiting
costs. In fiscal year 2003, research and development expense,
excluding stock based compensation, decreased $2.2 million
primarily due to reduced personnel cost, reduced travel expenses
and the reduction in the use of outside contractors. This
increase was offset by a reduction in third-party development
expenses.

General and administrative expense, excluding
stock based compensation, as a percentage of total revenue, was
9% for fiscal years 2004 and 2003 and 10% for fiscal year 2002.
In fiscal year 2004, general and administrative expenses,
excluding stock based compensation, increased $42,000 from
fiscal year 2003 to $17.9 million. During this period,
general and administrative expenses were negatively affected by
a $400,000 unfavorable foreign currency impact, which was offset
by equivalent favorable decreases in miscellaneous costs. In
fiscal year 2003, general and administrative expense, excluding
stock based compensation, decreased $1.5 million from
fiscal year 2002 to $17.8 million. This decrease is
primarily due to a reduction in the provision for doubtful
accounts due to the improved quality and aging of our accounts
receivable. This decrease was partially offset by employee
compensation and benefit expense related to increased average
headcount.

Stock based compensation and warrant charge was
$2.8 million, $4.2 million and $16.3 million in
fiscal years 2004, 2003 and 2002, respectively, of which
$56,000, $251,000, and $436,000 was included in cost of sales.
Deferred stock based compensation and warrant charge was
recorded for the following transactions:



| |                                                                                                                                                                                                                                                                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (i) In connection with the grant of stock
    options to employees and non-employee directors during the
    fiscal years ended March 31, 2000 and 1999, we recorded
    aggregate unearned compensation of $15.5 million,
    representing the difference between the deemed fair value of our
    common stock at the date of grant and the exercise price of such
    options.
|
| | (ii) As a result of the acquisitions of
    Translink Software, Inc., Premier Software Technology, Inc. and
    Alier, Inc. we recorded a deferred stock compensation charge of
    $27.9 million related to restricted stock issued to
    stockholders of the acquired companies.                                                                                              

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (iii) In connection with the acquisition of
    Active Software, in August 2000, 50% of Active Softwares
    remaining options vested upon consummation of the merger which
    resulted in an acceleration of amortization of deferred stock
    compensation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| | (iv) In March 2001 we entered into an OEM/
    Reseller agreement with i2 Technologies (i2) and issued a
    warrant which, as amended, permits i2 to purchase 710,000 shares
    of our common stock at an exercise price of $28.70 per
    share. The fair value of the warrant was based on the
    Black-Scholes valuation model was $23.6 million on the date
    of issuance which has been recorded as a deferred warrant
    charge. As part of the agreement, i2 will pay us Original
    Equipment Manufacturer (OEM) fees of $10.0 million over the
    term of the OEM/ Reseller agreement which will be recorded as a
    reduction to the deferred warrant charge and will not be
    recorded as revenue. In March 2004, we amended our OEM/ Reseller
    agreement with i2. We extended the term of the agreement by one
    year to March 2006 and also reduced the number of required
    webMethods on-site resources from 10 to 1 which resulted in a
    corresponding reduction of $1.3 million in OEM fees due
    under the agreement. Due to this change in the agreement, the
    amortization of the remaining unamortized deferred warrant
    charge has been changed from 4 years to 5 years to coincide with
    the new payment schedule, resulting in a decrease in the annual
    amortization of $757,000 from $3,402,000 to $2,645,000.
    Additionally, we made changes relating to the sharing of revenue
    related to maintenance.

The deferred stock compensation and warrant
charge is presented as a reduction of stockholders equity
and is amortized over the vesting period of the applicable
equity arrangement and is shown by expense category.

During our third quarter of fiscal year 2004 (the
quarter ended December 31, 2003), we reduced headcount by 39
employees representing a decrease of approximately 4%. In
connection with this reduction we recorded a restructuring
charge of $1.3 million, of which we have paid
$1.2 million. During our fourth quarter of fiscal year 2004
(the quarter ended March 31, 2004), we reduced headcount by
20 employees representing a decrease of approximately 2%.
In connection with this reduction we recorded a restructuring
charge of $2.6 million, consisting of $850,000 for
headcount reductions and $1.8 million for other related
restructuring charges. These reductions in headcount were more
than offset by increases in headcount related to the
acquisitions and purchase of technology previously discussed and
were part of an overall plan to further align our costs relative
to these investments and the overall strategy of the company.

During fiscal year 2001 and the first quarter of
fiscal year 2002 (the quarter ended June 30, 2001), we
increased personnel and infrastructure costs as we experienced
significant growth in revenue and demand for our software and
services and anticipated that growth to continue. We then
reassessed the demand for our software and services and, in
early July 2001, took decisive actions to reduce our operating
expenses to realign our cost structure to address the changing
market conditions resulting from the slow down in the global
economy. As part of this action, we reduced headcount by 14%, or
150 employees, through a reduction in force, closed excess sales
offices and consolidated our California facilities into two
locations. The headcount reductions were across all departments
with the exception of customer support. We recorded a
restructuring charge of $7.2 million, consisting of
$2.5 million for headcount reductions, $4.0 million
for consolidation of facilities, and $700,000 for other related
restructuring charges. Of these amounts, we have paid
$6.3 million since implementing the restructuring. The
remaining restructuring charges of $917,000 related to rent on
the excess facilities, and will be paid over the remaining
rental period extending through March 2008. During the third
quarter of fiscal year 2003 (the quarter ended December 31,
2002), we reduced headcount by 43 employees to 889, a 5%
decrease. In connection with this reduction, we recorded a
restructuring charge of $2.2 million, of which we have paid
$1.6 million.

We recorded goodwill and intangible assets in
connection with the acquisition of Premier and Translink in
fiscal year 2001. Amortization of goodwill and acquired
intangibles was $38.7 million in fiscal year 2002. The
estimated useful life of the goodwill and the acquired
intangibles was three years for trained and acquired assembled
workforce, one year for license agreements, two years for
non-compete agreements, three years for goodwill and four years
for favorable lease terms. Amortization of the goodwill and
indefinite lived intangibles ceased beginning April 1, 2002
upon our adoption of SFAS 142.

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We incurred an in-process research and
development charge of $4.3 million for fiscal year 2004.
There was no in-process research and development charge for
fiscal years 2003 and 2002. The $4.3 million charge during
fiscal year 2004 consists of: (i) a one-time charge of
$3.1 million recorded in connection with the acquisition
and write-off of The Dante Group technology and (ii) a
one-time charge of $1.2 million recorded in connection with
the acquisition and write-off of The Mind Electric technology.
We also incurred a $2.25 million charge in fiscal year 2004
related to the settlement of an intellectual property matter,
which is described in Item 3, Legal Proceedings, in this
report.

Interest income

Interest income decreased by approximately
$1.9 million or 40% to $2.9 million for fiscal year
2004 from $4.7 million for fiscal year 2003. Interest
income decreased by approximately $4.4 million or 48% to
$4.7 million for fiscal year 2003 from $9.1 million
for fiscal year 2002. These decreases for both periods were
primarily attributable to lower interest rates on corporate
paper, bonds and money market funds compared to those in the
same period in the prior year.

Interest expense

Interest expense is primarily due to equipment
leasing arrangements in the Americas. During fiscal year 2004,
interest expense decreased $469,000 to $205,000 from $674,000
during fiscal year 2003 due to the completion of previously
established leases and lower rates on leases initiated during
fiscal 2004. During fiscal year 2003 interest expense increased
$121,000 to $674,000 from $553,000 during fiscal year 2002. This
increase was primarily due to the continued addition of new
leases during fiscal 2003.

Other income (expense), net

Other income (expense), net includes gains and
losses on foreign currency transactions. During fiscal year 2004
our foreign currency transaction loss increased $491,000 to
$473,000 from an $18,000 gain in fiscal 2003. This was primarily
due to U.S. Dollar based contracts in Europe and U.S. Dollar
cash accounts held by operating subsidiaries in Europe and
Japan. During fiscal 2002 we experienced a $26,000 foreign
currency transaction loss.

Impairment of equity investment in private
companies

We recognized an other-than-temporary decline in
value of $1.0 million in one private company investment and
$5.2 million in four private company equity investments for
fiscal years 2003 and 2002, respectively. There was no further
impairment of these investments for fiscal year 2004.

Income taxes

We have recorded a valuation allowance for the
full amount of our net deferred tax assets, as the realizability
of the deferred tax assets is not currently predictable.

As of March 31, 2004, we had net operating
loss carry-forwards of approximately $276.9 million. These
net operating loss carry-forwards are available to reduce future
taxable income and begin to expire in fiscal year 2007. Under
the provisions of the Internal Revenue Code, certain substantial
changes in our ownership have limited the amount of net
operating loss carry-forwards that could be utilized annually in
the future to offset taxable income.

For fiscal year 2004, our operations in Japan
incurred tax expense of $323,000 after fully utilizing its net
operating losses generated in prior years.

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##### Table of Contents



Quarterly results of operations

The following tables set forth consolidated
statement of operations data for each of the eight quarters
ended March 31, 2004, as well as that data expressed as a
percentage of the total revenue for the quarters presented. This
information has been derived from our unaudited consolidated
financial statements. The unaudited consolidated financial
statements have been prepared on the same basis as the audited
consolidated financial statements contained elsewhere in this
report and include all adjustments, consisting only of normal
recurring adjustments that we consider necessary for a fair
presentation of such information. You should read this
information in conjunction with our annual audited consolidated
financial statements and related notes appearing elsewhere in
this report. Historical results may not be indicative of future
results.

|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        | 
|--------------------------------------------------------- | ------------------------------------------ | ------------------------------------------- | ------------------------ | -------- | ------ | --------- | ------- | -------- | ------ | -------- | ------ | -------- | ------ | --------- | ------ | -------- | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | 
|                                                          |                                            |                                            
|                                                          |                                            | Three Months Ended                         
|                                                          |                                            |                                            
|                                                          |                                            | Mar. 31,                                    |                          | Dec. 31, |        | Sept. 30, |         | June 30, |        | Mar. 31, |        | Dec. 31, |        | Sept. 30, |        | June 30,
|                                                          |                                            | 2004                                        |                          | 2003     |        | 2003      |         | 2003     |        | 2003     |        | 2002     |        | 2002      |        | 2002    
|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |         
|                                                          |                                            |                                            
|                                                          |                                            | (In thousands)                             
|Revenue:                                                  |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|                                                          | License                                    |                                             | $                        | 28,418   |        |           | $       | 25,037   |        |          | $      | 22,025   |        |           | $      | 21,802   |        |        | $      | 27,982 |        |        | $      | 33,940 |        |        | $      | 26,475 |        |        | $      | 28,669 |       
|                                                          | Professional services                      |                                             |                          | 13,262   |        |           |         | 11,210   |        |          |        | 10,578   |        |           |        | 8,873    |        |        |        | 8,641  |        |        |        | 7,951  |        |        |        | 8,584  |        |        |        | 8,202  |       
|                                                          | Maintenance                                |                                             |                          | 14,133   |        |           |         | 13,851   |        |          |        | 12,786   |        |           |        | 12,550   |        |        |        | 12,478 |        |        |        | 11,919 |        |        |        | 11,103 |        |        |        | 10,810 |       
|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|                                                          |                                            |                                             | Total revenue            |          |        | 55,813    |         |          |        | 50,098   |        |          |        | 45,389    |        |          |        | 43,225 |        |        |        | 49,101 |        |        |        | 53,810 |        |        |        | 46,162 |        |        |        | 47,681 | 
|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|Cost of revenue:                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|                                                          | Amortization of intangibles                |                                             |                          | 600      |        |           |         | 599      |        |          |        |         |        |           |        |         |        |        |        |       |        |        |        |       |        |        |        |       |        |        |        |       |       
|                                                          | License                                    |                                             |                          | 588      |        |           |         | 601      |        |          |        | 555      |        |           |        | 467      |        |        |        | 512    |        |        |        | 765    |        |        |        | 525    |        |        |        | 135    |       
|                                                          | Professional services and maintenance:     |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|                                                          |                                            | Stock based compensation                    |                          |          |       |           |         |          | 12     |          |        |          | 22     |           |        |          | 22     |        |        |        | 34     |        |        |        | 65     |        |        |        | 76     |        |        |        | 76     |       
|                                                          |                                            | Other professional services and maintenance |                          |          | 15,656 |           |         |          | 13,614 |          |        |          | 12,403 |           |        |          | 11,659 |        |        |        | 10,593 |        |        |        | 10,409 |        |        |        | 10,668 |        |        |        | 10,267 |       
|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|                                                          |                                            |                                             | Total cost of revenue    |          |        | 16,844    |         |          |        | 14,826   |        |          |        | 12,980    |        |          |        | 12,148 |        |        |        | 11,139 |        |        |        | 11,239 |        |        |        | 11,269 |        |        |        | 10,478 | 
|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|Gross profit                                              |                                            |                                             | 38,969                   |          |        |           | 35,272  |          |        |          | 32,409 |          |        |           | 31,077 |          |        |        | 37,962 |        |        |        | 42,571 |        |        |        | 34,893 |        |        |        | 37,203 |       
|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|Operating expenses:                                       |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|                                                          | Sales and marketing:                       |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|                                                          |                                            | Stock based compensation and warrant charge |                          |          | 663    |           |         |          | 689    |          |        |          | 721    |           |        |          | 696    |        |        |        | 912    |        |        |        | 896    |        |        |        | 983    |        |        |        | 970    |       
|                                                          |                                            | Other sales and marketing                   |                          |          | 22,791 |           |         |          | 24,617 |          |        |          | 21,467 |           |        |          | 22,450 |        |        |        | 21,747 |        |        |        | 24,309 |        |        |        | 22,592 |        |        |        | 24,310 |       
|                                                          | Research and development:                  |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|                                                          |                                            | Stock based compensation                    |                          |          |       |           |         |          | 5      |          |        |          | 10     |           |        |          |       |        |        |        | 12     |        |        |        | 26     |        |        |        | 40     |        |        |        | 19     |       
|                                                          |                                            | Other research and development              |                          |          | 11,542 |           |         |          | 11,446 |          |        |          | 10,857 |           |        |          | 11,200 |        |        |        | 11,282 |        |        |        | 12,059 |        |        |        | 11,821 |        |        |        | 12,279 |       
|                                                          | General and administrative:                |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|                                                          |                                            | Stock based compensation                    |                          |          |       |           |         |          | 1      |          |        |          | 3      |           |        |          | 3      |        |        |        | 3      |        |        |        |       |        |        |        | 23     |        |        |        | 21     |       
|                                                          |                                            | Other general and administrative            |                          |          | 4,593  |           |         |          | 4,333  |          |        |          | 4,524  |           |        |          | 4,423  |        |        |        | 4,780  |        |        |        | 4,758  |        |        |        | 4,228  |        |        |        | 4,065  |       
|                                                          | Restructuring and related charges          |                                             |                          | 2,605    |        |           |         | 1,315    |        |          |        |         |        |           |        |         |        |        |        | (82    | )      |        |        | 2,237  |        |        |        |       |        |        |        |       |       
|                                                          | In-process research and development        |                                             |                          |         |        |           |         | 4,284    |        |          |        |         |        |           |        |         |        |        |        |       |        |        |        |       |        |        |        |       |        |        |        |       |       
|                                                          | Settlement of intellectual property matter |                                             |                          | 2,250    |        |           |         |         |        |          |        |         |        |           |        |         |        |        |        |       |        |        |        |       |        |        |        |       |        |        |        |       |       
|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|                                                          |                                            |                                             | Total operating expenses |          |        | 44,444    |         |          |        | 46,690   |        |          |        | 37,582    |        |          |        | 38,772 |        |        |        | 38,654 |        |        |        | 44,285 |        |        |        | 39,687 |        |        |        | 41,664 | 
|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|Operating loss                                            |                                            |                                             | (5,475                   | )        |        |           | (11,418 | )        |        |          | (5,173 | )        |        |           | (7,695 | )        |        |        | (692   | )      |        |        | (1,714 | )      |        |        | (4,794 | )      |        |        | (4,461 | )     
|Interest income                                           |                                            |                                             | 575                      |          |        |           | 549     |          |        |          | 721    |          |        |           | 1,006  |          |        |        | 921    |        |        |        | 1,105  |        |        |        | 1,244  |        |        |        | 1,462  |       
|Interest expense                                          |                                            |                                             | (42                      | )        |        |           | (56     | )        |        |          | (17    | )        |        |           | (90    | )        |        |        | (129   | )      |        |        | (193   | )      |        |        | (245   | )      |        |        | (107   | )     
|Other (expense)/income                                    |                                            |                                             | (288                     | )        |        |           | (198    | )        |        |          | (5     | )        |        |           | 18     |          |        |        | 57     |        |        |        | 63     |        |        |        | (86    | )      |        |        | (16    | )     
|Impairment of equity investments in private
    companies |                                            |                                             |                         |          |        |           |        |          |        |          |       |          |        |           |       |          |        |        |       |        |        |        |       |        |        |        | (1,000 | )      |        |        |       |       
|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|(Loss)/income before income taxes                         |                                            |                                             | (5,230                   | )        |        |           | (11,123 | )        |        |          | (4,474 | )        |        |           | (6,761 | )        |        |        | 157    |        |        |        | (739   | )      |        |        | (4,881 | )      |        |        | (3,122 | )     
|                                                          | Provision for income taxes                 |                                             |                          | 323      |        |           |         |         |        |          |        |         |        |           |        |         |        |        |        |       |        |        |        |       |        |        |        |       |        |        |        |       |       
|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       
|Net (loss)/income                                         |                                            | $                                           | (5,553                   | )        |        | $         | (11,123 | )        |        | $        | (4,474 | )        |        | $         | (6,761 | )        |        | $      | 157    |        |        | $      | (739   | )      |        | $      | (4,881 | )      |        | $      | (3,122 | )     
|                                                          |                                            |                                             |                          |          |        |           |         |          |        |          |        |          |        |           |        |          |        |        |        |        |        |        |        |        |        |        |        |        |        |        |        |       

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|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |      |      |       | 
|--------------------------------------------------------- | ------------------------------------------ | ------------------------------------------- | ------------------------ | -------- | ---- | --------- | ----- | -------- | ---- | -------- | ----- | -------- | ---- | --------- | ----- | -------- | ---- | ----- | ---- | ---- | ---- | ----- | ---- | ---- | ---- | ----- | ----- | ---- | ---- | ----- | ---- | ---- | ---- | ----- | 
|                                                          |                                            |                                            
|                                                          |                                            | As a Percentage of Total Revenue           
|                                                          |                                            |                                            
|                                                          |                                            | Mar. 31,                                    |                          | Dec. 31, |      | Sept. 30, |       | June 30, |      | Mar. 31, |       | Dec. 31, |      | Sept. 30, |       | June 30,
|                                                          |                                            | 2004                                        |                          | 2003     |      | 2003      |       | 2003     |      | 2003     |       | 2002     |      | 2002      |       | 2002    
|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |         
|Revenue:                                                  |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|                                                          | License                                    |                                             |                          | 50.9     | %    |           |       | 50.0     | %    |          |       | 48.5     | %    |           |       | 50.4     | %    |       |      | 57.0 | %    |       |      | 63.1 | %    |       |       | 57.4 | %    |       |      | 60.1 | %   
|                                                          | Professional services                      |                                             |                          | 23.8     |      |           |       | 22.4     |      |          |       | 23.3     |      |           |       | 20.6     |      |       |      | 17.6 |      |       |      | 14.8 |      |       |       | 18.6 |      |       |      | 17.2 |     
|                                                          | Maintenance                                |                                             |                          | 25.3     |      |           |       | 27.6     |      |          |       | 28.2     |      |           |       | 29.0     |      |       |      | 25.4 |      |       |      | 22.1 |      |       |       | 24.0 |      |       |      | 22.7 |     
|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|                                                          |                                            |                                             | Total revenue            |          |      | 100.0     |       |          |      | 100.0    |       |          |      | 100.0     |       |          |      | 100.0 |      |      |      | 100.0 |      |      |      | 100.0 |       |      |      | 100.0 |      |      |      | 100.0 | 
|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|Cost of revenue:                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|                                                          | Amortization of intangibles                |                                             |                          | 1.0      |      |           |       | 1.2      |      |          |       |         |      |           |       |         |      |       |      |     |      |       |      |     |      |       |       |     |      |       |      |     |     
|                                                          | License                                    |                                             |                          | 1.1      |      |           |       | 1.2      |      |          |       | 1.2      |      |           |       | 1.0      |      |       |      | 1.0  |      |       |      | 1.4  |      |       |       | 1.1  |      |       |      | 0.3  |     
|                                                          | Professional services and maintenance:     |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |      |     
|                                                          |                                            | Stock based compensation                    |                          |          |     |           |       |          |     |          |       |          | 0.1  |           |       |          | 0.1  |       |      |      | 0.1  |       |      |      | 0.1  |       |       |      | 0.2  |       |      |      | 0.2  |      
|                                                          |                                            | Other professional services and maintenance |                          |          | 28.1 |           |       |          | 27.2 |          |       |          | 27.3 |           |       |          | 27.0 |       |      |      | 21.6 |       |      |      | 19.4 |       |       |      | 23.1 |       |      |      | 21.5 |      
|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|                                                          |                                            |                                             | Total cost of revenue    |          |      | 30.2      |       |          |      | 29.6     |       |          |      | 28.6      |       |          |      | 28.1  |      |      |      | 22.7  |      |      |      | 20.9  |       |      |      | 24.4  |      |      |      | 22.0  | 
|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|Gross profit                                              |                                            |                                             | 69.8                     |          |      |           | 70.4  |          |      |          | 71.4  |          |      |           | 71.9  |          |      |       | 77.3 |      |      |       | 79.1 |      |      |       | 75.6  |      |      |       | 78.0 |     
|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|Operating expenses:                                       |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|                                                          | Sales and marketing:                       |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |      |     
|                                                          |                                            | Stock based compensation and warrant charge |                          |          | 1.2  |           |       |          | 1.4  |          |       |          | 1.6  |           |       |          | 1.6  |       |      |      | 1.9  |       |      |      | 1.7  |       |       |      | 2.1  |       |      |      | 2.0  |      
|                                                          |                                            | Other sales and marketing                   |                          |          | 40.8 |           |       |          | 49.1 |          |       |          | 47.3 |           |       |          | 51.9 |       |      |      | 44.3 |       |      |      | 45.2 |       |       |      | 48.9 |       |      |      | 51.0 |      
|                                                          | Research and development:                  |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |      |     
|                                                          |                                            | Stock based compensation                    |                          |          |     |           |       |          |     |          |       |          |     |           |       |          |     |       |      |      |     |       |      |      |     |       |       |      | 0.1  |       |      |      |     |      
|                                                          |                                            | Other research and development              |                          |          | 20.7 |           |       |          | 22.9 |          |       |          | 23.9 |           |       |          | 25.9 |       |      |      | 23.0 |       |      |      | 22.4 |       |       |      | 25.6 |       |      |      | 25.8 |      
|                                                          | General and administrative:                |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |      |     
|                                                          |                                            | Stock based compensation                    |                          |          |     |           |       |          |     |          |       |          |     |           |       |          |     |       |      |      |     |       |      |      |     |       |       |      |     |       |      |      |     |      
|                                                          |                                            | Other general and administrative            |                          |          | 8.2  |           |       |          | 8.7  |          |       |          | 10.0 |           |       |          | 10.2 |       |      |      | 9.7  |       |      |      | 8.8  |       |       |      | 9.3  |       |      |      | 8.6  |      
|                                                          | Restructuring and related charges          |                                             |                          | 4.7      |      |           |       | 2.7      |      |          |       |         |      |           |       |         |      |       |      | (0.2 | )    |       |      | 4.2  |      |       |       |     |      |       |      |     |     
|                                                          | In-process research and development        |                                             |                          |         |      |           |       | 8.6      |      |          |       |         |      |           |       |         |      |       |      |     |      |       |      |     |      |       |       |     |      |       |      |     |     
|                                                          | Settlement of intellectual property matter |                                             |                          | 4.0      |      |           |       |         |      |          |       |         |      |           |       |         |      |       |      |     |      |       |      |     |      |       |       |     |      |       |      |     |     
|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|                                                          |                                            |                                             | Total operating expenses |          |      | 79.6      |       |          |      | 93.2     |       |          |      | 82.8      |       |          |      | 89.7  |      |      |      | 78.7  |      |      |      | 82.3  |       |      |      | 86.0  |      |      |      | 87.4  | 
|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|Operating loss                                            |                                            |                                             | (9.8                     | )        |      |           | (22.8 | )        |      |          | (11.4 | )        |      |           | (17.8 | )        |      |       | (1.4 | )    |      |       | (3.2 | )    |      |       | (10.4 | )    |      |       | (9.4 | )   
|Interest income                                           |                                            |                                             | 1.0                      |          |      |           | 1.1   |          |      |          | 1.6   |          |      |           | 2.3   |          |      |       | 1.9  |      |      |       | 2.1  |      |      |       | 2.7   |      |      |       | 3.1  |     
|Interest expense                                          |                                            |                                             | (0.1                     | )        |      |           | (0.1  | )        |      |          |      |          |      |           | (0.2  | )        |      |       | (0.3 | )    |      |       | (0.4 | )    |      |       | (0.5  | )    |      |       | (0.2 | )   
|Other (expense)/income                                    |                                            |                                             | (0.5                     | )        |      |           | (0.4  | )        |      |          |      |          |      |           |      |          |      |       | 0.1  |      |      |       | 0.1  |      |      |       | (0.2  | )    |      |       |     |     
|Impairment of equity investments in private
    companies |                                            |                                             |                         |          |      |           |      |          |      |          |      |          |      |           |      |          |      |       |     |      |      |       |     |      |      |       | (2.2  | )    |      |       |     |     
|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|(Loss)/income before income taxes                         |                                            |                                             | (9.4                     | )        |      |           | (22.2 | )        |      |          | (9.9  | )        |      |           | (15.6 | )        |      |       | 0.3  |      |      |       | (1.4 | )    |      |       | (10.6 | )    |      |       | (6.6 | )   
|Provision for income taxes                                |                                            |                                             | (0.6                     | )        |      |           |      |          |      |          |      |          |      |           |      |          |      |       |     |      |      |       |     |      |      |       |      |      |      |       |     |     
|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     
|Net (loss)/income                                         |                                            |                                             | (10.0                    | )%       |      |           | (22.2 | )%       |      |          | (9.9  | )%       |      |           | (15.6 | )%       |      |       | 0.3  | %    |      |       | (1.4 | )%   |      |       | (10.6 | )%   |      |       | (6.6 | )%  
|                                                          |                                            |                                             |                          |          |      |           |       |          |      |          |       |          |      |           |       |          |      |       |      |      |      |       |      |      |      |       |       |      |      |       |      |     




LIQUIDITY AND CAPITAL RESOURCES

As of March 31, 2004 we had cash, cash
equivalents and short-term and long-term securities available
for sale in the amount of $155.9 million as compared to
$201.6 million as of March 31, 2003. This decrease was
due in part to $32.4 million of net cash used in connection
with the acquisitions of two business and the purchase of
technology previous discussed. The decrease in working capital
is primarily due to increased cash used in operations, the
reinvestment of certain marketable securities which were
previously short term in nature but have now been reinvested for
longer terms, and increases in accounts payable and accrual
balances offset by a decrease in cash used in investing
activities at March 31, 2004 as compared to March 31,
2003.

Net cash used in operating activities was
$17.7 million, $12.8 million, and $4.1 million in
fiscal years 2004, 2003 and 2002, respectively. The increase in
cash used in operating activities during fiscal year 2004

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compared to fiscal year 2003 was due primarily to
a larger net loss, offset by decreases in cash used for accounts
payable, accrued expenses and accrued salaries and commissions,
and decreases in deferred revenue balances and an increase in
the accounts receivable balance.


Net cash provided by investing activities was
$7.1 million in fiscal year 2004 and net cash used in
investing activities was $11.7 million and
$21.2 million in fiscal years 2003 and 2002, respectively.
Cash provided by investing activities in fiscal year 2004
primarily reflects net sales of marketable securities offset by
$32.4 million in cash used for the acquisition of
businesses and technology and $2.7 million in capital
expenditure. Cash used in investing activities in fiscal year
2003 and 2002 primarily reflects purchases of property and
equipment and net purchases of marketable securities offset in
fiscal 2002 by $2.0 million in proceeds from the repayment
of an investment in a private company. Capital expenditures were
$2.7 million, $3.0 million, and $5.9 million in
fiscal years 2004, 2003 and 2002, respectively. Capital
expenditures consisted of purchases of operating resources to
manage operations, including computer hardware and software,
office furniture and equipment and leasehold improvements. Since
inception, we have generally funded capital expenditures either
through capital leases and the use of working capital.

Net cash provided by financing activities was
$3.3 million, $4.4 million and $14.4 million in
fiscal years 2004, 2003 and 2002, respectively. These cash flows
primarily reflect net cash proceeds from exercises of stock
options and net cash proceeds from Employee Stock Purchase Plan
(ESPP) common stock issuances offset by payments on capital
leases. Net cash proceeds from exercises of stock options were
$3.0 million, $2.6 million and $10.5 million in
fiscal years 2004, 2003 and 2002 respectively. Net cash proceeds
from ESPP common stock issuances were $2.5 million,
$3.0 million and $5.0 million in fiscal years 2004,
2003 and 2002 respectively. Payments on capital leases were
$3.3 million, $4.9 million and $3.1 million in
fiscal years 2004, 2003 and 2002, respectively.

We have a line of credit to borrow up to a
maximum principal amount of $20,000,000 with a maturity date of
October 10, 2004, which we expect to renew. Any borrowings
under this line bear interest at the banks prime rate per
annum. As of March 31, 2004, we had not borrowed against
this line of credit. In connection with the line of credit, we
have a letter of credit totaling $235,000 related to an office
lease. Borrowings under this line are limited to 80% of eligible
accounts receivable. Interest is payable on the unpaid principal
balance at the banks prime rate.

We believe that our existing working capital and
our line of credit will be sufficient to meet our working
capital and operating resource expenditure requirements for at
least the next twelve months. However, we may utilize cash
resources to fund acquisitions or investments in complementary
businesses, technologies or product lines. In the event
additional financing is required, we may not be able to raise it
on acceptable terms or at all.




RECENTLY ISSUED ACCOUNTING
PRONOUNCEMENTS

In November 2002, the EITF reached a consensus on
EITF No. 00-21, Revenue Arrangements with Multiple
Deliverables. EITF No. 00-21 addresses certain
aspects of the accounting by a vendor for arrangements under
which the vendor will perform multiple revenue-generating
activities. EITF No. 00-21 will be effective for interim
periods beginning after June 15, 2003. We adopted EITF
No. 00-21 and have determined that it has no impact on our
financial position, results of operations or cash flows.

In January 2003, the Financial Accounting
Standards Board issued Interpretation No. 46 (FIN
No. 46), Consolidation of Variable Interest Entities,
an Interpretation of ARB No. 51, which relates to the
identification of, and financial reporting for,
variable-interest entities (VIEs). FIN No. 46 has
far-reaching effects and applies to new entities that are
created after January 31, 2003, as well as to existing VIEs
no later than the beginning of the first interim or annual
reporting period that starts after July 1, 2003. The
adoption of this standard did not have a material impact on our
financial position, results of operations and cash flows.

In May 2003, the Financial Accounting Standards
Board issued SFAS No. 150 (SFAS 150), Accounting
for Certain Financial Instruments with Characteristics of Both
Liabilities and Equity. SFAS

41



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150 requires that certain instruments with
certain characteristics be classified as liabilities as opposed
to equity. This statement is effective for financial instruments
entered into or modified after May 30, 2003, and otherwise
is effective July 1, 2003. The adoption of this standard
did not have a material impact on our financial position,
results of operations and cash flows.







|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
    MARKET RISK

We are exposed to a variety of risks, including
changes in interest rates affecting the return on our
investments and foreign currency fluctuations. We have
established policies and procedures to manage our exposure to
fluctuations in interest rates and foreign currency exchange
rates.

Interest rate risk.We maintain our funds in money market
accounts, corporate bonds, commercial paper, Treasury notes and
agency notes. Our exposure to market risk due to fluctuations in
interest rates relates primarily to our interest earnings on our
cash deposits. These securities are subject to interest rate
risk inasmuch as their fair value will fall if market interest
rates increase. If market interest rates were to increase
immediately and uniformly by 10% from the levels prevailing as
of March 31, 2004, the fair value of the portfolio would
not decline by a material amount. We do not use derivative
financial instruments to mitigate risks. However, we do have an
investment policy that would allow us to invest in short-term
and long-term investments such as money market instruments and
corporate debt securities. Our policy attempts to reduce such
risks by typically limiting the maturity date of such securities
to no more than twenty-four months with a maximum average
maturity to our whole portfolio of such investments at twelve
months, placing our investments with high credit quality issuers
and limiting the amount of credit exposure with any one issuer.

Foreign currency exchange rate risk.Our exposure to market risk due to
fluctuations in foreign currency exchange rates relates
primarily to the intercompany balances with our subsidiaries
located in Australia, Canada, United Kingdom, France, Germany,
Japan, the Netherlands, South Korea, Hong Kong, Malaysia and
Singapore. Transaction gains or losses have not been significant
in the past, and there is no hedging activity on foreign
currencies. We would not experience a material foreign exchange
loss based on a hypothetical 10% adverse change in the price of
the euro, Great Britain pound, Singapore dollar, Australian
dollar, Malaysian ringgit, South Korean won, Canadian dollar or
Japanese yen against the U.S. dollar. Consequently, we do not
expect that a reduction in the value of such accounts
denominated in foreign currencies resulting from even a sudden
or significant fluctuation in foreign exchange rates would have
a direct material impact on our financial position, results of
operations or cash flows.

Notwithstanding the foregoing, the direct effects
of interest rate and foreign currency exchange rate fluctuations
on the value of certain of our investments and accounts, and the
indirect effects of fluctuations in foreign currency could have
a material adverse effect on our business, financial condition
and results of operations. For example, international demand for
our products is affected by foreign currency exchange rates. In
addition, interest rate fluctuations may affect the buying
patterns of our customers. Furthermore, interest rate and
currency exchange rate fluctuations have broad influence on the
general condition of the U.S. foreign and global economics,
which could materially adversely affect our business, financial
condition results of operations and cash flows.






|        |                                                
|------- | -----------------------------------------------
|Item 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY
    DATA

The consolidated financial statements of
webMethods are submitted on pages F-1 through F-27 of this
report.

42



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##### Table of Contents








|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
    ON ACCOUNTING AND FINANCIAL DISCLOSURES

None.






|         |                        
|-------- | -----------------------
|Item 9A. | CONTROLS AND PROCEDURES

As of March 31, 2004, webMethods
management, including our Chief Executive Officer and Chief
Financial Officer, have conducted an evaluation of the
effectiveness of disclosure controls and procedures pursuant to
Exchange Act Rule 13a-15. Based on that evaluation, the
Chief Executive Officer and Chief Financial Officer have
concluded that our disclosure controls and procedures are
effective to ensure that information we are required to disclose
in reports that we file or submit under the Securities Exchange
Act of 1934, as amended, is recorded, processed, summarized and
reported within the time periods specified in Securities and
Exchange Commission rules and forms. While webMethods continues
the process of documenting, testing and enhancing, where
necessary or appropriate, its internal controls over financial
reporting, there have been no significant changes in internal
controls, or in factors that could significantly affect internal
controls, during the quarter ended March 31, 2004 that have
materially affected, or are reasonably likely to materially
affect, webMethods internal control over financial
reporting.

43



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##### Table of Contents






PART III

The following information contained in the
definitive Proxy Statement of webMethods in connection with our
2004 Annual Meeting of Stockholders is incorporated by reference
into this report.






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | DIRECTORS AND EXECUTIVE OFFICERS OF THE
    REGISTRANT

Information regarding directors of webMethods
will be set forth in the definitive Proxy Statement for
webMethods 2004 Annual Meeting of Stockholders, and is
incorporated into this report by reference. Information
regarding executive officers of webMethods is set forth in
Item 1 of this report.






|         |                       
|-------- | ----------------------
|Item 11. | EXECUTIVE COMPENSATION

Information regarding executive compensation will
be set forth in the definitive Proxy Statement for
webMethods 2004 Annual Meeting of Stockholders, and is
incorporated into this report by reference.






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
    OWNERS AND MANAGEMENT

Information regarding security ownership of
certain beneficial owners and management will be set forth in
the definitive Proxy Statement for webMethods 2004 Annual
Meeting of Stockholders, and is incorporated into this report by
reference.






|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | CERTAIN RELATIONSHIPS AND RELATED
    TRANSACTIONS

Information regarding certain relationships and
related transactions will be set forth in the definitive Proxy
Statement for webMethods 2004 Annual Meeting of
Stockholders, and is incorporated into this report by reference.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | PRINCIPAL ACCOUNTANT FEES AND
    SERVICES

Information regarding fees billed for services
rendered by webMethods independent accountants and related
information will be set forth in the definitive Proxy Statement
for webMethods 2004 Annual Meeting of Stockholders, and is
incorporated into this report by reference.

44



---



##### Table of Contents






PART IV



Item 15.  EXHIBITS, FINANCIAL
STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) Documents filed as part of the report:



| |     |                                                            
| | --- | -----------------------------------------------------------
| | (1) | Report of Independent Registered Public
    Accounting Firm

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                                                                                       |  |      |     | 
|---------------------------------------------------------------------------------------------------------------------- |  | ---- | --- | 
|                                                                                                                       |  | Page
|                                                                                                                       |  |     
|Report of Independent Registered Public
    Accounting Firm                                                            |  |      | F-1 | 
|Consolidated Balance Sheets at March 31,
    2004 and 2003                                                             |  |      | F-2 | 
|Consolidated Statements of Operations and
    Comprehensive Loss for the years ended March 31, 2004, 2003
    and 2002 |  |      | F-3 | 
|Consolidated Statements of Changes in
    Stockholders Equity for the years ended March 31,
    2004, 2003 and 2002   |  |      | F-4 | 
|Consolidated Statements of Cash Flows for the
    years ended March 31, 2004, 2003 and 2002                            |  |      | F-5 | 
|Notes to Consolidated Financial Statements                                                                             |  |      | F-6 | 



| |     |                                                 
| | --- | ------------------------------------------------
| | (2) | Financial Statement Schedules and Report Thereon

|                                                                                            |  |  |      | 
|------------------------------------------------------------------------------------------- |  |  | ---- | 
|Schedule II  Valuation and
    Qualifying Accounts                                         |  |  | F-26 | 
|Report of Independent Registered Public
    Accounting Firm on Financial Statement Schedule |  |  | F-27 | 



| |             
| | ------------
| | (3) Exhibits




|        |         |             |  |                                                                                                                                               
|------- | ------- | ----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |         |            
|Number  |         | Description
|        |         |            
|        | 2.1(1)  |             |  | Agreement and Plan of Merger dated as of
    May 20, 2000, by and among webMethods, Inc., Wolf
    Acquisition, Inc. and Active Software, Inc.
|        | 3.1(2)  |             |  | Fifth Amended and Restated Certificate of
    Incorporation of webMethods, Inc., as amended                                                   
|        | 3.2(3)  |             |  | Amended and Restated Bylaws of webMethods, Inc.                                                                                               
|        | 4.1(3)  |             |  | Specimen certificate for shares of webMethods,
    Inc. Common Stock                                                                          
|        | 4.2(4)  |             |  | Rights Agreement dated as of October 18,
    2001 between webMethods, Inc. and American Stock Transfer &
    Trust Company                    
|        | 10.1(3) |             |  | Second Amended and Restated Investor Rights
    Agreement                                                                                     
|        | 10.2(5) |             |  | webMethods, Inc. Amended and Restated Stock
    Option Plan, as Amended                                                                       
|        | 10.3(3) |             |  | Employee Stock Purchase Plan                                                                                                                  
|        | 10.4(3) |             |  | Indemnification Agreement entered into between
    webMethods, Inc. and each of its directors                                                 
|        | 21.1(6) |             |  | Subsidiaries of webMethods, Inc.                                                                                                              
|        | 23.1*   |             |  | Consent of PricewaterhouseCoopers LLP                                                                                                         
|        | 24(6)   |             |  | Power of Attorney (included on signature page of
    webMethods Form 10-K for the year ended
    March 31, 2004 filed on June 14, 2004)      
|        | 31.1*   |             |  | Rule 13a-14(a) Certification of Chief
    Executive Officer                                                                                   
|        | 31.2*   |             |  | Rule 13a-14(a) Certification of Chief
    Financial Officer                                                                                   
|        | 32.1* # |             |  | Section 1350 Certification of Chief
    Executive Officer                                                                                     
|        | 32.2* # |             |  | Section 1350 Certification of Chief
    Financial Officer                                                                                     




45



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##### Table of Contents





---

|    |                                                                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Incorporated by reference to webMethods
    Registration Statement on Form S-4, as amended (File
    No. 333-39572).                                                                  
|   
|(2) | Incorporated by reference to webMethods
    Form 10-K for the year ended March 31, 2002 (File
    No. 1-15681).                                                                       
|   
|(3) | Incorporated by reference to webMethods
    Registration Statement on Form S-1, as amended (File
    No. 333-91309).                                                                  
|   
|(4) | Incorporated by reference to webMethods
    Registration Statement on Form 8-A (File No. 1-15681).                                                                                    
|   
|(5) | Incorporated by reference to webMethods
    Form 10-K for the year ended March 31, 2003 (File
    No. 1-15681).                                                                       
|   
|   
|(6) | Incorporated by reference to webMethods
    Form 10-K for the year ended March 31, 2004 filed with
    the Securities and Exchange Commission on June 14, 2004
    (File No. 1-15681).
|   
|   
|*   | Filed herewith.                                                                                                                                                                        
|   
|#   | This item is furnished as an exhibit to this
    report but is not filed with the Securities and Exchange
    Commission.                                                              




(b) Reports on Form 8-K. The
following reports on Form 8-K have been furnished, but not
filed, by webMethods, Inc. since the beginning of its fiscal
quarter on January 1, 2004 through March 31, 2004.







|                 |  |          |       |               |  |  |                                       | 
|---------------- |  | -------- | ----- | ------------- |  |  | ------------------------------------- | 
|Date of Report   |  | Item No. |       | Item Reported
|                 |  |          |       |              
|January 21, 2004 |  |          | 7, 12 |               |  |  | Press release dated January 21, 2004. | 




(c) Exhibits.The exhibits required
by this Item are listed under Item 15(a)(3).

(d) Financial Statement Schedule.The
consolidated financial statement schedule required by this Item
is listed under Item 15(a)(2).

| |  |          |    |             |  |                                  
| |  | -------- | -- | ----------- |  | ---------------------------------
| |  | Schedule |    | Description
| |  |          |    |            
| |  |          | II |             |  | Valuation and Qualifying Accounts

All other schedules for which provision is made
in the applicable accounting regulation of the Securities and
Exchange Commission are not required under the related
instructions or are applicable, and therefore have been omitted.

46



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##### Table of Contents






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, in the city of Fairfax,
Virginia on August 10, 2004.






| |                 
| | ----------------
| | WEBMETHODS, INC.



| |     |                    
| | --- | -------------------
| | By: | /s/ PHILLIP MERRICK

| |                          
| | -------------------------
| |                          
| | Phillip Merrick          
| | Chairman of the Board and
| | Chief Executive Officer  




Pursuant to the requirements of the Securities
Exchange Act of 1934, as amended, this report has been signed
below by the following persons on behalf of the registrant in
the capacities and on the dates indicated.







|                                                          |  |                                                                        |  |                
|--------------------------------------------------------- |  | ---------------------------------------------------------------------- |  | ---------------
|Signature                                                 |  | Title                                                                  |  | Date           
|                                                          |  |                                                                        |  |                
|/s/ PHILLIP MERRICKPhillip Merrick                        |  | Chairman of the Board and Chief Executive Officer                      |  | August 10, 2004
|/s/ MARY DRIDIMary Dridi                                  |  | Executive Vice President and Chief Financial
    Officer and Treasurer |  | August 10, 2004
|*Gary J. Fernandes                                        |  | Director                                                               |  | August 10, 2004
|*James P. Gauer                                           |  | Director                                                               |  | August 10, 2004
|*R. James Green                                           |  | Director                                                               |  | August 10, 2004
|*William A. Halter                                        |  | Director                                                               |  | August 10, 2004
|*Jerry Jasinowski                                         |  | Director                                                               |  | August 10, 2004
|*Jack L. Lewis                                            |  | Director                                                               |  | August 10, 2004
|*Gene Riechers                                            |  | Director                                                               |  | August 10, 2004
|*William V. Russell                                       |  | Director                                                               |  | August 10, 2004
|*Robert T. Vasan                                          |  | Director                                                               |  | August 10, 2004
|*By: /s/ PHILLIP MERRICKPhillip Merrick, Attorney-in-Fact |  |                                                                        |  |                




47



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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM

To the Board of Directors and Stockholders of 
 webMethods, Inc.

In our opinion, the accompanying consolidated
balance sheets and the related consolidated statements of
operations and comprehensive loss, changes in stockholders
equity and cash flows present fairly, in all material respects,
the financial position of webMethods, Inc. and its subsidiaries
at March 31, 2004 and 2003, and the results of their
operations and their cash flows for each of the three years in
the period ended March 31, 2004 in conformity with
accounting principles generally accepted in the United States of
America. 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 the
standards of the Public Company Accounting Oversight Board
(United States). Those standards 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 our opinion.

As discussed in Note 1, effective on
April 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 142, and accordingly, changed its
method of accounting for goodwill and other intangible assets.

/s/ PRICEWATERHOUSECOOPERS LLP

McLean, Virginia

May 28, 2004


F-1



---



##### Table of Contents



WEBMETHODS, INC.

CONSOLIDATED BALANCE SHEETS

|                                         |                                                                                                                               |                                            |        |          |         |  |        |          |         | 
|---------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------ | -------- | ------- |  | ------ | -------- | ------- | 
|                                         |                                                                                                                               |                                           
|                                         |                                                                                                                               | Year Ended March 31,                      
|                                         |                                                                                                                               |                                           
|                                         |                                                                                                                               | 2004                                       |        | 2003    
|                                         |                                                                                                                               |                                            |        |         
|                                         |                                                                                                                               |                                           
|                                         |                                                                                                                               | (In thousands, except                     
|                                         |                                                                                                                               | share and per share data)                 
|ASSETS                                   |                                                                                                                               |                                            |        |          |         |  |        |         
|Current assets:                          |                                                                                                                               |                                            |        |          |         |  |        |         
|                                         | Cash and cash equivalents                                                                                                     |                                            | $      | 75,462   |         |  | $      | 79,702   |        
|                                         | Marketable securities available for sale                                                                                      |                                            |        | 44,328   |         |  |        | 97,079   |        
|                                         | Accounts receivable, net of allowance of $2,103
    and $2,850.                                                               |                                            |        | 47,050   |         |  |        | 43,691   |        
|                                         | Prepaid expenses and other current assets                                                                                     |                                            |        | 6,398    |         |  |        | 7,562    |        
|                                         |                                                                                                                               |                                            |        |          |         |  |        |         
|                                         |                                                                                                                               | Total current assets                       |        |          | 173,238 |  |        |          | 228,034 | 
|Marketable securities available for sale |                                                                                                                               |                                            | 36,157 |          |         |  | 24,845 |         
|Property and equipment, net              |                                                                                                                               |                                            | 8,106  |          |         |  | 12,068 |         
|Goodwill                                 |                                                                                                                               |                                            | 46,704 |          |         |  | 29,838 |         
|Intangibles assets, net                  |                                                                                                                               |                                            | 10,787 |          |         |  |       |         
|Other assets                             |                                                                                                                               |                                            | 9,130  |          |         |  | 9,651  |         
|                                         |                                                                                                                               |                                            |        |          |         |  |        |         
|                                         |                                                                                                                               | Total assets                               |        | $        | 284,122 |  |        | $        | 304,436 | 
|                                         |                                                                                                                               |                                            |        |          |         |  |        |         
|LIABILITIES AND STOCKHOLDERS EQUITY     |                                                                                                                               |                                            |        |          |         |  |        |         
|Current liabilities:                     |                                                                                                                               |                                            |        |          |         |  |        |         
|                                         | Accounts payable                                                                                                              |                                            | $      | 11,055   |         |  | $      | 9,768    |        
|                                         | Accrued expenses                                                                                                              |                                            |        | 17,084   |         |  |        | 14,802   |        
|                                         | Accrued salaries and commissions                                                                                              |                                            |        | 11,560   |         |  |        | 11,648   |        
|                                         | Deferred revenue                                                                                                              |                                            |        | 36,785   |         |  |        | 39,649   |        
|                                         | Current portion of capital lease obligations                                                                                  |                                            |        | 909      |         |  |        | 2,743    |        
|                                         |                                                                                                                               |                                            |        |          |         |  |        |         
|                                         |                                                                                                                               | Total current liabilities                  |        |          | 77,393  |  |        |          | 78,610  | 
|                                         | Capital lease obligations, net of current portion
    and other                                                               |                                            |        | 373      |         |  |        | 567      |        
|                                         | Other long term liabilities                                                                                                   |                                            |        | 1,000    |         |  |        |         |        
|                                         | Long term deferred revenue                                                                                                    |                                            |        | 2,802    |         |  |        | 6,700    |        
|                                         |                                                                                                                               |                                            |        |          |         |  |        |         
|                                         |                                                                                                                               | Total liabilities                          |        |          | 81,568  |  |        |          | 85,877  | 
|                                         |                                                                                                                               |                                            |        |          |         |  |        |         
|Commitments and contingencies            |                                                                                                                               |                                            |        |          |         |  |        |         
|Stockholders equity:                    |                                                                                                                               |                                            |        |          |         |  |        |         
|                                         | Common stock, $0.01 par value; 500,000,000 shares
    authorized; 52,746,722 and 51,766,572 shares issued and
    outstanding |                                            |        | 527      |         |  |        | 518      |        
|                                         | Additional paid-in capital                                                                                                    |                                            |        | 521,455  |         |  |        | 515,828  |        
|                                         | Deferred stock compensation and warrant charge                                                                                |                                            |        | (5,625   | )       |  |        | (9,450   | )      
|                                         | Accumulated deficit                                                                                                           |                                            |        | (316,360 | )       |  |        | (288,449 | )      
|                                         | Accumulated other comprehensive income                                                                                        |                                            |        | 2,557    |         |  |        | 112      |        
|                                         |                                                                                                                               |                                            |        |          |         |  |        |         
|                                         |                                                                                                                               | Total stockholders equity                 |        |          | 202,554 |  |        |          | 218,559 | 
|                                         |                                                                                                                               |                                            |        |          |         |  |        |         
|                                         |                                                                                                                               | Total liabilities and stockholders equity |        | $        | 284,122 |  |        | $        | 304,436 | 
|                                         |                                                                                                                               |                                            |        |          |         |  |        |         

The accompanying notes are an integral part of
these consolidated financial statements.

F-2



---



##### Table of Contents



WEBMETHODS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS AND
COMPREHENSIVE LOSS

|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |         |         |         |  
|------------------------------------------------------------------------ | ------------------------------------------ | ---------------------------------------------------- | ------------------------ | ------- | ------ | ------- | ---------- | ------- | ------ | ------- | ---------- | ------- | ------- | ------- | -
|                                                                         |                                            |                                                     
|                                                                         |                                            | Year Ended March 31,                                
|                                                                         |                                            |                                                     
|                                                                         |                                            | 2004                                                 |                          | 2003    |        | 2002   
|                                                                         |                                            |                                                      |                          |         |        |        
|                                                                         |                                            |                                                     
|                                                                         |                                            | (In thousands, except share and per share data)     
|Revenue:                                                                 |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|                                                                         | License                                    |                                                      | $                        | 97,282  |        |         | $          | 117,066 |        |         | $          | 121,803 |        
|                                                                         | Professional services                      |                                                      |                          | 43,923  |        |         |            | 33,378  |        |         |            | 35,800  |        
|                                                                         | Maintenance                                |                                                      |                          | 53,320  |        |         |            | 46,310  |        |         |            | 38,393  |        
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|                                                                         |                                            |                                                      | Total revenue            |         |        | 194,525 |            |         |        | 196,754 |            |         |         | 195,996 |  
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|Cost of revenue:                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|                                                                         | Amortization of intangibles                |                                                      |                          | 1,199   |        |         |            |        |        |         |            |        |        
|                                                                         | License                                    |                                                      |                          | 2,211   |        |         |            | 1,937   |        |         |            | 2,335   |        
|                                                                         | Professional services and maintenance:     |                                                      |                          |         |        |         |            |         |        |         |            |         |        
|                                                                         |                                            | Stock based compensation                             |                          |         | 56     |         |            |         | 251    |         |            |         | 436     |        
|                                                                         |                                            | Other professional services and maintenance          |                          |         | 53,332 |         |            |         | 41,937 |         |            |         | 42,124  |        
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|                                                                         |                                            |                                                      | Total cost of revenue    |         |        | 56,798  |            |         |        | 44,125  |            |         |         | 44,895  |  
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|Gross profit                                                             |                                            |                                                      | 137,727                  |         |        |         | 152,629    |         |        |         | 151,101    |        
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|Operating expenses:                                                      |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|                                                                         | Sales and marketing:                       |                                                      |                          |         |        |         |            |         |        |         |            |         |        
|                                                                         |                                            | Stock based compensation and warrant charge          |                          |         | 2,769  |         |            |         | 3,761  |         |            |         | 2,865   |        
|                                                                         |                                            | Other sales and marketing costs                      |                          |         | 91,325 |         |            |         | 92,958 |         |            |         | 106,377 |        
|                                                                         | Research and development:                  |                                                      |                          |         |        |         |            |         |        |         |            |         |        
|                                                                         |                                            | Stock based compensation                             |                          |         | 15     |         |            |         | 97     |         |            |         | 12,526  |        
|                                                                         |                                            | Other research and development costs                 |                          |         | 45,045 |         |            |         | 47,441 |         |            |         | 49,634  |        
|                                                                         | General and administrative:                |                                                      |                          |         |        |         |            |         |        |         |            |         |        
|                                                                         |                                            | Stock based compensation                             |                          |         | 7      |         |            |         | 47     |         |            |         | 433     |        
|                                                                         |                                            | Other general and administrative costs               |                          |         | 17,873 |         |            |         | 17,831 |         |            |         | 19,372  |        
|                                                                         | Restructuring and related charges          |                                                      |                          | 3,920   |        |         |            | 2,155   |        |         |            | 7,243   |        
|                                                                         | Amortization of goodwill and intangibles   |                                                      |                          |        |        |         |            |        |        |         |            | 38,697  |        
|                                                                         | In-process research and development        |                                                      |                          | 4,284   |        |         |            |        |        |         |            |        |        
|                                                                         | Settlement of intellectual property matter |                                                      |                          | 2,250   |        |         |            |        |        |         |            |        |        
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|                                                                         |                                            |                                                      | Total operating expenses |         |        | 167,488 |            |         |        | 164,290 |            |         |         | 237,147 |  
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|Operating loss                                                           |                                            |                                                      | (29,761                  | )       |        |         | (11,661    | )       |        |         | (86,046    | )      
|Interest income                                                          |                                            |                                                      | 2,851                    |         |        |         | 4,732      |         |        |         | 9,116      |        
|Interest expense                                                         |                                            |                                                      | (205                     | )       |        |         | (674       | )       |        |         | (553       | )      
|Other (expense) income                                                   |                                            |                                                      | (473                     | )       |        |         | 18         |         |        |         | (26        | )      
|Impairment of equity investment in private
    companies                 |                                            |                                                      |                         |         |        |         | (1,000     | )       |        |         | (5,200     | )      
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|Loss before income taxes                                                 |                                            |                                                      | (27,588                  | )       |        |         | (8,585     | )       |        |         | (82,709    | )      
|                                                                         | Provision for income taxes                 |                                                      |                          | 323     |        |         |            |        |        |         |            |        |        
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|Net loss attributable to common shareholders                             |                                            | $                                                    | (27,911                  | )       |        | $       | (8,585     | )       |        | $       | (82,709    | )      
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|Basic and diluted net loss per share                                     |                                            | $                                                    | (0.54                    | )       |        | $       | (0.17      | )       |        | $       | (1.67      | )      
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|Shares used in computing basic and diluted net
    loss per common share |                                            |                                                      | 52,136,919               |         |        |         | 51,281,729 |         |        |         | 49,492,654 |        
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|Comprehensive loss:                                                      |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|                                                                         | Net loss                                   |                                                      | $                        | (27,911 | )      |         | $          | (8,585  | )      |         | $          | (82,709 | )      
|                                                                         | Other comprehensive income (loss):         |                                                      |                          |         |        |         |            |         |        |         |            |         |        
|                                                                         |                                            | Unrealized loss on securities available for
    sale |                          |         | (165   | )       |            |         | (135   | )       |            |         | (692    | )      
|                                                                         |                                            | Foreign currency cumulative translation adjustment   |                          |         | 2,610  |         |            |         | 750    |         |            |         | (417    | )      
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        
|                                                                         |                                            |                                                      | Total comprehensive loss |         | $      | (25,466 | )          |         | $      | (7,970  | )          |         | $       | (83,818 | )
|                                                                         |                                            |                                                      |                          |         |        |         |            |         |        |         |            |        

The accompanying notes are an integral part of
these consolidated financial statements.

F-3



---



##### Table of Contents



WEBMETHODS, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN
STOCKHOLDERS EQUITY

for the years ended March 31, 2002, 2003
and 2004


|                                                                                                  |  |              |        |            |  |              |     |             |  |               |         |             |  |       |         |   |  |   |          |   |  |   |        |   |  |   |         |  
|------------------------------------------------------------------------------------------------- |  | ------------ | ------ | ---------- |  | ------------ | --- | ----------- |  | ------------- | ------- | ----------- |  | ----- | ------- | - |  | - | -------- | - |  | - | ------ | - |  | - | ------- | -
|                                                                                                  |  |              |        |            |  |              |     | Deferred    |  |               |         | Accumulated |  |      
|                                                                                                  |  |              |        |            |  | Stock        |     |             |  | Other         |         |            
|                                                                                                  |  | Common Stock |        | Additional |  | Compensation |     |             |  | Comprehensive |         |            
|                                                                                                  |  |              |        | Paid-in    |  | and Warrant  |     | Accumulated |  | Income        |         |            
|                                                                                                  |  | Shares       |        | Amount     |  | Capital      |     | Charge      |  | Deficit       |         | (Loss)      |  | Total
|                                                                                                  |  |              |        |            |  |              |     |             |  |               |         |             |  |      
|Balance, March 31, 2001.                                                                          |  |              | 48,733 |            |  | $            | 487 |             |  | $             | 499,825 |             |  | $     | (38,154 | ) |  | $ | (197,155 | ) |  | $ | 606    |   |  | $ | 265,609 |  
|                                                                                                  |  |              |        |            |  |              |     |             |  |               |         |             |  |       |         |   |  |   |          |   |  |   |        |   |  |   |         |  
|Stock options exercised, net                                                                      |  |              | 1,442  |            |  |              | 15  |             |  |               | 10,497  |             |  |       |        |   |  |   |         |   |  |   |       |   |  |   | 10,512  |  
|ESPP common stock issuances                                                                       |  |              | 302    |            |  |              | 3   |             |  |               | 4,978   |             |  |       |        |   |  |   |         |   |  |   |       |   |  |   | 4,981   |  
|Amortization of deferred stock compensation
    related to options                                |  |              |       |            |  |              |    |             |  |               |        |             |  |       | 954     |   |  |   |         |   |  |   |       |   |  |   | 954     |  
|Compensation charge related to accelerated vesting                                                |  |              |       |            |  |              |    |             |  |               | 264     |             |  |       |        |   |  |   |         |   |  |   |       |   |  |   | 264     |  
|Adjustment of deferred compensation related to
    forfeitures                                    |  |              |       |            |  |              |    |             |  |               | (5,283  | )           |  |       | 5,283   |   |  |   |         |   |  |   |       |   |  |   |        |  
|Amortization of deferred warrant charge                                                           |  |              |       |            |  |              |    |             |  |               |        |             |  |       | 3,402   |   |  |   |         |   |  |   |       |   |  |   | 3,402   |  
|Amortization of deferred stock compensation
    related to restricted stock                       |  |              |       |            |  |              |    |             |  |               |        |             |  |       | 11,640  |   |  |   |         |   |  |   |       |   |  |   | 11,640  |  
|Proceeds from OEM fees applied to deferred
    warrant charge                                     |  |              |       |            |  |              |    |             |  |               |        |             |  |       | 2,000   |   |  |   |         |   |  |   |       |   |  |   | 2,000   |  
|Other comprehensive loss                                                                          |  |              |       |            |  |              |    |             |  |               |        |             |  |       |        |   |  |   |         |   |  |   | (1,109 | ) |  |   | (1,109  | )
|Net loss                                                                                          |  |              |       |            |  |              |    |             |  |               |        |             |  |       |        |   |  |   | (82,709  | ) |  |   |       |   |  |   | (82,709 | )
|                                                                                                  |  |              |        |            |  |              |     |             |  |               |         |             |  |       |         |   |  |   |          |   |  |   |        |   |  |   |         |  
|Balance, March 31, 2002.                                                                          |  |              | 50,477 |            |  | $            | 505 |             |  | $             | 510,281 |             |  | $     | (14,875 | ) |  | $ | (279,864 | ) |  | $ | (503   | ) |  | $ | 215,544 |  
|                                                                                                  |  |              |        |            |  |              |     |             |  |               |         |             |  |       |         |   |  |   |          |   |  |   |        |   |  |   |         |  
|Stock options exercised, net                                                                      |  |              | 907    |            |  |              | 9   |             |  |               | 2,608   |             |  |       |        |   |  |   |         |   |  |   |       |   |  |   | 2,617   |  
|ESPP common stock issuances                                                                       |  |              | 383    |            |  |              | 4   |             |  |               | 2,957   |             |  |       |        |   |  |   |         |   |  |   |       |   |  |   | 2,961   |  
|Adjustment of deferred compensation related to
    forfeitures                                    |  |              |       |            |  |              |    |             |  |               | (303    | )           |  |       | 303     |   |  |   |         |   |  |   |       |   |  |   |        |  
|Amortization of deferred warrant charge                                                           |  |              |       |            |  |              |    |             |  |               |        |             |  |       | 3,402   |   |  |   |         |   |  |   |       |   |  |   | 3,402   |  
|Amortization of deferred stock compensation
    related to restricted stock                       |  |              |       |            |  |              |    |             |  |               |        |             |  |       | 470     |   |  |   |         |   |  |   |       |   |  |   | 470     |  
|Compensation charge related to stock option
    grants to non-employees                           |  |              |       |            |  |              |    |             |  |               | 285     |             |  |       |        |   |  |   |         |   |  |   |       |   |  |   | 285     |  
|Proceeds from OEM fees applied to deferred
    warrant charge                                     |  |              |       |            |  |              |    |             |  |               |        |             |  |       | 1,250   |   |  |   |         |   |  |   |       |   |  |   | 1,250   |  
|Other comprehensive income                                                                        |  |              |       |            |  |              |    |             |  |               |        |             |  |       |        |   |  |   |         |   |  |   | 615    |   |  |   | 615     |  
|Net loss                                                                                          |  |              |       |            |  |              |    |             |  |               |        |             |  |       |        |   |  |   | (8,585   | ) |  |   |       |   |  |   | (8,585  | )
|                                                                                                  |  |              |        |            |  |              |     |             |  |               |         |             |  |       |         |   |  |   |          |   |  |   |        |   |  |   |         |  
|Balance, March 31, 2003.                                                                          |  |              | 51,767 |            |  | $            | 518 |             |  | $             | 515,828 |             |  | $     | (9,450  | ) |  | $ | (288,449 | ) |  | $ | 112    |   |  | $ | 218,559 |  
|                                                                                                  |  |              |        |            |  |              |     |             |  |               |         |             |  |       |         |   |  |   |          |   |  |   |        |   |  |   |         |  
|Stock options exercised, net                                                                      |  |              | 620    |            |  |              | 6   |             |  |               | 3,033   |             |  |       |        |   |  |   |         |   |  |   |       |   |  |   | 3,039   |  
|ESPP common stock issuances                                                                       |  |              | 360    |            |  |              | 3   |             |  |               | 2,478   |             |  |       |        |   |  |   |         |   |  |   |       |   |  |   | 2,481   |  
|Adjustment of deferred compensation related to
    forfeitures                                    |  |              |       |            |  |              |    |             |  |               | (48     | )           |  |       | 48      |   |  |   |         |   |  |   |       |   |  |   |        |  
|Amortization of deferred warrant charge                                                           |  |              |       |            |  |              |    |             |  |               |        |             |  |       | 2,645   |   |  |   |         |   |  |   |       |   |  |   | 2,645   |  
|Amortization of deferred stock compensation
    related to restricted stock                       |  |              |       |            |  |              |    |             |  |               |        |             |  |       | 132     |   |  |   |         |   |  |   |       |   |  |   | 132     |  
|Compensation charge related to stock option
    grants to non-employees                           |  |              |       |            |  |              |    |             |  |               | 70      |             |  |       |        |   |  |   |         |   |  |   |       |   |  |   | 70      |  
|Compensation charge related to accelerated
    vesting of stock option grants issued to employees |  |              |       |            |  |              |    |             |  |               | 94      |             |  |       |        |   |  |   |         |   |  |   |       |   |  |   | 94      |  
|Proceeds from OEM fees applied to deferred
    warrant charge                                     |  |              |       |            |  |              |    |             |  |               |        |             |  |       | 1,000   |   |  |   |         |   |  |   |       |   |  |   | 1,000   |  
|Other comprehensive income                                                                        |  |              |       |            |  |              |    |             |  |               |        |             |  |       |        |   |  |   |         |   |  |   | 2,445  |   |  |   | 2,445   |  
|Net loss                                                                                          |  |              |       |            |  |              |    |             |  |               |        |             |  |       |        |   |  |   | (27,911  | ) |  |   |       |   |  |   | (27,911 | )
|                                                                                                  |  |              |        |            |  |              |     |             |  |               |         |             |  |       |         |   |  |   |          |   |  |   |        |   |  |   |         |  
|Balance, March 31, 2004.                                                                          |  |              | 52,747 |            |  | $            | 527 |             |  | $             | 521,455 |             |  | $     | (5,625  | ) |  | $ | (316,360 | ) |  | $ | 2,557  |   |  | $ | 202,554 |  
|                                                                                                  |  |              |        |            |  |              |     |             |  |               |         |             |  |       |         |   |  |   |          |   |  |   |        |   |  |   |         |  

The accompanying notes are an integral part of
these consolidated financial statements.

F-4



---



##### Table of Contents



WEBMETHODS, INC.



CONSOLIDATED STATEMENTS OF CASH
FLOWS


|                                                             |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |         |         |  
|------------------------------------------------------------ | --------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------- | ------- | ------ | ---- | ------- | ------ | ------- | - | ------- | ------- | ------- | -
|                                                             |                                                                                   |                                                                                                                                                              
|                                                             |                                                                                   | Year Ended March 31,                                                                                                                                         
|                                                             |                                                                                   |                                                                                                                                                              
|                                                             |                                                                                   | 2004                                                                                                                                                          |         | 2003    |        | 2002
|                                                             |                                                                                   |                                                                                                                                                               |         |         |        |     
|                                                             |                                                                                   |                                                                                                                                                              
|                                                             |                                                                                   | (In thousands)                                                                                                                                               
|Cash flows from operating activities:                        |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        
|                                                             | Net loss                                                                          |                                                                                                                                                               | $       | (27,911 | )      |      | $       | (8,585 | )       |   | $       | (82,709 | )      
|                                                             | Adjustments to reconcile net loss to net cash
    used in operating activities:   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |         |        
|                                                             |                                                                                   | Depreciation and amortization                                                                                                                                 |         |         | 8,428  |      |         |        | 10,044  |   |         |         | 8,453   |  
|                                                             |                                                                                   | Provision for doubtful accounts                                                                                                                               |         |         | 19     |      |         |        | 384     |   |         |         | 2,840   |  
|                                                             |                                                                                   | Impairment of equity investments                                                                                                                              |         |         |       |      |         |        | 1,000   |   |         |         | 5,200   |  
|                                                             |                                                                                   | Loss on disposal of equipment                                                                                                                                 |         |         |       |      |         |        |        |   |         |         | 574     |  
|                                                             |                                                                                   | Amortization of deferred stock compensation and
    compensation for accelerated vesting related to employee stock
    options and non-employee stock warrant |         |         | 2,846  |      |         |        | 4,156   |   |         |         | 16,260  |  
|                                                             |                                                                                   | Amortization of goodwill                                                                                                                                      |         |         |       |      |         |        |        |   |         |         | 35,590  |  
|                                                             |                                                                                   | Amortization of acquired intangibles                                                                                                                          |         |         | 1,199  |      |         |        |        |   |         |         | 3,107   |  
|                                                             |                                                                                   | Write off of in-process research and development                                                                                                              |         |         | 4,284  |      |         |        |        |   |         |         |        |  
|                                                             |                                                                                   | Conversion of interest income to equity in
    private company investments                                                                                    |         |         | (257   | )    |         |        |        |   |         |         |        |  
|                                                             |                                                                                   | Non cash restructuring and related costs, and
    other                                                                                                       |         |         | 473    |      |         |        |        |   |         |         |        |  
|                                                             | Increase (decrease) in cash resulting from
    changes in assets and liabilities: |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |         |        
|                                                             |                                                                                   | Accounts receivable                                                                                                                                           |         |         | (1,016 | )    |         |        | 4,477   |   |         |         | 9,373   |  
|                                                             |                                                                                   | Prepaid expenses and other current assets                                                                                                                     |         |         | 1,448  |      |         |        | 181     |   |         |         | 2,720   |  
|                                                             |                                                                                   | Other non-current assets                                                                                                                                      |         |         | 91     |      |         |        | 551     |   |         |         | (4,569  | )
|                                                             |                                                                                   | Accounts payable                                                                                                                                              |         |         | 538    |      |         |        | (6,065  | ) |         |         | 6,596   |  
|                                                             |                                                                                   | Accrued expenses                                                                                                                                              |         |         | 1,752  |      |         |        | (1,698  | ) |         |         | 3,386   |  
|                                                             |                                                                                   | Accrued salaries and commissions                                                                                                                              |         |         | (649   | )    |         |        | (4,689  | ) |         |         | 176     |  
|                                                             |                                                                                   | Deferred revenue                                                                                                                                              |         |         | (8,932 | )    |         |        | (12,562 | ) |         |         | (11,124 | )
|                                                             |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        
|Net cash used in operating activities                        |                                                                                   |                                                                                                                                                               | (17,687 | )       |        |      | (12,806 | )      |         |   | (4,127  | )      
|                                                             |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        
|Cash flows from investing activities:                        |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        
|                                                             | Acquisition of businesses and technology, net of
    cash acquired                |                                                                                                                                                               |         | (32,384 | )      |      |         |       |         |   |         |        |        
|                                                             | Purchases of property and equipment                                               |                                                                                                                                                               |         | (2,744  | )      |      |         | (2,967 | )       |   |         | (5,859  | )      
|                                                             | Net sales (purchases) of marketable
    securities available for sale             |                                                                                                                                                               |         | 41,274  |        |      |         | (8,717 | )       |   |         | (17,360 | )      
|                                                             | Repayments of investments in private companies                                    |                                                                                                                                                               |         | 1,000   |        |      |         |       |         |   |         | 2,000   |        
|                                                             |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        
|Net cash provided by (used in) investing
    activities      |                                                                                   |                                                                                                                                                               | 7,146   |         |        |      | (11,684 | )      |         |   | (21,219 | )      
|                                                             |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        
|Cash flows from financing activities:                        |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        
|                                                             | Borrowings under capital leases                                                   |                                                                                                                                                               |         |        |        |      |         | 2,500  |         |   |         |        |        
|                                                             | Payments on capital leases                                                        |                                                                                                                                                               |         | (3,255  | )      |      |         | (4,932 | )       |   |         | (3,135  | )      
|                                                             | Proceeds from exercise of stock options                                           |                                                                                                                                                               |         | 3,039   |        |      |         | 2,617  |         |   |         | 10,512  |        
|                                                             | Proceeds from ESPP common stock issuances                                         |                                                                                                                                                               |         | 2,481   |        |      |         | 2,961  |         |   |         | 4,981   |        
|                                                             | Proceeds from OEM fees applied to deferred
    warrant charge                     |                                                                                                                                                               |         | 1,000   |        |      |         | 1,250  |         |   |         | 2,000   |        
|                                                             |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        
|Net cash provided by financing activities                    |                                                                                   |                                                                                                                                                               | 3,265   |         |        |      | 4,396   |        |         |   | 14,358  |        
|                                                             |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        
|Effect of the exchange rate on cash and cash
    equivalents |                                                                                   |                                                                                                                                                               | 3,036   |         |        |      | 1,299   |        |         |   | (228    | )      
|                                                             |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        
|Net decrease in cash and cash equivalents                    |                                                                                   |                                                                                                                                                               | (4,240  | )       |        |      | (18,795 | )      |         |   | (11,216 | )      
|Cash and cash equivalents at beginning of period             |                                                                                   |                                                                                                                                                               | 79,702  |         |        |      | 98,497  |        |         |   | 109,713 |        
|                                                             |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        
|Cash and cash equivalents at end of period                   |                                                                                   | $                                                                                                                                                             | 75,462  |         |        | $    | 79,702  |        |         | $ | 98,497  |        
|                                                             |                                                                                   |                                                                                                                                                               |         |         |        |      |         |        |         |   |         |        

The accompanying notes are an integral part of
these consolidated financial statements.

F-5



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##### Table of Contents



WEBMETHODS, INC.



NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS


1.     Organization

webMethods, Inc. (the Company) provides software
and services for end-to-end business integration solutions. The
Company offers a set of software products that enable
organizations to run, manage and optimize their business. Our
software products and related services give organizations the
ability, seamlessly and in real-time, to integrate disparate
information resources, to connect customers, vendors and
business partners with the organization and its employees, to
view and manage the connected information resources, data,
business processes and human workflows and to provide Web
services at the enterprise level. The Company was incorporated
in Delaware on June 12, 1996.

The Companys operations are subject to
certain risks and uncertainties, including, among others, rapid
technological changes, success of the Companys product
marketing and product distribution strategies, the need to
manage growth, the need to retain key personnel and protect
intellectual property, and the availability of additional
capital financing on terms acceptable to the Company.

2.     Summary of
significant accounting policies

Principles
of consolidation

The accompanying consolidated financial
statements include the accounts of webMethods, Inc. and all
wholly owned subsidiaries. All material intercompany accounts
and transactions have been eliminated.

Use
of estimates

The preparation of financial statements in
conformity with accounting principles generally accepted in the
United States of America requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities
at the date of the financial statements and the reported amounts
of revenue and expenses during the period. Actual results could
differ from these estimates.

Reclassification

Certain prior year amounts in the consolidated
financial statements have been reclassified to conform to the
current year presentation.

Fair
value information

The carrying amount of current assets and current
liabilities approximates fair value because of the short
maturity of these instruments.

Cash
and cash equivalents

The Company considers all highly liquid
investments with original maturities of three months or less to
be cash equivalents.

Allowance
for doubtful accounts

The Company maintains allowances for doubtful
accounts for estimated losses which may result from the
inability of our customers to make required payments to us.
These allowances are established through analysis of the
credit-worthiness of each customer with a receivable balance,
determined by credit reports from third parties, published or
publicly available financial information, customers specific
experience including payment practices and history, inquires,
and other financial information from our customers.

F-6



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2.     Summary of
significant accounting policies 
(Continued)


Marketable
securities

The Companys marketable securities consist
of corporate bonds, commercial paper and U.S. government and
agency securities with maturities of less than two years.
Securities are classified as available for sale since management
intends to hold the securities for an indefinite period and may
sell the securities prior to their maturity. The marketable
securities are carried at aggregate fair value based generally
on quoted market prices. Gains and losses are determined based
on the specific identification method. Available for sale
securities that are reasonably expected by management to be sold
within one year from the balance sheet date are classified as
current assets.

Property
and equipment

Property and equipment are stated at cost.
Depreciation is computed on the straight-line method over the
estimated useful lives of the related assets, ranging from three
to five years. Leasehold improvements are amortized over the
shorter of the lease term or their useful life. Leased property
or equipment meeting certain criteria is capitalized and the
present value of the related lease payments is recorded as a
liability. Amortization of capitalized leased assets is computed
on the straight-line method over the term of the lease. Repairs
and maintenance are expensed as incurred. At the time of
retirement or other disposal of property and equipment, the cost
and related accumulated depreciation are removed from their
respective accounts and any resulting gain or loss is included
in operations.

Included in property and equipment is the cost of
internally developed software. In accordance with Statement of
Position (SOP) 98-1, Accounting for the Costs
of Computer Software Developed or Obtained for Internal
Use, eligible internally developed software costs incurred
are capitalized subsequent to the completion of the preliminary
project stage. After all substantial testing and deployment is
completed and the software is ready for its intended use,
internally developed software costs are amortized using the
straight-line method over the estimated useful life of the
software, generally up to three years.

Investments
in private companies

Investments in private companies in which the
Company owns less than a 20% voting equity interest and has no
significant influence are accounted for using the cost method.
Included in other assets as of March 31, 2004 and 2003, is
$1,057,000 and $1,800,000, respectively, of private company
preferred stock carried at cost and convertible debt carried at
book value. This private Company was also a business partner of
the Company. The Company performs periodic reviews of its
investment for impairment. The investments in privately held
companies are considered impaired when a review of the
investees operations and other indicators of impairment
indicate that the carrying value of the investment is not likely
to be recoverable. Such indicators include, but are not limited
to, limited capital resources, limited prospects of receiving
additional financing, and prospects for liquidity of the related
securities. During fiscal year 2003, the Company recorded an
other than temporary write down of $1,000,000 related to the
impairment of one private equity investment. During fiscal year
2002, the Company recorded an other than temporary write down of
$5,200,000 related to the impairment of four private equity
investments. The Company did not record an other than temporary
write down in fiscal year 2004.

Software
development costs

Software development costs are expensed as
incurred until technological feasibility has been established,
at which time such costs are capitalized until the product is
available for general release to customers. The Company defines
the establishment of technological feasibility as the completion
of all planning, designing, coding and testing activities that
are necessary to establish products that meet design

F-7



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2.     Summary of
significant accounting policies 
(Continued)


specifications including functions, features and
technical performance requirements. Under the Companys
definition, establishing technological feasibility is considered
complete only after the majority of customer testing and
customer feedback has been incorporated into product
functionality. To date, the period between technological
feasibility and general availability has been short, and thus
all software development costs qualifying for capitalization are
insignificant.

Goodwill
and acquired intangible assets

The cost of business acquisitions accounted for
using the purchase method is allocated first to identifiable
assets and liabilities based on estimated fair values. The
excess of cost over identifiable assets and liabilities is
recorded as goodwill. Prior to April 1, 2002, identifiable
intangible assets related to the acquisition of favorable lease
terms were amortized on a straight-line basis over four years.
Goodwill and assembled workforce were amortized on a
straight-line basis over three years. Non-compete agreements
were amortized on a straight-line basis over one year.

On April 1, 2002, the Company adopted
Statement of Financial Accounting Standards No. 142 (SFAS
No. 142) Goodwill and Other Intangible Assets,
which eliminated the amortization of goodwill and other
intangibles with indefinite lives unless the intangible asset is
deemed to be impaired. In accordance with SFAS 142, all of our
goodwill is associated with our corporate reporting unit, as we
do not have multiple reporting units. In accordance with the
SFAS No. 142, goodwill is tested for impairment using a
two-step process. The first step is to identify a potential
impairment and the second step measures the amount of the
impairment loss, if any. Goodwill is deemed to be impaired if
the carrying amount of the asset exceeds its estimated fair
value. The Company performed an impairment test of its goodwill
and determined that no impairment of remaining goodwill existed
at adoption and at March 31, 2004.

The following table summarizes the impact of the
adoption of SFAS No. 142 on net loss and net loss per share
and the impact had SFAS No. 142 been in effect for all
periods presented (in thousands, except share and per share
amounts):

|                                          |  |                      |            |      |  |      |            |   |  |   |            |  
|----------------------------------------- |  | -------------------- | ---------- | ---- |  | ---- | ---------- | - |  | - | ---------- | -
|                                          |  |                     
|                                          |  | Year Ended March 31,
|                                          |  |                     
|                                          |  | 2004                 |            | 2003 |  | 2002
|                                          |  |                      |            |      |  |     
|Net loss                                  |  | $                    | (27,911    | )    |  | $    | (8,585     | ) |  | $ | (82,709    | )
|Adjustments:                              |  |                      |            |      |  |      |            |   |  |   |            |  
|Amortization of goodwill                  |  |                      |           |      |  |      |           |   |  |   | 35,590     |  
|                                          |  |                      |            |      |  |      |            |   |  |   |            |  
|Adjusted net loss                         |  | $                    | (27,911    | )    |  | $    | (8,585     | ) |  | $ | (47,119    | )
|Weighted average shares-basic and diluted |  |                      | 52,136,919 |      |  |      | 51,281,729 |   |  |   | 49,492,654 |  
|                                          |  |                      |            |      |  |      |            |   |  |   |            |  
|Adjusted basic and diluted EPS            |  | $                    | (0.54      | )    |  | $    | (0.17      | ) |  | $ | (0.95      | )
|Reported basic and diluted EPS            |  | $                    | (0.54      | )    |  | $    | (0.17      | ) |  | $ | (1.67      | )

Finite intangible assets are amortized over their
useful lives and are subject to impairment tests under SFAS No.
144, Accounting for the Impairment or Disposal of
Long-Lived Assets. See Impairment of long-lived
assets accounting policy below.

Impairment
of long-lived assets

The Company periodically evaluates the
recoverability of its long-lived assets. This evaluation
consists of a comparison of the carrying value of the assets
with the assets expected future cash flows, undiscounted
and without interest costs. Estimates of expected future cash
flows represent managements best estimate based on
reasonable and supportable assumptions and projections. If the
expected future

F-8



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2.     Summary of
significant accounting policies 
(Continued)


cash flows, undiscounted and without interest
charges, exceed the carrying value of the asset, no impairment
is recognized. Impairment losses are measured as the difference
between the carrying value of long-lived assets and their fair
value, based on discounted future cash flows of the related
asset.

Income
taxes

Deferred tax assets and liabilities are
recognized for the estimated future tax consequences of
temporary differences and income tax credits. Temporary
differences are primarily the result of the differences between
the tax bases of assets and liabilities and their financial
reporting amounts. Deferred tax assets and liabilities are
measured by applying enacted statutory tax rates applicable to
the future years in which deferred tax assets or liabilities are
expected to be settled or realized. Valuation allowances are
established when necessary to reduce deferred tax assets to the
amount expected to be realized. The Company has provided a full
valuation allowance against its net deferred tax asset as of
March 31, 2004 and March 31, 2003.

Foreign
currency translations

The functional currency for the Companys
foreign subsidiaries is the local currency. Assets and
liabilities of the Companys foreign operations are
translated into U.S. dollars at the exchange rates in effect at
the balance sheet date; revenues and expenses are translated
using the average exchange rates in effect during the period.
The cumulative translation adjustments are included in
accumulated other comprehensive income or loss, which is a
separate component of stockholders equity. Foreign
currency transaction gains or losses are included in the results
of operations.

Revenue
recognition

The Company enters into arrangements, which may
include the sale of software licenses, professional services and
maintenance or various combinations of each element. The Company
recognizes revenue based on Statement of Position
(SOP) 97-2, Software Revenue
Recognition, as amended, and modified by SOP 98-9,
Modification of SOP 97-2, Software Revenue Recognition,
With Respect to Certain Transactions, SEC Staff Accounting
Bulletin (SAB) No. 101 Revenue Recognition in
Financial Statements, SAB 104 Revenue
Recognition, and other authoritative accounting
literature. SOP 98-9 modified SOP 97-2 by requiring revenue to
be recognized using the residual method if certain
conditions are met. Revenues are recognized based on the
residual method when an agreement has been signed by both
parties, the fees are fixed or determinable, collection of the
fees is probable, delivery of the product has occurred and no
other significant obligations remain. Historically, the Company
has not experienced significant returns or offered exchanges of
its products.

For multi-element arrangements, each element of
the arrangement is analyzed and the Company allocates a portion
of the total fee under the arrangement to the undelivered
elements, such as professional services, training and
maintenance. Revenues allocated to the undelivered elements are
deferred using vendor-specific objective evidence of fair value
of the elements and the remaining portion of the fee is
allocated to the delivered elements (generally the software
license), under the residual method. Vendor specific-objective
evidence of fair value is based on the price the customer is
required to pay when the element is sold separately (i.e. hourly
time and material rates charged for consulting services when
sold separately from a software license and the optional renewal
rates charged by the Company for maintenance arrangements).

For electronic delivery, the product is
considered to have been delivered when the access code to
download the software from the Companys web site and
activation key, as applicable, has been provided

F-9



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2.     Summary of
significant accounting policies 
(Continued)


to the customer. If an element of the license
agreement has not been delivered, revenue for the element is
deferred based on its vendor-specific objective evidence of fair
value. If vendor-specific objective evidence of fair value does
not exist, all revenue is deferred until sufficient objective
evidence exists or all elements have been delivered.

If the fee due from the customer is not fixed or
determinable, revenue is recognized as payments become due. If
collectibility is not considered probable, revenue is recognized
when the fee is collected.

License revenue: Amounts allocated to license
revenues under the residual method are recognized at the time of
delivery of the software when vendor-specific objective evidence
of fair value exists for the undelivered elements, if any, and
all the other revenue recognition criteria discussed above have
been met.

Professional services revenue: Revenues from
professional services are comprised of consulting,
implementation services and training. Consulting services are
generally sold on a time-and-materials basis and include
services such as installation and building non-complex
interfaces to allow the software to operate in customized
environments. Services are generally separable from the other
elements under the arrangement since the performance of the
services is not essential to the functionality (i.e. the
services do not involve significant production, modification or
customization of the software or building complex interfaces) of
any other element of the transaction. Revenues for professional
services and training are recognized when the services are
performed.

Maintenance revenue: Maintenance revenues consist
primarily of fees for providing when-and-if-available
unspecified software upgrades and technical support over a
specified term. Maintenance revenues are recognized on a
straight-line basis over the term of the contract.

Stock-based
compensation

The Company measures compensation expense for its
employee stock-based compensation using the intrinsic value
method and provides pro forma disclosures of net loss as if the
fair value method had been applied in measuring compensation
expense. Under the intrinsic value method of accounting for
stock based compensation, when the exercise price of options
granted to employees is less than the fair value of the
underlying stock on the grant date, compensation expense is
recognized over the applicable vesting period.

The following table summarizes the Companys
results on a pro forma basis as if it had recorded compensation
expense based upon the fair value at the grant date for awards
consistent with the methodology prescribed in SFAS 123,
Accounting for Stock-Based Compensation, for fiscal
years 2004, 2003 and 2002 (in thousands, except per share
amounts):

|                                                                                  |  |                      |         |      |  |      |         |   |  |   |         |  
|--------------------------------------------------------------------------------- |  | -------------------- | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                                                                  |  |                     
|                                                                                  |  | Year Ended March 31,
|                                                                                  |  |                     
|                                                                                  |  | 2004                 |         | 2003 |  | 2002
|                                                                                  |  |                      |         |      |  |     
|Net loss attributable to common shareholders, as
    reported                     |  | $                    | (27,911 | )    |  | $    | (8,585  | ) |  | $ | (82,709 | )
|Add: Stock-based compensation expense determined
    under intrinsic value method |  |                      | 202     |      |  |      | 755     |   |  |   | 12,858  |  
|Less: Stock-based compensation expense determined
    under fair value method     |  |                      | (26,508 | )    |  |      | (56,466 | ) |  |   | (18,368 | )
|Net loss attributable to common shareholders, pro
    forma                       |  |                      | (54,217 | )    |  |      | (64,296 | ) |  |   | (88,219 | )
|Basic and diluted net loss per common share, as
    reported                      |  |                      | (.54    | )    |  |      | (.17    | ) |  |   | (1.67   | )
|Basic and diluted net loss per common share, pro
    forma                        |  |                      | (1.04   | )    |  |      | (1.25   | ) |  |   | (1.78   | )

F-10



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2.     Summary of
significant accounting policies 
(Continued)


The fair value of each option grant is estimated
on the date of grant using the Black-Scholes valuation model
with the following weighted average assumptions:

|                        |  |                             |      |                              |  |      |      |      |  |      |      |      |  |  |      |   |  |  |      |   |  |  |      |  
|----------------------- |  | --------------------------- | ---- | ---------------------------- |  | ---- | ---- | ---- |  | ---- | ---- | ---- |  |  | ---- | - |  |  | ---- | - |  |  | ---- | -
|                        |  |                             |      |                             
|                        |  | Employee Stock Option Plans |      | Employee Stock Purchase Plan
|                        |  | March 31,                   |      | March 31,                   
|                        |  |                             |      |                             
|                        |  | 2004                        |      | 2003                         |  | 2002 |      | 2004 |  | 2003 |      | 2002
|                        |  |                             |      |                              |  |      |      |      |  |      |      |     
|Expected volatility     |  |                             | 53   | %                            |  |      | 97   | %    |  |      | 125  | %    |  |  | 49   | % |  |  | 87   | % |  |  | 138  | %
|Risk-free interest rate |  |                             | 2.79 | %                            |  |      | 2.93 | %    |  |      | 4.40 | %    |  |  | 3.08 | % |  |  | 3.04 | % |  |  | 4.87 | %
|Expected life (years)   |  |                             | 4    |                              |  |      | 4    |      |  |      | 4    |      |  |  | 1    |   |  |  | 0.5  |   |  |  | 1    |  
|Expected dividend yield |  |                             | 0    | %                            |  |      | 0    | %    |  |      | 0    | %    |  |  | 0    | % |  |  | 0    | % |  |  | 0    | %

The weighted average fair value per share for
stock option grants that were awarded during the years ended
March 31, 2004, 2003 and 2002 was $9.00, $8.93 and $15.65,
respectively.

Stock-based
compensation to non-employees and warrant charge

The Company measures expense for its non-employee
stock-based compensation and warrant charge using the fair value
method. Under the fair value method, the fair value of each
option or warrant is estimated on the date of the grant using
the Black-Scholes valuation model with the following weighted
average assumptions: risk-free interest rate at the date of
grant, expected life of the instrument, expected dividends and
volatility at the date of the grant. The risk-free interest rate
and the volatility are based on the expected term of the
instrument.

Net
loss per share

Basic loss per share is computed based on the
weighted average number of outstanding shares of common stock.
Diluted loss per share adjusts the weighted average for the
potential dilution that could occur if stock options or warrants
or convertible securities were exercised or converted into
common stock. Diluted loss per share is the same as basic loss
per share for all periods presented because the effects of such
items were anti-dilutive given the Companys losses.

Segment
reporting

The Company operates as a single segment and will
evaluate additional segment disclosure requirements as it
expands its operations. See Note 18 for required geographic
segment information.

Guarantees
and indemnification

In January 2003, the Company adopted FASB
Interpretation No. 45, Guarantors Accounting
and Disclosure Requirements for Guarantees, Including Indirect
Guaranteed of Indebtedness of Others which requires that
the Company recognize the fair value for guarantee and
indemnification arrangements issued or modified after
December 31, 2002, if these arrangements are within the
scope of the Interpretation. In addition, the Company continues
to monitor the conditions that are subject to the guarantees and
indemnifications, as required under previously existing
generally accepted accounting principles, in order to identify
if a loss has occurred. If the Company determines it is probable
that a loss has occurred then any such estimable loss would be
recognized under those guarantees and indemnifications. Some of
the software licenses granted by the Company contain provisions
that indemnify licensees of the Companys software from
damages and costs resulting from claims alleging that the
Companys software infringes the intellectual property
rights of a third-party. The Company has historically received
only a limited number of requests for indemnification under
these provisions and have not been required to make material

F-11



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2.     Summary of
significant accounting policies 
(Continued)


payments pursuant to these provisions.
Accordingly, the Company has not recorded a liability related to
these indemnification provisions. The Company does not have any
guarantees or indemnification arrangements other than the
indemnification clause in some of its software licenses and
certain guarantees of performance by subsidiaries. The adoption
of this standard did not have a material effect on the
Companys financial position, results of operations and
cash flows.

Recent
accounting pronouncements

In November 2002, the EITF reached a consensus on
EITF No. 00-21, Revenue Arrangements with Multiple
Deliverables. EITF No. 00-21 addresses certain aspects of
the accounting by a vendor for arrangements under which the
vendor will perform multiple revenue-generating activities. EITF
No. 00-21 will be effective for interim periods beginning
after June 15, 2003. The adoption of this standard did not
have a material effect on the Companys financial position,
results of operations and cash flows.

In January 2003, the FASB issued Interpretation
No. 46 (FIN No. 46), Consolidation of Variable
Interest Entities, an Interpretation of ARB No. 51, which
relates to the identification of, and financial reporting for,
variable-interest entities (VIEs). FIN No. 46 has
far-reaching effects and applies to new entities that are
created after January 31, 2003, as well as to existing VIEs
no later than the beginning of the first interim or annual
reporting period that starts after July 1, 2003. The
adoption of this standard provision did not have an impact on
the Companys consolidated financial position, results of
operations or cash flows.

In May 2003, the Financial Accounting Standards
Board issued SFAS No. 150 (SFAS 150), Accounting for
Certain Financial Instruments with Characteristics of Both
Liabilities and Equity. SFAS 150 requires that certain
instruments with certain characteristics be classified as
liabilities as opposed to equity. This statement is effective
for financial instruments entered into or modified after
May 30, 2003, and otherwise is effective July 1, 2003.
The adoption of this standard provision did not have an impact
on the Companys consolidated financial position, results
of operations or cash flows.

3.     Related-party
transactions

An individual who is a director and stockholder
and former corporate secretary of the Company is associated with
a law firm that has rendered various legal services for the
Company. For the years ended March 31, 2004, 2003 and 2002,
the Company has paid the firm approximately $1,421,000,
$764,000, and $1,223,000 respectively. As of March 31, 2004
and 2003, the aggregate amounts in trade accounts payable for
these services was approximately $58,000 and $65,000,
respectively.

4.     Investments in
private companies

In April 2000, the Company made an investment in
a third-party totaling $2,000,000 of which $1,000,000 was equity
and $1,000,000 was convertible debt. The Company and this
third-party share a common Board member. In March 2002, the
Company recorded an other-than-temporary decline in value of
$200,000 in the equity investment. In June 2003, the Company
received $1,000,000 in repayment of the convertible debt and
converted $257,000 of interest income into additional equity.
The third-party was a business partner of the Company. As of
March 31, 2004 and 2003, the carrying value of the
investment in this third-party was $1,057,000 and $1,800,000,
respectively. The Company incurred royalty expense of $1,391,000
and $1,168,000 to this investment in the years ended
March 31, 2004 and 2003, respectively. The Company did not
incur royalty expense to this third-party in the year ended
March 31, 2002.

F-12



---



##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



4.     Investments in
private companies  (Continued)


In September 2002, the Company recorded an
other-than-temporary decline in value of $1,000,000 in another
one of the equity investments the Company made in a private
company during 2000.

5.     Concentrations
of credit risk

Financial instruments, which potentially expose
the Company to concentration of credit risk, consist primarily
of cash and cash equivalents, marketable securities and accounts
receivable. The Company maintains its cash and cash equivalents
in bank accounts, which, at times, may exceed federally insured
limits. The Company has not experienced any losses on such
accounts. Accounts receivable consists principally of amounts
due from large, credit-worthy companies. The Company monitors
the balances of individual accounts to assess any collectibility
issues.

6.     Marketable
securities

The cost and estimated fair value of marketable
securities, which consist of corporate bonds, commercial paper
and US government and agency securities, by contractual maturity
are as follows:

|                                     |  |                |        |                |  |      |        |            |  |   |         |  |  |   |         | 
|------------------------------------ |  | -------------- | ------ | -------------- |  | ---- | ------ | ---------- |  | - | ------- |  |  | - | ------- | 
|                                     |  |                |        |               
|                                     |  | March 31, 2004 |        | March 31, 2003
|                                     |  |                |        |               
|                                     |  | Cost           |        | Fair Value     |  | Cost |        | Fair Value
|                                     |  |                |        |                |  |      |        |           
|                                     |  |                |        |               
|                                     |  | (In thousands) |        | (In thousands)
|Due in one year or less              |  | $              | 44,313 |                |  | $    | 44,328 |            |  | $ | 96,799  |  |  | $ | 97,079  | 
|Due after one year through two years |  |                | 36,037 |                |  |      | 36,157 |            |  |   | 24,825  |  |  |   | 24,845  | 
|                                     |  |                |        |                |  |      |        |            |  |   |         |  |  |   |         | 
|                                     |  | $              | 80,350 |                |  | $    | 80,485 |            |  | $ | 121,624 |  |  | $ | 121,924 | 
|                                     |  |                |        |                |  |      |        |            |  |   |         |  |  |   |         | 

The gross unrealized holding gains were $135,000
and $300,000 for the years ended March 31, 2004 and 2003,
respectively. The unrealized holding gains have been included,
in accumulated other comprehensive income, which is a separate
component of stockholders equity.

7.     Property and
equipment

Property and equipment consisted of the following:

|                                          |  |                |         |      |  |   |         |  
|----------------------------------------- |  | -------------- | ------- | ---- |  | - | ------- | -
|                                          |  |               
|                                          |  | March 31,     
|                                          |  |               
|                                          |  | 2004           |         | 2003
|                                          |  |                |         |     
|                                          |  |               
|                                          |  | (In thousands)
|Equipment                                 |  | $              | 18,852  |      |  | $ | 22,226  |  
|Software                                  |  |                | 6,049   |      |  |   | 7,694   |  
|Furniture                                 |  |                | 3,475   |      |  |   | 4,033   |  
|Leasehold improvements                    |  |                | 3,104   |      |  |   | 2,912   |  
|                                          |  |                |         |      |  |   |         |  
|                                          |  |                | 31,480  |      |  |   | 36,865  |  
|Accumulated depreciation and amortization |  |                | (23,374 | )    |  |   | (24,797 | )
|                                          |  |                |         |      |  |   |         |  
|                                          |  | $              | 8,106   |      |  | $ | 12,068  |  
|                                          |  |                |         |      |  |   |         |  

During the year ended March 31, 2004 and
2003, the Company had acquired certain equipment and software
under capital leases. Assets under capital leases included in
equipment as of March 31, 2004 and 2003 are $5,240,000 and
$9,236,000, respectively. Assets under capital lease included in
software as of March 31, 2004 and 2003 are $0 and $515,000,
respectively. Related to these capital leases and included

F-13



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



7.     Property and
equipment  (Continued)


in the accumulated depreciation and amortization
is $3,859,000 and $6,871,000 at March 31, 2004 and 2003,
respectively.

During the year ended March 31, 2004, the
Company paid $569,000 for equipment and software that was
previously leased and fully depreciated. This purchase occurred
upon termination of the lease period.

8.     Income
taxes

The components of income tax expense at
March 31, 2004 and 2003 are as follows:

|                                 |         |                |     |      |     |   |   |   |   | 
|-------------------------------- | ------- | -------------- | --- | ---- | --- | - | - | - | - | 
|                                 |         |               
|                                 |         | March 31,     
|                                 |         |               
|                                 |         | 2004           |     | 2003
|                                 |         |                |     |     
|                                 |         |               
|                                 |         | (In thousands)
|Current tax provision:           |         |                |     |      |     |   |   |  
|                                 | Federal |                | $   |     |     |   | $ |  |  
|                                 | State   |                |     |     |     |   |   |  |  
|                                 | Foreign |                |     | 323  |     |   |   |  |  
|                                 |         |                |     |      |     |   |   |  
|                                 |         | Total current  |     | $    | 323 |   |   | $ |  | 
|                                 |         |                |     |      |     |   |   |  
|Deferred tax provision:          |         |                |     |      |     |   |   |  
|                                 | Federal |                | $   |     |     |   | $ |  |  
|                                 | State   |                |     |     |     |   |   |  |  
|                                 | Foreign |                |     |     |     |   |   |  |  
|                                 |         |                |     |      |     |   |   |  
|                                 |         | Total deferred |     | $    |    |   |   | $ |  | 
|                                 |         |                |     |      |     |   |   |  
|Total provision for income taxes |         | $              | 323 |      |     | $ |  |  
|                                 |         |                |     |      |     |   |   |  

The Companys entire provision for income
tax expense at March 31, 2004 is related to operations in
Japan after fully utilizing its net operating losses generated
in prior years.

Net operating loss carryforwards (NOLs) as of
March 31, 2004 are approximately $276,876,000 which begins
to expire in 2007. Approximately $1,826,000 included in the
current year NOL is related to deductions associated with stock
option exercises. The realization of the benefits of the NOLs is
dependent on sufficient taxable income in future years. Lack of
future earnings, a change in the ownership of the Company, or
the application of the alternative minimum tax rules could
adversely affect the Companys ability to utilize the NOLs.

Pretax income from continuing operations for the
years ending March 31 was taxed under the following
jurisdictions:

|         |  |                |         |      |  |      |         |   |  |   |         |  
|-------- |  | -------------- | ------- | ---- |  | ---- | ------- | - |  | - | ------- | -
|         |  | 2004           |         | 2003 |  | 2002
|         |  |                |         |      |  |     
|         |  |               
|         |  | (In thousands)
|Domestic |  | $              | (26,435 | )    |  | $    | 4,740   |   |  | $ | (70,755 | )
|Foreign  |  |                | (1,153  | )    |  |      | (13,325 | ) |  |   | (11,954 | )
|         |  |                |         |      |  |      |         |   |  |   |         |  
|Total    |  | $              | (27,588 | )    |  | $    | (8,585  | ) |  | $ | (82,709 | )
|         |  |                |         |      |  |      |         |   |  |   |         |  

F-14



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



8.     Income
taxes  (Continued)


The tax effect of each temporary difference is as
follows:

|                                      |  |                |          |      |  |   |         |  
|------------------------------------- |  | -------------- | -------- | ---- |  | - | ------- | -
|                                      |  |               
|                                      |  | March 31,     
|                                      |  |               
|                                      |  | 2004           |          | 2003
|                                      |  |                |          |     
|                                      |  |               
|                                      |  | (In thousands)
|Net operating loss carryforwards      |  | $              | 102,226  |      |  | $ | 86,740  |  
|Accrued expenses                      |  |                | 585      |      |  |   | 46      |  
|Deferred revenue                      |  |                | 3,556    |      |  |   | 1,856   |  
|Accounts receivable                   |  |                | 960      |      |  |   | 751     |  
|Impairment loss in equity investments |  |                | 2,350    |      |  |   | 2,350   |  
|Property and equipment                |  |                | (337     | )    |  |   | 568     |  
|Stock option compensation             |  |                | 7,473    |      |  |   | 6,394   |  
|Acquired intangibles                  |  |                | (1,559   | )    |  |   | (9,050  | )
|Research and development credit       |  |                | 8,034    |      |  |   | 6,287   |  
|Other                                 |  |                | 421      |      |  |   | 291     |  
|Valuation allowance                   |  |                | (123,709 | )    |  |   | (96,233 | )
|                                      |  |                |          |      |  |   |         |  
|Net deferred tax assets               |  | $              |         |      |  | $ |        |  
|                                      |  |                |          |      |  |   |         |  

Though management believes that future taxable
income of the Company may be sufficient to utilize a substantial
amount of the benefits of the Companys net operating loss
carryforwards and to realize its deferred tax assets, a
valuation allowance has been recorded to completely offset the
carrying value of the deferred tax assets as management has
concluded that the realization of the deferred tax assets does
not meet the more likely than not criterion. The
change in the valuation allowance was an increase of
$27,476,000, which can be attributed primarily to accrued
deferred tax liabilities and additional operating losses.

The provision for income taxes differs from the
amount of taxes determined by applying the U.S. Federal
statutory rate to income before income taxes as a result of the
following:

|                                                             |                    |           |       |      |   |      |       |    |   |  |       |    |  
|------------------------------------------------------------ | ------------------ | --------- | ----- | ---- | - | ---- | ----- | -- | - |  | ----- | -- | -
|                                                             |                    |          
|                                                             |                    | March 31,
|                                                             |                    |          
|                                                             |                    | 2004      |       | 2003 |   | 2002
|                                                             |                    |           |       |      |   |     
|U.S. Federal statutory rate                                  |                    |           | (34.0 | )%   |   |      | (34.0 | )% |   |  | (34.0 | )%
|State and local taxes, net of Federal income tax
    benefit |                    |           | (3.7  | )    |   |      | 2.5   |    |   |  | (1.4  | ) 
|Non-deductible items                                         |                    |           | 1.4   |      |   |      | 2.1   |    |   |  | 18.8  |   
|Change in valuation allowance                                |                    |           | 47.0  |      |   |      | 34.0  |    |   |  | 6.6   |   
|Amortization of nondeductible goodwill                       |                    |           |      |      |   |      |      |    |   |  | 14.6  |   
|Change in general business credit                            |                    |           | (6.3  | )    |   |      | (21.1 | )  |   |  | (5.3  | ) 
|Foreign rate differential                                    |                    |           | (3.2  | )    |   |      | 16.5  |    |   |  | 0.3   |   
|Other                                                        |                    |           |      |      |   |      |      |    |   |  | 0.4   |   
|                                                             |                    |           |       |      |   |      |       |    |   |  |       |   
|                                                             | Effective tax rate |           |       | 1.2  | % |      |       |   | % |  |       |   | %
|                                                             |                    |           |       |      |   |      |       |    |   |  |       |   

9.     Notes payable
and lines of credit

As of March 31, 2004, the Company had a line
of credit agreement with a bank to borrow up to a maximum
principal amount of $20,000,000 with a maturity date of
October 10, 2004 and an interest rate on unpaid principal
balances of the banks prime rate. Borrowings under this
note are limited to 80% of eligible accounts receivable.
Interest is payable on any unpaid principal balance at the
banks prime rate.

F-15



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



9.     Notes payable
and lines of credit  (Continued)


The agreement includes restrictive covenants
which require the Company to maintain, among other things, a
ratio of quick assets to current liabilities, excluding deferred
revenue of at least 1.5 to 1.0 and a quarterly revenue covenant
such that total revenue for each fiscal quarter must be the
greater of $35,000,000 or 85% of the total revenue for the
immediately preceding fiscal quarter.

As of March 31, 2004, the Company had not
borrowed against this line of credit. In connection with the
line of credit agreement, the Company obtained a letter of
credit totaling $235,000 related to an office lease.

10.     Lease
commitments

The Company has an equipment line of credit with
a leasing company for the leasing of equipment and software.
Under this arrangement, the Company can enter into leases for
equipment and software for a period of one year from the date of
the arrangement. The interest rate under these leases is fixed
at the date of each individual lease, based on the 36-month
treasury yield plus 3.7%. Principal and interest is payable
under each lease in 36 monthly installments. At expiration
of the lease term, the Company will have the option to purchase
the equipment at fair market value. This arrangement includes a
restrictive covenant that requires the Company to maintain a
minimum of $2,500,000 of cash and marketable securities. During
fiscal year 2004, the Company obtained another equipment line of
credit with another leasing company for the leasing of equipment
and software. Under this arrangement, the Company can enter into
leases for equipment and software for a period of one year from
the date of the arrangement. The interest rate under these
leases is fixed at the date of each individual lease at an
interest rate of 5.95%. Principal and interest is payable under
each lease in 24 monthly installments. At expiration of the
lease term, the Company will have the option to purchase the
equipment at fair market value.

The Company leases office space in various
locations under operating leases expiring through fiscal year
2011. Total rent expense was approximately $10,287,000,
$9,492,000 and $11,783,000 for the years ended March 31,
2004, 2003 and 2002, respectively.

Future minimum lease payments under the
Companys capital and operating leases are as follows:

|                                                 |            |                |        |         |  |   |       |     | 
|------------------------------------------------ | ---------- | -------------- | ------ | ------- |  | - | ----- | --- | 
|                                                 |            | Operating      |        | Capital
|                                                 |            |                |        |        
|                                                 |            |               
|                                                 |            | (In thousands)
|Years ending March 31,                           |            |                |        |         |  |   |       |    
|                                                 | 2005       |                | $      | 12,800  |  |   | $     | 968 | 
|                                                 | 2006       |                |        | 8,417   |  |   |       | 358 | 
|                                                 | 2007       |                |        | 8,198   |  |   |       | 29  | 
|                                                 | 2008       |                |        | 2,714   |  |   |       |    | 
|                                                 | 2009       |                |        | 783     |  |   |       |    | 
|                                                 | Thereafter |                |        | 426     |  |   |       |    | 
|                                                 |            |                |        |         |  |   |       |    
|                                                 |            | $              | 33,338 |         |  |   | 1,355 |    
|                                                 |            |                |        |         |  |   |       |    
|Less amounts representing interest               |            |                |        |         |  |   | (73   | )  
|                                                 |            |                |        |         |  |   |       |    
|                                                 |            |                |        |         |  |   | 1,282 |    
|Less current portion                             |            |                |        |         |  |   | (909  | )  
|                                                 |            |                |        |         |  |   |       |    
|Capital lease obligation, net of current portion |            |                |        |         |  | $ | 373   |    
|                                                 |            |                |        |         |  |   |       |    

F-16



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

11.     Stockholders
equity

Preferred
stock

The Companys Certificate of Incorporation,
as amended, includes 50,000,000 authorized shares of
undesignated preferred stock with a par value of $.01, none of
which were outstanding as of March 31, 2004.

Warrant

In March 2001, the Company entered into an OEM/
Reseller agreement with i2 Technologies (i2). In connection with
the agreement the Company issued to i2 a warrant to purchase
750,000 shares of the Companys common stock at an
exercise price of $40.88 per share. The fair value of the
warrant based on the Black-Scholes valuation model was
$23,606,000 on the date of issuance which has been recorded as a
deferred warrant charge. As part of the agreement, i2 will pay
the Company OEM fees of $10,000,000 over the term of the
OEM/Reseller agreement which will reduce the deferred warrant
charge. The Company received $1,000,000 and $1,250,000, of OEM
fees from i2 during the years ended March 31, 2004 and
2003, respectively. These fees were recorded as a reduction to
the deferred warrant charge. The Company recorded $2,645,000 and
$3,402,000 of amortization of the deferred warrant charge to
sales and marketing expense for the years ending March 31,
2004 and 2003, respectively. In April 2001, the Company signed
an amended warrant agreement which reduced the number of shares
of common stock i2 can purchase from 750,000 to 710,000 and, in
addition, reduced the exercise price per share from $40.88 to
$28.70. Based on the remeasurement of the warrant using the
Black-Scholes valuation model the fair value of the amended
warrant did not exceed the current fair value of the original
warrant. The Company did not incur an additional charge as a
result of this amendment. The fair value of the warrants granted
to i2 was estimated on the date of grant and amendment, using
the following weighted average assumptions or range of weighted
average assumption: Risk-free interest rate of 4.9%, term of
3.75 to 4 years, volatility of 114% to 159%, and no
dividends anticipated. As of March 31, 2004, 710,000
warrants remain outstanding with a remaining life of
approximately two years.

In March 2003, the OEM/ Reseller agreement was
modified to reduce the amount of OEM fees owed to webMethods
related to this agreement from $10,000,000 payable over four
years to $8,750,000 payable over five years. In addition, the
number of resources committed by webMethods to i2 has been
reduced as well as an elimination of the fee previously due to
i2 on certain maintenance arrangements. Due to this change in
the agreement, the amortization of the remaining unamortized
deferred warrant charge has been changed from 4 years to
5 years to coincide with the new payment schedule,
resulting in a decrease in the annual amortization of $757,000
from $3,402,000 to $2,645,000.

12.     Business
acquisitions

The Company acquired Premier and Translink in
April 2000, their results of the operations have been included
in the Companys financial statements from the date of
acquisition. In connection with the acquisition of these
companies we recorded deferred compensation related to
restricted stock. During fiscal year 2002, the Company
recorded $11,640,000 of amortization of deferred stock
compensation which is based on the vesting period of related
restricted stock. During fiscal years 2003 and 2004, there was
no amortization of deferred stock compensation related to
restricted stock for these acquisitions.

In October 2003, the Company completed the
business acquisitions of The Mind Electric, Inc.
(TME) and The Dante Group, Inc. TME was a provider
of software for service oriented architectures, and The Dante
Group was a provider of business activity monitoring software.

F-17



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



12.     Business
acquisitions  (Continued)


The acquisitions of TME and The Dante Group were
accounted for under the purchase method of accounting and,
accordingly, the results of operations of each acquisition are
included in the Companys financial statements from the
date of acquisition. As a result of these acquisitions, the
Company has recorded charges for in-process research and
development and has recorded assets related to existing
technology.

In-process research and development represents
in-process technology that, as of the date of the acquisition,
had not reached technological feasibility and had no alternative
future use. Based on valuation assessments, the value of these
projects was determined by estimating the projected net cash
flows from the sale of the completed products, reduced by the
portion of the revenue attributable to developed technology. The
resulting cash flows were then discounted back to their present
values at appropriate discount rates. Consideration was given to
the stage of completion, complexity of the work completed to
date, the difficulty of completing the remaining development and
the costs already incurred. The amounts allocated to the
acquired in-process research and development were immediately
expensed in the period the acquisition was completed.

Existing technology represents purchased
technology for which development had been completed as of the
date of acquisition. This amount was determined using the income
approach. This method consisted of estimating future net cash
flows attributable to existing technology for a discrete
projection period and discounting the net cash flows to their
present value. The existing technology will be amortized over
its expected useful life of 60 months.

The aggregate purchase price for these
acquisitions, including $593,000 in direct acquisition costs,
has been allocated to the assets acquired and liabilities
assumed based upon their estimated fair values at the date of
acquisition as follows (in thousands):

|                                       |  |                 |        |     |  |       |       |   |  |   |        |  
|-------------------------------------- |  | --------------- | ------ | --- |  | ----- | ----- | - |  | - | ------ | -
|                                       |  | The Dante Group |        | TME |  | Total
|                                       |  |                 |        |     |  |      
|Cash and cash equivalents              |  | $               | 90     |     |  | $     | 3     |   |  | $ | 93     |  
|Accounts receivable                    |  |                 | 69     |     |  |       | 116   |   |  |   | 185    |  
|Property and equipment                 |  |                 | 146    |     |  |       | 31    |   |  |   | 177    |  
|Other assets                           |  |                 | 93     |     |  |       | 7     |   |  |   | 100    |  
|Accounts payable                       |  |                 | (32    | )   |  |       | (580  | ) |  |   | (612   | )
|Accrued expenses and other liabilities |  |                 | (231   | )   |  |       | (230  | ) |  |   | (461   | )
|Deferred revenue                       |  |                 | (138   | )   |  |       | (38   | ) |  |   | (176   | )
|In-process research and development    |  |                 | 3,138  |     |  |       | 1,146 |   |  |   | 4,284  |  
|Existing technology                    |  |                 | 3,530  |     |  |       | 2,379 |   |  |   | 5,909  |  
|Customer relationships                 |  |                 | 392    |     |  |       | 441   |   |  |   | 833    |  
|Goodwill                               |  |                 | 12,152 |     |  |       | 4,715 |   |  |   | 16,867 |  
|                                       |  |                 |        |     |  |       |       |   |  |   |        |  
|Total cash purchase price              |  | $               | 19,209 |     |  | $     | 7,990 |   |  | $ | 27,199 |  
|                                       |  |                 |        |     |  |       |       |   |  |   |        |  

We determined the valuation of the identifiable
intangible assets using the income approach and a valuation
report from an independent appraiser. The amounts allocated to
the identifiable intangible assets were determined through
established valuation techniques accepted in the technology and
software industries.

The income approach, which includes an analysis
of the cash flows and risks associated with achieving such cash
flows, was the primary technique utilized in valuing the other
identifiable intangible assets. Key assumptions included
discount factors ranging from 26% to 31%, and estimates of
revenue growth,

F-18



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



12.     Business
acquisitions  (Continued)


maintenance renewal rates, cost of sales,
operating expenses and taxes. The purchase price in excess of
the net liabilities assumed and the identifiable intangible
assets acquired was allocated to goodwill.

The following unaudited pro forma supplemental
table presents selected financial information as though the
purchases of TME and The Dante Group, which may be material
acquisitions for this purpose, had been completed at the
beginning of the periods presented. The unaudited pro forma data
gives effect to actual operating results prior to the
acquisition, adjusted to include the pro forma effect of
amortization of intangibles, reduction in interest income on
cash paid for the acquisitions and the elimination of the charge
for acquired in-process research and development. The unaudited
pro forma data for the year ended March 31, 2004, includes
a $1.4 million nonrecurring compensation charge for
accelerated vesting of options of The Dante Group which occurred
just prior to the transaction. These unaudited pro forma amounts
do not purport to be indicative of the results that would have
actually been obtained if the acquisitions occurred as of the
beginning of the periods presented or that may be obtained in
the future (in thousands, except per share data):

|                                               |  |                       |         |      |  |   |         |  
|---------------------------------------------- |  | --------------------- | ------- | ---- |  | - | ------- | -
|                                               |  |                      
|                                               |  | Years Ended March 31,
|                                               |  |                      
|                                               |  | 2004                  |         | 2003
|                                               |  |                       |         |     
|                                               |  |                      
|                                               |  | (Unaudited)          
|Pro forma net revenue                          |  | $                     | 195,067 |      |  | $ | 198,348 |  
|Pro forma net loss                             |  |                       | (30,242 | )    |  |   | (12,842 | )
|Pro forma net loss per basic and diluted share |  | $                     | (0.58   | )    |  | $ | (0.25   | )

13.     Acquisition
of technology

In October 2003, the Company acquired the portal
solution technology and certain fixed assets of DataChannel for
$5,278,000 in cash, including $176,000 in direct acquisition
costs. The Company also assumed deferred revenue of $66,000
related to on-going maintenance contracts.

The acquisition of the existing portal solution
technology of $5,243,000 was recorded as purchased technology
and is amortized over the estimated useful life of
60 months. The technology is expected to complement the
Companys existing technology and the incremental efforts
required to market the portal solution product were minimal. The
Company determined that as of the date of the technology
purchase the purchased technology had alternative future use and
had attained technological feasibility.

The estimated intangible amortization expense for
each fiscal year ended March 31 is as follows (in
thousands):

|     |  |   |        | 
|---- |  | - | ------ | 
|2005 |  | $ | 2,396  | 
|2006 |  |   | 2,396  | 
|2007 |  |   | 2,396  | 
|2008 |  |   | 2,396  | 
|2009 |  |   | 1,203  | 
|     |  |   |        | 
|     |  | $ | 10,787 | 
|     |  |   |        | 

14.     Stock based
compensation

Stock
incentive plan

On November 1, 1996, the Company adopted the
1996 Stock Incentive Plan (the Plan). The Plan is administered
by a Committee appointed by the Board of Directors, which has
the authority to determine

F-19



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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



14.     Stock based
compensation  (Continued)


which officers, directors and key employees are
awarded options pursuant to the Plan and to determine the terms
and option exercise prices of the stock options.

In August 2000, the Company increased the number
of shares to 20,731,000 shares of the Companys common
stock for issuance upon the exercise of options granted under
the Plan. Pursuant to an amendment to the Plan adopted by the
Board of Directors on June 6, 2001 and approved by the
Companys stockholders on September 7, 2001, the
number of shares of the Companys common stock available
for issuance under Plan was increased on April 1, 2002 by
2,462,195 and again on April 1, 2003 by
2,462,195 shares of common stock, and subject to the
Boards discretion, may be increased by up to the same
amount each April 1 thereafter during the remaining
four-year term of the Plan. At March 31, 2004, options to
purchase 16,788,460 shares were outstanding.

Qualified incentive stock options granted
pursuant to the plans have an exercise price equal to the fair
value of the underlying common stock at the date of grant, vest
ratably over three or four years after the date of award and
have a term of ten years.

The following table summarizes the Companys
activity for all of its stock option awards:

|                            |           |               |            |                |   |                  |        |        |  |   |        |        |  |   |       |       | 
|--------------------------- | --------- | ------------- | ---------- | -------------- | - | ---------------- | ------ | ------ |  | - | ------ | ------ |  | - | ----- | ----- | 
|                            |           |               |            |                |   |                 
|                            |           |               |            | Range of       |   | Weighted Average
|                            |           | Stock Options |            | Exercise Price |   | Exercise Price  
|                            |           |               |            |                |   |                 
|                            |           |               |            |                |   |                  |        |       
|Outstanding, March 31, 2001 |           |               | 15,743,245 |                |   | $                | 0.11  |        |  | $ | 254.27 |        |  | $ | 58.18 |      
|                            | Granted   |               |            | 11,294,307     |   |                  |        | 6.32  |  |   |        | 34.17  |  |   |       | 15.65 | 
|                            | Exercised |               |            | (1,451,256     | ) |                  |        | 0.11  |  |   |        | 29.00  |  |   |       | 7.26  | 
|                            | Cancelled |               |            | (10,008,085    | ) |                  |        | 0.11  |  |   |        | 254.27 |  |   |       | 76.97 | 
|                            |           |               |            |                |   |                  |        |        |  |  
|Outstanding, March 31, 2002 |           |               | 15,578,211 |                |   |                  | 0.11  |        |  |   | 161.29 |        |  |   | 19.77 |      
|                            | Granted   |               |            | 3,606,974      |   |                  |        | 4.32  |  |   |        | 17.82  |  |   |       | 8.93  | 
|                            | Exercised |               |            | (906,603       | ) |                  |        | 0.11  |  |   |        | 14.36  |  |   |       | 3.20  | 
|                            | Cancelled |               |            | (2,448,580     | ) |                  |        | 0.11  |  |   |        | 151.09 |  |   |       | 17.70 | 
|                            |           |               |            |                |   |                  |        |        |  |  
|Outstanding, March 31, 2003 |           |               | 15,830,002 |                |   |                  | 0.11  |        |  |   | 161.29 |        |  |   | 18.49 |      
|                            | Granted   |               |            | 5,598,215      |   |                  |        | 7.54  |  |   |        | 11.70  |  |   |       | 9.00  | 
|                            | Exercised |               |            | (620,216       | ) |                  |        | 0.11  |  |   |        | 9.08   |  |   |       | 4.90  | 
|                            | Cancelled |               |            | (4,016,541     | ) |                  |        | 2.88  |  |   |        | 161.29 |  |   |       | 20.44 | 
|                            |           |               |            |                |   |                  |        |        |  |  
|Outstanding, March 31, 2004 |           |               | 16,791,460 |                |   | $                | 0.11  |        |  | $ | 161.29 |        |  | $ | 15.30 |      
|                            |           |               |            |                |   |                  |        |        |  |  

Information regarding stock options outstanding
as of March 31, 2004 is as follows:




|                |       |           |  |                  |  |                  |        |             |  |                     |  |  |            |  |  |  |      |  |  |   |       |  |  |  |           |  |  |   |       | 
|--------------- | ----- | --------- |  | ---------------- |  | ---------------- | ------ | ----------- |  | ------------------- |  |  | ---------- |  |  |  | ---- |  |  | - | ----- |  |  |  | --------- |  |  | - | ----- | 
|                |       |           |  |                  |  |                  |        |             |  |                    
|                |       |           |  |                  |  |                  |        | Outstanding |  | Options Exercisable
|                |       |           |  |                  |  |                  |        |             |  |                    
|                |       |           |  | Weighted Average |  |                  |        |            
|Range of        |       | Number of |  | Remaining        |  | Weighted Average |        | Number of   |  | Weighted Average   
|Exercise Prices |       | Shares    |  | Contractual Life |  | Exercise Price   |        | Shares      |  | Exercise Price     
|                |       |           |  |                  |  |                  |        |             |  |                    
|$               | 0.11  |           |  |                 |  | $                | 8.57   |             |  |                     |  |  | 3,720,563  |  |  |  | 7.55 |  |  | $ | 6.45  |  |  |  | 1,958,585 |  |  | $ | 5.19  | 
|                | 8.58  |           |  |                 |  |                  | 9.58   |             |  |                     |  |  | 3,584,981  |  |  |  | 9.11 |  |  |   | 8.87  |  |  |  | 713,288   |  |  |   | 8.86  | 
|                | 9.60  |           |  |                 |  |                  | 12.00  |             |  |                     |  |  | 1,702,280  |  |  |  | 8.67 |  |  |   | 10.55 |  |  |  | 534,474   |  |  |   | 11.28 | 
|                | 12.01 |           |  |                 |  |                  | 14.36  |             |  |                     |  |  | 5,294,402  |  |  |  | 7.59 |  |  |   | 14.29 |  |  |  | 4,371,987 |  |  |   | 14.28 | 
|                | 14.70 |           |  |                 |  |                  | 161.29 |             |  |                     |  |  | 2,489,234  |  |  |  | 6.91 |  |  |   | 43.18 |  |  |  | 1,933,185 |  |  |   | 46.20 | 
|                |       |           |  |                  |  |                  |        |             |  |                     |  |  |            |  |  |  |      |  |  |   |       |  |  |  |           |  |  |   |       | 
|$               | 0.11  |           |  |                 |  | $                | 161.29 |             |  |                     |  |  | 16,791,460 |  |  |  | 7.91 |  |  | $ | 15.30 |  |  |  | 9,511,519 |  |  | $ | 18.32 | 
|                |       |           |  |                  |  |                  |        |             |  |                     |  |  |            |  |  |  |      |  |  |   |       |  |  |  |           |  |  |   |       | 




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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



14.     Stock based
compensation  (Continued)


Certain options for employee and non-employee
directors granted during the years ended March 31, 2000,
1999 and 1998 resulted in deferred stock compensation as the
estimated fair value (derived by reference to contemporaneous
sales of convertible preferred stock) was greater than the
exercise price on the date of grant. The total deferred stock
compensation associated with these options was approximately
$16,093,000. This amount is being amortized over the respective
vesting periods of these options, ranging from three to four
years. Approximately $202,000, $754,000 and $1,218,000 was
amortized during the years ended March 31, 2004, 2003 and
2002 respectively, related to these options.

In April 2001, the Company implemented an option
exchange program whereby employees were offered the opportunity
to exchange stock options with split-adjusted exercise prices of
$40.00 and above for new options to purchase an equal number of
shares. These options were grants occurring more than six months
and a day following the date the options were accepted for
exchange and are treated as fixed awards. A total of 7,489,000
options were surrendered for exchange under this program. The
Board of Directors on November 16, 2001, approved the
exchange and on that date 6,015,713 new options were granted
with an exercise price of $14.36 per share. Employees who
surrendered 1,473,287 options left the Company prior to the new
grants.

Employee
Stock Purchase Plan

In January 2000, the Board of Directors approved
the Companys 2000 Employee Stock Purchase Plan (the ESPP).
The ESPP became effective upon the completion of the
Companys initial public offering on February 10,
2000. A total of 4,500,000 shares of common stock have been made
available for issuance under the ESPP as of March 31, 2004.
The number of shares of common stock available for issuance
under the ESPP will be increased on the first day of each
calendar year during the remaining nine year term of the ESPP by
750,000 shares of common stock.

The ESPP, which is intended to qualify under
Section 423 of the IRS Code, is implemented by a series of
overlapping offering periods of 24 months duration,
with new offering periods, other than the first offering period,
commencing on or about January 1 and July 1 of each
year. Each offering period consists of four consecutive purchase
periods of approximately six months duration, and at the
end of each offering period, the Company will make a purchase on
behalf of the participants. Participants generally may not
purchase more than 1,000 shares on any purchase date or
stock having a value measured at the beginning of the offering
period greater than $25,000 in any calendar year.

The purchase price per share is 85% of the lower
of (1) the fair market value of the Companys common
stock on the purchase date and (2) the fair market value of
a share of the Companys common stock on the last trading
day before the offering date.

In June 1999, Active Software approved the 1999
Employee Stock Purchase Plan (the Purchase Plan). In
connection with the merger of Active Software, the Company
assumed the Purchase Plan for all currently eligible employees
of Active Software. Eligible employees of the Purchase Plan may
purchase a limited number of shares of the Companys common
stock. Each participant can elect to purchase the Companys
common stock on the first day of each 24 month offering
period (which begins on May 1 and November 1 of each
year) and such option is automatically exercised on the last day
of each six month purchase period during the offering period.
The purchase price for the Companys common stock under the
Purchase Plan is 85% of the lesser of the fair market value of
the common stock (1) on the first day of the applicable
offering period and (2) on the last day of the applicable
purchase period. This plan terminated on October 31, 2001.

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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



14.     Stock based
compensation  (Continued)


The following table summarizes shares of common
stock available for issuance and shares purchased as of
March 31, 2004 (in thousands).

|                             |  |  |       |  
|---------------------------- |  |  | ----- | -
|Balance at March 31, 2002.   |  |  | 2,661 |  
|                             |  |  |       |  
|Additional authorized shares |  |  | 750   |  
|Purchases                    |  |  | (383  | )
|                             |  |  |       |  
|Balance at March 31, 2003.   |  |  | 3,028 |  
|                             |  |  |       |  
|Additional authorized shares |  |  | 750   |  
|Purchases                    |  |  | (360  | )
|                             |  |  |       |  
|Balance at March 31, 2004.   |  |  | 3,418 |  
|                             |  |  |       |  

Shareholder
Rights Plan

In October 2001, the Board of Directors adopted a
shareholder rights plan, which may cause substantial dilution to
a person or group that attempts to acquire webMethods on terms
not approved by the Board of Directors. Under the plan,
webMethods distributed one right for each share of its common
stock outstanding at the close of business on October 18,
2001. Initially, the rights trade with shares of webMethods
common stock and are represented by webMethods common stock
certificates. The rights are not immediately exercisable and
generally become exercisable if a person or group acquires, or
commences a tender or exchange offer to acquire, beneficial
ownership of 15% or more of webMethods common stock while the
plan is in place. Each right will become exercisable, unless
redeemed, by its holder (unless an acquiring person or member of
that group) for shares of webMethods or of the third-party
acquirer having a value of twice the rights then-current
exercise price. The rights are redeemable by webMethods and will
expire on October 18, 2011.

15.     Employee
benefit plan

As of April 1, 1997, the Company adopted a
contributory 401(k) plan covering all full-time employees who
meet prescribed service requirements. There are no required
Company matching contributions. The plan provides for
discretionary contributions by the Company. The Company made no
contributions during the years ended March 31, 2004, 2003
and 2002.

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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

16.     Supplemental
disclosures of cash flow information:

|                                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |       |  | 
|-------------------------------------------- | ------------------------------------------------------------------ | -------------------- | ---- | ------ | - | ---- | --- | ----- |  | - | --- | ----- |  | 
|                                             |                                                                    |                     
|                                             |                                                                    | Year Ended March 31,
|                                             |                                                                    |                     
|                                             |                                                                    | 2004                 |      | 2003   |   | 2002
|                                             |                                                                    |                      |      |        |   |     
|                                             |                                                                    |                     
|                                             |                                                                    | (In thousands)      
|Cash paid during the period for interest     |                                                                    | $                    | 197  |        |   | $    | 673 |       |  | $ | 511 |      
|                                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|Non-cash investing and financing activities: |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|                                             | Equipment purchased under capital lease                            |                      | $    | 1,457  |   |      | $   | 1,665 |  |   | $   | 3,061 | 
|                                             | Conversion of interest income into equity in
    private company   |                      | $    | 257    |   |      | $   |      |  |   | $   |      | 
|                                             | Change in net unrealized gain or loss on
    marketable securities |                      | $    | 165    |   |      | $   | 135   |  |   | $   | 692   | 
|Dante Acquisition:                           |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|                                             | Fair value of assets acquired, net of cash
    acquired            |                      | $    | 308    |   |      | $   |      |  |   | $   |      | 
|                                             |                                                                    | Less:                |      |        |   |      |     |       |  |   |     |       |  | 
|                                             | Liabilities assumed                                                |                      |      | (401   | ) |      |     |      |  |   |     |      | 
|                                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|                                             |                                                                    |                      | (93  | )      |   |      |    |       |  |   |    |      
|                                             | In-process research and development                                |                      |      | 3,138  |   |      |     |      |  |   |     |      | 
|                                             | Existing technology                                                |                      |      | 3,530  |   |      |     |      |  |   |     |      | 
|                                             | Customer relationships                                             |                      |      | 392    |   |      |     |      |  |   |     |      | 
|                                             | Goodwill                                                           |                      |      | 12,152 |   |      |     |      |  |   |     |      | 
|                                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|                                             | Cash paid for acquisition, net of cash acquired                    |                      | $    | 19,119 |   |      | $   |      |  |   | $   |      | 
|                                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|TME Acquisition:                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|                                             | Fair value of assets acquired, net of cash
    acquired            |                      | $    | 154    |   |      | $   |      |  |   | $   |      | 
|                                             |                                                                    | Less:                |      |        |   |      |     |       |  |   |     |       |  | 
|                                             | Liabilities assumed                                                |                      |      | (848   | ) |      |     |      |  |   |     |      | 
|                                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|                                             |                                                                    |                      | (694 | )      |   |      |    |       |  |   |    |      
|                                             | In-process research and development                                |                      |      | 1,146  |   |      |     |      |  |   |     |      | 
|                                             | Existing technology                                                |                      |      | 2,379  |   |      |     |      |  |   |     |      | 
|                                             | Customer relationships                                             |                      |      | 441    |   |      |     |      |  |   |     |      | 
|                                             | Goodwill                                                           |                      |      | 4,715  |   |      |     |      |  |   |     |      | 
|                                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|                                             | Cash paid for acquisition, net of cash acquired                    |                      | $    | 7,987  |   |      | $   |      |  |   | $   |      | 
|                                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|Datachannel Assets Acquired from Netegrity:  |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|                                             | Fair value of assets acquired, net of cash
    acquired            |                      | $    | 101    |   |      | $   |      |  |   | $   |      | 
|                                             |                                                                    | Less:                |      |        |   |      |     |       |  |   |     |       |  | 
|                                             | Liabilities assumed                                                |                      |      | (66    | ) |      |     |      |  |   |     |      | 
|                                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|                                             |                                                                    |                      | 35   |        |   |      |    |       |  |   |    |      
|                                             | Existing technology                                                |                      |      | 5,243  |   |      |     |      |  |   |     |      | 
|                                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |      
|                                             | Cash paid for acquisition, net of cash acquired                    |                      | $    | 5,278  |   |      | $   |      |  |   | $   |      | 
|                                             |                                                                    |                      |      |        |   |      |     |       |  |   |     |      

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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

17.     Restructuring
and Related Charges

In response to changing market conditions,
including the decline in information technology spending, the
Company implemented restructuring plans in the second quarter of
fiscal 2002, third quarter of fiscal 2003, third quarter of
fiscal 2004 and the fourth quarter of 2004.

During the quarter ended September 30, 2001,
the Company recorded a restructuring charge of
$7.2 million, consisting of headcount reductions,
consolidations of facilities, and other related restructuring
charges. During the quarter ended December 31, 2002, the
Company recorded a restructuring charge of $2.2 million due
to a further reduction in headcount. In addition, in October
2003, the Company recorded a restructuring charge of
$1.3 million due to an additional headcount reduction of
approximately 39 employees or 4% of the workforce. During
the quarter ended March 31, 2004, the Company announced and
implemented a restructuring plan designed to further align its
cost structure with expected revenue and business requirements
resulting in an additional restructuring charge of
$2.6 million. Actions taken included a reduction in the
Companys employee workforce by approximately 20 positions
or 2% of the workforce and the consolidation of our Berkeley,
California office into our Sunnyvale, California office.

As of March 31, 2004 and March 31,
2003, respectively, $3.1 million and $1.8 million of
restructuring charges remained unpaid. This portion primarily
relates to rent on the excess facilities and will be paid over
the remaining rental periods.

The following table sets forth a summary of total
restructuring and related charges, payments made against those
charges and the remaining liabilities as of March 31, 2004.

|                                    |  |                |        |             |  |            |        |       |  |   |      |   |  |   |        |  
|----------------------------------- |  | -------------- | ------ | ----------- |  | ---------- | ------ | ----- |  | - | ---- | - |  | - | ------ | -
|                                    |  |                |        | Severance   |  | Impairment |        |      
|                                    |  | Excess         |        | And Related |  | of Fixed   |        |      
|                                    |  | Facilities     |        | Benefits    |  | Assets     |        | Total
|                                    |  |                |        |             |  |            |        |      
|                                    |  |               
|                                    |  | (In thousands)
|Balance at March 31, 2001           |  | $              |       |             |  | $          |       |       |  | $ |     |   |  | $ |       |  
|Fiscal 2002 charges                 |  |                | 3,610  |             |  |            | 3,489  |       |  |   | 144  |   |  |   | 7,243  |  
|Non-cash write-down of fixed assets |  |                |       |             |  |            |       |       |  |   | (144 | ) |  |   | (144   | )
|Cash payments made in fiscal 2002   |  |                | (615   | )           |  |            | (3,489 | )     |  |   |     |   |  |   | (4,104 | )
|                                    |  |                |        |             |  |            |        |       |  |   |      |   |  |   |        |  
|Balance at March 31, 2002           |  |                | 2,995  |             |  |            |       |       |  |   |     |   |  |   | 2,995  |  
|Fiscal 2003 charges                 |  |                |       |             |  |            | 2,155  |       |  |   |     |   |  |   | 2,155  |  
|Cash payments made in fiscal 2003   |  |                | (1,296 | )           |  |            | (2,101 | )     |  |   |     |   |  |   | (3,397 | )
|                                    |  |                |        |             |  |            |        |       |  |   |      |   |  |   |        |  
|Balance at March 31, 2003           |  |                | 1,699  |             |  |            | 54     |       |  |   |     |   |  |   | 1,753  |  
|Fiscal 2004 charges                 |  |                | 1,508  |             |  |            | 2,165  |       |  |   | 247  |   |  |   | 3,920  |  
|Non-cash write-down of fixed assets |  |                |       |             |  |            |       |       |  |   | (247 | ) |  |   | (247   | )
|Cash payments made in fiscal 2004   |  |                | (847   | )           |  |            | (1,470 | )     |  |   |     |   |  |   | (2,317 | )
|                                    |  |                |        |             |  |            |        |       |  |   |      |   |  |   |        |  
|Balance at March 31, 2004           |  | $              | 2,360  |             |  | $          | 749    |       |  | $ |     |   |  | $ | 3,109  |  
|                                    |  |                |        |             |  |            |        |       |  |   |      |   |  |   |        |  

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##### Table of Contents



WEBMETHODS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

18.     Segment
information

The Company conducts operations worldwide and is
primarily managed on a geographic basis with those geographic
segments being the Americas, Japan, Europe and Asia Pacific
regions. Revenue is primarily attributable to the region in
which the contract is signed and the product is deployed.
Information regarding geographic areas is as follows:

|                  |       |                       |         |         |  |      |         |         |  |   |         |         | 
|----------------- | ----- | --------------------- | ------- | ------- |  | ---- | ------- | ------- |  | - | ------- | ------- | 
|                  |       |                      
|                  |       | Years Ended March 31,
|                  |       |                      
|                  |       | 2004                  |         | 2003    |  | 2002
|                  |       |                       |         |         |  |     
|                  |       |                      
|                  |       | (In thousands)       
|Revenues          |       |                       |         |         |  |      |         |         |  |   |         |        
|Americas          |       | $                     | 114,507 |         |  | $    | 133,756 |         |  | $ | 143,003 |        
|Europe            |       |                       | 44,965  |         |  |      | 36,351  |         |  |   | 35,666  |        
|Japan             |       |                       | 20,456  |         |  |      | 15,274  |         |  |   | 6,632   |        
|Asia Pacific      |       |                       | 14,597  |         |  |      | 11,373  |         |  |   | 10,695  |        
|                  |       |                       |         |         |  |      |         |         |  |   |         |        
|                  | Total |                       | $       | 194,525 |  |      | $       | 196,754 |  |   | $       | 195,996 | 
|                  |       |                       |         |         |  |      |         |         |  |   |         |        
|Long Lived Assets |       |                       |         |         |  |      |         |         |  |   |         |        
|Americas          |       | $                     | 70,497  |         |  | $    | 47,853  |         |  | $ | 55,360  |        
|Europe            |       |                       | 2,189   |         |  |      | 2,228   |         |  |   | 1,555   |        
|Japan             |       |                       | 1,681   |         |  |      | 935     |         |  |   | 697     |        
|Asia Pacific      |       |                       | 360     |         |  |      | 541     |         |  |   | 676     |        
|                  |       |                       |         |         |  |      |         |         |  |   |         |        
|                  | Total |                       | $       | 74,727  |  |      | $       | 51,557  |  |   | $       | 58,288  | 
|                  |       |                       |         |         |  |      |         |         |  |   |         |        

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##### Table of Contents



SCHEDULE II  VALUATION AND QUALIFYING
ACCOUNTS

Allowance for doubtful accounts for the years
ended March 31, 2002, 2003 and 2004:

|                                                              |  |                |       |            |  |            |       |            |  |   |       |  |  |   |       | 
|------------------------------------------------------------- |  | -------------- | ----- | ---------- |  | ---------- | ----- | ---------- |  | - | ----- |  |  | - | ----- | 
|                                                              |  | Balance at     |       |            |  |            |       | Balance at
|                                                              |  | Beginning of   |       |            |  |            |       | End of    
|                                                              |  | Period         |       | Provisions |  | Deductions |       | Period    
|                                                              |  |                |       |            |  |            |       |           
|                                                              |  |               
|                                                              |  | (In thousands)
|Year ended March 31, 2002 allowance for
    doubtful accounts |  | $              | 4,342 |            |  | $          | 2,840 |            |  | $ | 3,497 |  |  | $ | 3,685 | 
|Year ended March 31, 2003 allowance for
    doubtful accounts |  |                | 3,685 |            |  |            | 280   |            |  |   | 1,115 |  |  |   | 2,850 | 
|Year ended March 31, 2004 allowance for
    doubtful accounts |  |                | 2,850 |            |  |            | 19    |            |  |   | 766   |  |  |   | 2,103 | 

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##### Table of Contents



Report of Independent Registered Public
Accounting Firm on

Financial Statement Schedule


To the Board of Directors and Stockholders 
 of webMethods Inc.:

Our audit of the consolidated financial
statements referred to in our report dated May 28, 2004,
appearing in this Form 10-K of webMethods, Inc. for
the year ended March 31, 2004 also included an audit of the
financial statement schedule listed in Item 15(a)(2) of
this Form 10-K. In our opinion, this financial statement
schedule presents fairly, in all material respects, the
information set forth therein when read in conjunction with the
related consolidated financial statements.

/s/ PRICEWATERHOUSECOOPERS LLP 
 ____________________________________ 
 McLean, Virginia 
 May 28, 2004

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##### Table of Contents



EXHIBIT INDEX




|        |         |             |  |                                                                                                                                               
|------- | ------- | ----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |         |            
|Number  |         | Description
|        |         |            
|        | 2.1(1)  |             |  | Agreement and Plan of Merger dated as of
    May 20, 2000, by and among webMethods, Inc., Wolf
    Acquisition, Inc. and Active Software, Inc.
|        | 3.1(2)  |             |  | Fifth Amended and Restated Certificate of
    Incorporation of webMethods, Inc., as amended                                                   
|        | 3.2(3)  |             |  | Amended and Restated Bylaws of webMethods, Inc.                                                                                               
|        | 4.1(3)  |             |  | Specimen certificate for shares of webMethods,
    Inc. Common Stock                                                                          
|        | 4.2(4)  |             |  | Rights Agreement dated as of October 18,
    2001 between webMethods, Inc. and American Stock Transfer &
    Trust Company                    
|        | 10.1(3) |             |  | Second Amended and Restated Investor Rights
    Agreement                                                                                     
|        | 10.2(5) |             |  | webMethods, Inc. Amended and Restated Stock
    Option Plan, as Amended                                                                       
|        | 10.3(3) |             |  | Employee Stock Purchase Plan                                                                                                                  
|        | 10.4(3) |             |  | Indemnification Agreement entered into between
    webMethods, Inc. and each of its directors                                                 
|        | 21.1(6) |             |  | Subsidiaries of webMethods, Inc.                                                                                                              
|        | 23.1*   |             |  | Consent of PricewaterhouseCoopers LLP                                                                                                         
|        | 24(6)   |             |  | Power of Attorney (included on signature page of
    webMethods Form 10-K for the year ended
    March 31, 2004 filed on June 14, 2004)      
|        | 31.1*   |             |  | Rule 13a-14(a) Certification of Chief
    Executive Officer                                                                                   
|        | 31.2*   |             |  | Rule 13a-14(a) Certification of Chief
    Financial Officer                                                                                   
|        | 32.1* # |             |  | Section 1350 Certification of Chief
    Executive Officer                                                                                     
|        | 32.2* # |             |  | Section 1350 Certification of Chief
    Financial Officer                                                                                     






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|    |                                                                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(1) | Incorporated by reference to webMethods
    Registration Statement on Form S-4, as amended (File
    No. 333-39572).                                                                  
|   
|   
|   
|(2) | Incorporated by reference to webMethods
    Form 10-K for the year ended March 31, 2002 (File
    No. 1-15681).                                                                       
|   
|   
|   
|(3) | Incorporated by reference to webMethods
    Registration Statement on Form S-1, as amended (File
    No. 333-91309).                                                                  
|   
|   
|   
|(4) | Incorporated by reference to webMethods
    Registration Statement on Form 8-A (File No. 1-15681).                                                                                    
|   
|   
|   
|(5) | Incorporated by reference to webMethods
    Form 10-K for the year ended March 31, 2003 (File
    No. 1-15681).                                                                       
|   
|   
|   
|(6) | Incorporated by reference to webMethods
    Form 10-K for the year ended March 31, 2004 filed with
    the Securities and Exchange Commission on June 14, 2004
    (File No. 1-15681).
|   
|   
|   
|*   | Filed herewith.                                                                                                                                                                        
|   
|   
|   
|#   | This item is furnished as an exhibit to this
    report but is not filed with the Securities and Exchange
    Commission.                                                              
|