UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-K

[X]  ANNUAL REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES  EXCHANGE
     ACT OF 1934 For the fiscal year ended December 31, 1997
[    ]  TRANSITION  REPORT  PURSUANT  TO SECTION  13 OR 15(d) OF THE  SECURITIES
     EXCHANGE ACT OF 1934 For the transition period from _____ to _____ .

                         Commission File Number: 0-26130

                              LEGATO SYSTEMS, INC.
             (Exact name of registrant as specified in its charter)
Delaware                                                              94-3077394
(State of incorporation)                                        (I.R.S. Employer
                                                             Identification No.)
                                3210 Porter Drive
                           Palo Alto, California 94304
                    (Address of principal executive offices)

                                 (650) 812-6000
              (Registrant's telephone number, including area code)

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

           Securities registered pursuant to Section 12(g) of the Act:

                         Preferred Share Purchase Rights
                         Common Stock, $.0001 par value
                             (Title of each class).

     Indicate by check mark  whether the  registrant:  (1) has filed all reports
required to be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of
1934  during  the  preceding  12 months  (or for such  shorter  period  that the
registrant was required to file such reports),  and (2) has been subject to such
filing requirements for the past 90 days. Yes X No


     Indicate by check mark if disclosure of delinquent  filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's  knowledge,  in definitive proxy or information  statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]


     The aggregate  market value of the voting stock held by  non-affiliates  of
the registrant as of February 28, 1998 was approximately $841,756,692. Shares of
Common Stock held by each officer and director  have been  excluded in that such
persons may be deemed to be affiliates.  This  determination of affiliate status
is not necessarily a conclusive determination for other purposes.

     The number of shares  outstanding  of the  registrant's  common stock as of
February 28, 1998 was 18,118,862.

                       DOCUMENTS INCORPORATED BY REFERENCE

Part III - Portions of the registrant's  definitive Proxy Statement to be issued
in conjunction with the  registrant's  Annual Meeting of Stockholders to be held
on May 14, 1998.


<PAGE>


                              LEGATO SYSTEMS, INC.
                             FORM 10-K ANNUAL REPORT
                            FOR THE FISCAL YEAR ENDED
                                DECEMBER 31, 1997


                                Table of Contents
<TABLE>

PART I

<S>        <C>                                                                                              <C>
Item 1.    Business.......................................................................................   1

Item 2.    Properties.....................................................................................  14

Item 3.    Legal Proceedings..............................................................................  14

Item 4.    Submission of Matters to a Vote of Security Holders............................................  14

Item 4a.   Executive Officers of the Registrant...........................................................  14

PART II

Item 5.    Market for  Registrant's Common Equity and Related Stockholder Matters.........................  15

Item 6.    Selected Consolidated Financial Data...........................................................  16

Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations..........  16

Item 8.    Consolidated Financial Statements and Supplementary Data.......................................  21

Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure...........  21

PART III

Item 10.   Directors and Executive Officers of the Registrant.............................................  39

Item 11.   Executive Compensation.........................................................................  39

Item 12.   Security Ownership of Certain Beneficial Owners and Management.................................  39

Item 13.   Certain Relationships and Related Transactions.................................................  39

PART IV

Item 14.   Exhibits, Financial Statement Schedule and Reports on Form 8-K.................................  40

Signatures ...............................................................................................  44
</TABLE>
<PAGE>

                                     PART I


ITEM 1.  BUSINESS


     The  discussion  in this  report  on  Form  10-K  contains  forward-looking
statements  that involve risks and  uncertainties.  The statements  contained in
this Report that are not purely historical are 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,  including
statements  regarding  the  Company's  expectations,   beliefs,   intentions  or
strategies regarding the future. All forward-looking statements included in this
document are based on  information  available to the Company on the date hereof,
and the  Company  assumes  no  obligation  to  update  any such  forward-looking
statements.  The Company's  actual  results could differ  materially  from those
discussed  herein.  Factors that could cause or contribute  to such  differences
include,  but are not limited to, those  discussed  elsewhere in this item under
the heading "Risk Factors" as well as those discussed  elsewhere in this Report,
and the risks discussed in the Company's Securities Exchange Commission filings.

     Legato  Systems,  Inc.  ("Legato" or the  "Company")  was  incorporated  in
Delaware in September 1988. The Company  develops,  markets and supports network
storage management software products for heterogeneous  client/server  computing
environments.  The Company  believes it is currently a technology  leader in the
network  storage   management   software  market  because  of  the  scalability,
heterogeneity,  performance,  ease  of use  and  central  administration  of its
software  products.  The  Company's  NetWorker  family of  products  and  Global
Enterprise  Management  Systems  ("G.E.M.S.")  software  supports  many  storage
management  server platforms and can accommodate a variety of clients,  servers,
applications, databases and storage devices. The Company's long term strategy is
to create an integrated set of solutions centered around storage management that
enhance and simplify network computing as a whole.


     The Company utilizes multiple distribution  channels,  including resellers,
OEMs  and  direct  sales,  as a  part  of  the  Company's  strategy  to  achieve
comprehensive  coverage in the market.  The Company  licenses its source code to
leading computer system and software suppliers,  including Amdahl,  Banyan, Data
General,  Digital, ICL,  Nihon-Unisys,  NEC, Siemens Nixdorf,  Silicon Graphics,
Sony,  Sun  Microsystems,  Tandem and Unisys,  which port the  products to their
proprietary  platforms,  sell the  products  through  their  direct and indirect
distribution  channels  and  provide  primary  support  for the  products  after
installation.  These relationships  enable the Company to reach a broad customer
base,  while reducing  development,  support and product costs. The Company also
has established strategic partnerships with Hewlett-Packard,  Informix, Netscape
and Oracle.

Background

     The Company's  NetWorker software has been designed to address the emerging
requirements  of storage  management in  client/server  computing  environments.
NetWorker  employs a client/server  architecture  in which a server  centralizes
storage management services for a wide variety of clients, including servers and
desktop  computers.  NetWorker  provides  a  cost-effective  storage  management
solution  that  scales  to  support  large  networks,   supports   heterogeneous
client/server  computing  environments,  accomplishes  storage  management tasks
within stringent time  constraints,  reduces the cost of network  administration
and employs an easy-to-use  graphical user  interface.  The core elements of the
Legato solution include:


     Scalability.  The Company's storage management architecture,  also referred
to as Enterprise Storage  Management  Architecture  ("ESMA"),  is designed to be
scalable so that it can grow with an expanding  network and  accommodate  a wide
range of storage  management  needs. The Company's  storage server family can be
configured or expanded to meet the storage  requirement  needs of a changing and
dynamic network. The Company's architecture is modular, so that clients, servers
and storage devices can be upgraded or added without  requiring  redesign of the
entire  system.  An existing  server can be quickly  upgraded to a more powerful
server with minimal modification.  Furthermore,  the Company's  architecture can
adapt to growing  networks  with its  ability  to easily add  clients to a given
storage  management  server.  For example, a single NetWorker storage management
server has been  employed to manage data located on hundreds of clients  ranging
from desktop computers to large file servers.

     Heterogeneity.  The Company's storage management  solutions are designed to
support a wide range of servers,  clients,  applications,  databases and storage
devices. Servers, clients, applications, databases and storage devices supported
by the Company's  BusinesSuite  products include Informix,  Microsoft  Exchange,
Microsoft  SQL,  Oracle,  SAP R/3 and Sybase.  The  Company's  family of storage
management  server  products  operates on NetWare,  Windows NT, and UNIX systems
(Solaris,  AIX,  HP-UX and SCO UNIX),  as well as on UNIX systems and Windows NT
offered by the Company's OEMs such as Banyan, Data General,  Digital,  ICL, NEC,
Siemens Nixdorf,  Silicon Graphics,  Sony, Sun Microsystems,  Tandem and Unisys.
Server and desktop computer clients supported  include DOS, NetWare,  Macintosh,
OS/2, UNIX, Vines, Windows and Windows NT. Storage devices supported include all
popular tape drives, and optical and tape robotic storage devices. All NetWorker
server  platforms  inter-operate  with  all  supported  clients.  As  a  result,
customers  can mix and match  clients  and  servers as  necessary  to meet their
specific requirements.


     Performance.  Organizations  usually need to accomplish  storage management
functions (which tend to consume network  bandwidth as large amounts of data are
transferred  over the network) during a network's  off-peak hours. The Company's
NetWorker  storage  management  server  can  process  data from many  clients in
parallel,  allowing high volumes of network data to be managed within  stringent
time constraints. NetWorker is designed to take advantage of improvements in the
physical   environment  to  deliver  higher  performance.   As  networks  employ
higher-speed computers, faster and increased capacity storage devices and higher
bandwidth networking  technologies,  NetWorker can exploit these capabilities to
move data quickly.  In 1996,  the Company  began  shipping a series of optimized
storage servers,  Power Edition,  which is based upon its core technology and is
targeted for very large  databases or data  centers that further  increases  the
performance and scalability of the Company's products.

     Ease of Use. The Company's storage management  solutions have been designed
to be easy to use for both network  administrators  and end users. The Company's
architecture  permits a network  administrator to perform the storage management
function for the entire network either from the storage server or a client.  The
network  administrator  can access the  Company's  products  through a number of
graphical user  interfaces,  including  Windows,  Windows NT and Motif.  Network
administrators  can also  automate  their storage  operations by adding  robotic
storage libraries,  further reducing the need for human  intervention.  Finally,
the Company's  architecture  supports a simple user  interface  that permits end
users  to  access  or  recover  copies  of  their  files  without  the  need for
intervention by the network administrator.


     Central  Administration.  The Company's  recently shipped G.E.M.S.  product
allows information system  organizations the ability to globally manage hundreds
and even thousands of Networker storage servers. G.E.M.S. provides services such
as policy management,  software  distribution,  universal licensing and advanced
media management and can be integrated with management  frameworks  including CA
Unicenter,  HP Openview,  Siemens  Transview,  Sun Enterprise Manager and Tivoli
TME.

Architecture

     The most basic function of a storage  management system is data protection.
The process of data  protection  involves making backup copies of data stored on
hard  disks  onto  low-cost,  high  capacity  removable  media such as tapes and
optical disks.


     The Company's  extensible  architecture  provides  reliable data protection
services. Data may be managed according to the application that produces it. For
example, a relational  database may be frequently  updated. To back up this kind
of database  efficiently,  it is  necessary  to  understand  how the database is
constructed,  so that a consistent  copy of the database can be made while it is
undergoing   change  and  while  the  database  is   "on-line."   The  Company's
architecture can accommodate the data produced by different applications because
of its Application Specific Module ("ASM") technology.  Each ASM can be tailored
to the specific  storage  management  needs of a particular  kind of application
data,  and all ASMs are  implemented  using a modular  architecture  designed to
permit new ASMs to be easily integrated into the Company's storage offerings.


     Once data is read from the  client  hard  disk,  it is  transmitted  to the
storage   management   software  that  resides  on  the  storage   server  using
industry-standard  communications  protocols  such  as  TCP/IP  and  SPX/IPX.  A
high-performance,  integrated  database is fundamental to the storage management
server engine.  This database has two roles:  to keep track of where the storage
management server has stored the data, and to keep track of what data is stored.
The Company's  architecture  makes it possible for clients to query the database
as to what data is under  management  and to access this data  themselves.  This
enables novice users to directly access the system,  thereby reducing the burden
on network administrators.

     One of the most  critical  ways the  Company's  architecture  achieves  its
ability to  accommodate  an increasing  number of clients while  retaining  high
performance is by  implementing  parallel data transfers from the clients to the
storage  management  server in the same way that  adding  more  tellers to serve
customers allows a bank to process more transactions in the same amount of time.
When an additional  client's data is managed, it may be scheduled for processing
by the  storage  management  server  at the  same  time as the data  from  other
clients.  Thus, one slow client need not slow down the entire storage management
process.  The  Company's  architecture  achieves  this  parallelism  by  writing
multiple  client data streams to the tape  simultaneously.  This allows the full
bandwidth  of the tape  drive to be used as the data  from many  clients  can be
delivered  to the tape  drive in the same  amount  of time as the data  from one
client. As a result,  one high-capacity  tape drive can be shared effectively by
more than one client on the network,  and therefore,  it may not be necessary to
purchase  several  tape drives to  accomplish  data  protection  in the required
amount of time.


     An increasingly important function of the architecture to some end users is
to  facilitate  the  management  of data  according  to its  criticality.  As an
example, a set of quarterly reports may be grouped together and filed away. This
data  may  not  need to be  accessed  on a  regular  basis,  but may  need to be
retrievable  for a period of years because of certain  regulatory  requirements.
This class of data is termed  "archive"  data,  because it may be filed away for
future reference and need not be kept on-line.  When archived data is needed, it
must  be  explicitly  retrieved,  typically  from  offsite  storage.  It is also
possible to archive data in such a way that it appears to be on-line, when it in
reality is stored  elsewhere.  This  process  is  referred  to as  "hierarchical
storage  management."  The indexing  technology  embedded  within the  Company's
storage  products is designed to support the management of protected,  archived,
and hierarchically managed data.


     To reduce the  burden on  expensive  administrative  staff,  the  Company's
architecture  allows the storage management server to be managed remotely,  from
an easy-to-use,  graphical user interface familiar to the administrator. The use
of a common administrative protocol developed by the Company greatly facilitates
the development of diverse user  interfaces that support remote  administration.
The  Company's  family of storage  management  products can also automate a wide
range of storage management  functions and can employ robotic storage devices to
remove  the need for  human  intervention  to  retrieve  a  particular  piece of
removable storage media.

Products

     The Company's  family of storage  management  server software - NetWorker -
provides  network storage  management  services for a wide variety of platforms.
NetWorker  consists of two basic  components:  a client module that accesses the
data being managed, and a server module that performs the protection, management
and control of network data. Typically,  the server module is selected to run on
the platform most familiar to the administrative  staff in an organization;  the
client modules are selected according to the type of computers  installed on the
network.  Server software is available from the Company for NetWare,  Windows NT
and several UNIX platforms, including IBM, HP and Sun versions of UNIX. A number
of applications and enhancements options are available for the storage server.

     The base NetWorker  server product  provides data  protection  services for
clients and  includes  client  software for the same  platform as the  NetWorker
server, as well as support for a set of popular  non-robotic storage devices. In
multiple platform environments, client software for dissimilar platforms must be
purchased.  The following client packages are currently available: (i) ClientPak
for UNIX,  which  supports a diverse set of UNIX clients;  (ii) ClientPak for PC
Desktops,  which supports DOS, OS/2, Windows and Windows NT; (iii) ClientPak for
Windows NT; (iv) ClientPak for NetWare and (v) ClientPak for Macintosh.

     NetWorker for UNIX is licensed by the number of clients to be supported and
has the  following  storage  management  server  options  available:  (i) Client
Connections  - the  ability to  increase  the  number of clients of the  storage
management  server beyond the ten supported by the base product;  (ii) Archive -
the ability to archive data; (iii)  Autochanger - the ability to employ tape and
optical jukeboxes of varying capacities;  (iv) StorSuite - the ability to manage
migrated files to less costly media; (v) BusinesSuite - the ability to utilize a
family of add-on modules tailored for databases and business applications;  (vi)
SNMP  Modules  -  the  ability  to  integrate  with  leading  system  management
offerings;  (vii) Silo Support - the ability to leverage mainframe-class storage
silos;  (viii) High Speed  Device  Support - the  ability to utilize  high speed
devices;  (ix)  Storage  Nodes - the ability to perform very  high-speed  backup
locally which is managed centrally.

     NetWorker for Windows NT is Microsoft  BackOffice certified and licensed by
the  number  of  clients  to be  supported  and it  has  the  following  storage
management  server options  available:  (i) Client  Connections - the ability to
increase the number of clients of the storage  management  server beyond the ten
supported by the base product; (ii) Archive - the ability to archive data; (iii)
Autochanger  - the  ability  to employ  tape and  optical  jukeboxes  of varying
capacities;  (iv)  BusinesSuite  - the  ability  to  utilize  a family of add-on
modules tailored for databases and business  applications such as SQL Server and
Exchange Server;  (v) SNMP Module - the ability to integrate with leading system
management  offerings;  and (vi) Open File Manager - the ability to protect open
files.

     NetWorker  for NetWare is licensed by the number of clients to be supported
and has the following storage  management server options  available:  (i) Client
Connections  - the  ability to  increase  the  number of clients of the  storage
management  server beyond the ten supported by the base product;  (ii) Archive -
the ability to archive data; (iii)  Autochanger - the ability to employ tape and
optical jukeboxes of varying capacities; (iv) Mainframe Module -- the ability to
store data on storage devices attached to a mainframe; and (v) Open File Manager
- the ability to protect open files.

     NetWorker for server  software has an entry end user list price from $2,000
to $6,000,  while a fully configured  NetWorker system can have an end user list
price of over $100,000.

Sales and Marketing

     The Company's  strategy is to deploy a comprehensive  sales,  marketing and
support  infrastructure to meet the storage management needs of users of complex
client/server  networks,  both in North America and  overseas.  The Company uses
multiple distribution channels to reach end user customers,  which range in size
from individual corporate departments or small businesses to large multinational
corporations.  Network  storage  management  software may be utilized in a broad
range of industries. The range of distribution channels includes resellers, OEMs
and direct sales. The Company has established regional sales offices to increase
the effectiveness of and support to the Company's channel partners.  The Company
has  recently   established   a  dedicated   sales  force  to  penetrate   large
enterprise-wide opportunities.

Resellers

     North America Premier Reseller Program. The Company's North America Premier
Reseller  program  is a  significant  source of revenue  in North  America.  The
Premier Reseller program enables third-party integrators specializing in storage
management  and  client/server  network  solutions to provide end user customers
with complete solutions,  including systems and storage hardware,  complementary
software and the Company's  software.  The reseller is responsible  for managing
the sales and installation process in each customer situation. In large, complex
opportunities, the Company's support personnel work with the reseller to provide
technical support. This approach enables the Company to cost effectively achieve
broader market coverage, while maintaining close contact with end user customers
in  order  to  obtain  input  on  product  direction  and  to  monitor  customer
satisfaction.  The Company  provides  sales and  pre-sale  technical  support to
business partners and end user customers from the Company's headquarters in Palo
Alto and from regional offices in the Boston, Chicago,  Dallas, Los Angeles, New
York, Seattle, Toronto, and Washington, D.C. metropolitan areas.


     North  America  Distributor  Program.  To further  expand  coverage  in the
marketplace,  the Company  sells its  products to large  regional  and  national
distributors  who sell the  Company's  products to resellers  with  expertise in
integrating  network  solutions for end users.  The Company  provides support to
these network solutions resellers.  The Company currently has relationships with
various major  distributors,  including  Access  Graphics,  Anthem  Electronics,
Gates/Arrow, Ingram Micro, TechData and Tenex Data.


     International  Reseller and Distributor  Programs.  The Company has similar
reseller  and  distributor  programs  internationally.   The  Company  currently
operates  regional  offices  for the United  Kingdom  (London),  Central  Europe
(Munich), Southern Europe (Paris),  Scandinavia (Sweden) and Benelux (Amsterdam)
to support resellers and distributors  throughout  Europe.  The Company also has
opened sales offices in Australia and Japan for sales and support to the Pacific
Rim. Sales and support to Latin America are headquartered out of Miami.


     International  product  sales were $19.8  million,  $10.7  million and $4.7
million, representing 24 percent, 20 percent and 16 percent of total revenues in
1997, 1996 and 1995,  respectively.  The majority of international  sales during
these  periods  were  made in Europe  and  Canada.  The  Company  believes  that
international  markets present an attractive growth opportunity and is expanding
the scope of its international operations.  The Company has engaged, and intends
to add,  international  resellers and distributors in targeted  countries and is
developing joint marketing programs with certain resellers and distributors.  To
facilitate  penetration  in  certain  markets,  the  Company,  on its own and in
cooperation  with  certain  international  distributors,  is in the  process  of
localizing certain of its products to targeted languages.


     The Company also relies  significantly  on its  resellers for the marketing
and  distribution of its products.  The Company's  agreements with resellers are
generally  not  exclusive  and in many cases may be  terminated  by either party
without  cause.  Many of the  Company's  resellers  carry product lines that are
competitive  with those of the  Company.  There can be no  assurance  that these
resellers  will give a high priority to the marketing of the Company's  products
or  that  they  will  continue  to  carry  the  Company's  products.  Events  or
occurrences  of this nature  could  materially  adversely  affect the  Company's
business, operating results and financial condition.

OEMs


     Source Code OEM Program. The source code OEM program generates  significant
royalty revenues for the Company.  Under this program,  the Company licenses its
software products,  in source code form, to leading computer system and software
suppliers  from which the Company  receives  an initial  license fee and ongoing
royalty  revenue.  The OEM partner is then responsible for porting the Company's
software to its unique  operating  system  environment,  testing it,  selling it
through the OEM  partner's  direct  sales force and  distribution  channels  and
providing  the primary  customer  support after  installation.  The OEM partners
generally have exclusive rights to the products on their  proprietary  platforms
(subject to certain minimum  royalty  obligations),  but in certain cases,  work
cooperatively  to  incorporate  their  enhancements  into the Company's  storage
products on an ongoing basis. The benefit of this approach for end users is that
they can acquire the Company's family of storage management  products as part of
a complete systems  solution from a single vendor,  with such vendor providing a
single  point of contact for  customer  support.  The benefit to the Company has
been  access to its OEM  partners'  customer  bases,  both in North  America and
overseas,  without a  commensurate  investment  in fixed  expense.  The  Company
currently has source code OEM agreements in place with several  computer  system
and software suppliers,  including Amdahl,  Banyan, Data General,  Digital, ICL,
Nihon-Unisys,  NEC, Siemens Nixdorf,  Silicon Graphics,  Sony, Sun Microsystems,
Tandem and Unisys.


     Strategic Partner Program.  The Strategic Partner program is an alternative
to the source code OEM program for major system  providers who wish to offer the
Company's  products  along with theirs,  but prefer not to make an investment in
enhancing  the base  Legato  product.  For  example,  SunSoft,  a private  label
reseller,  licenses the object code for the standard  Legato  products and sells
and  supports the  products  under the SunSoft  logo as described  above for the
source code OEM program. The Company also has established strategic partnerships
with Hewlett-Packard, Informix, Netscape and Oracle.


     The  source  code  OEMs  and  strategic  partner  programs   accounted  for
approximately  $16.7 million,  $12.9 million and $8.4 million in 1997,  1996 and
1995,  respectively.  SunSoft  accounted for  approximately  11 percent of total
revenues for each of the years ended December 31, 1997, 1996 and 1995. There can
be no assurance that such customers,  including SunSoft will continue to account
for a  significant  percentage  of the  Company's  revenues in the  future.  The
Company is currently investing,  and intends to continue to invest,  significant
resources to develop this channel,  which could materially  adversely affect the
Company's operating margins.  There can be no assurance that the Company will be
successful in its efforts to increase the revenues  represented by this channel.
The  Company  is  dependent  upon its OEMs'  ability to  develop  new  products,
applications and product  enhancements on a timely and cost-effective basis that
will meet changing customer needs and respond to emerging industry standards and
other technological  changes. There is no assurance that the Company's OEMs will
effectively meet these technological  challenges.  These OEMs are not within the
control of the Company,  may incorporate into their products the technologies of
other  companies  in addition to those of the Company and are not  obligated  to
purchase products from the Company.  There can be no assurance that any OEM will
continue to carry the Company's  products,  and the inability to recruit, or the
loss  of,  important  OEMs  could  materially  adversely  affect  the  Company's
business, operating results and financial condition.


Enterprise Sales and Marketing

     Enterprise Sales Program.  As storage management  applications  increase in
strategic  importance to major enterprises,  the Company has recognized the need
to  establish  even closer  relationships  with its largest  corporate  clients.
Customers  participating  in the  Company's  enterprise  sales  program  have an
assigned salesperson and Company executive contact, participate in the Company's
technical  exchange  program and work closely with the Company to develop  large
projects  for  installations  over  a  period  of  time.  The  enterprise  sales
representatives  coordinate  business  partner  activity  across the  customer's
enterprise and closely monitors customer satisfaction.

     Corporate  Marketing.  The Company  supports  its  resellers  and OEMs with
extensive  marketing  programs  designed to establish the Company's image in key
markets and to generate end user demand. The Company participates in trade shows
and advertises in key network systems  publications  and on the Internet.  Leads
are  qualified by the  Company's  inside sales staff and provided to its channel
partners. Additionally, resellers and distributors are provided with promotional
and  educational  materials and can qualify for market  development  funding for
specific promotional activities tailored for their solutions and geography.

Customer Service and Support

     The Company employs  systems  engineers who work closely with the Company's
direct sales  personnel to assist  resellers  and end users with  pre-sales  and
post-sales support matters.  In addition,  Legato employs a centralized  support
organization  which  provides  customers  with  technical  support,   education,
training and consulting services.


     Technical  Support.  The Company  offers  software  updates,  telephone and
electronic support and on-site reviews to its customers.  Customers who register
the Company's  products receive  software updates and technical  support free of
charge  for one month  after  initial  purchase.  Beyond the  initial  one month
period,  customers may purchase remote technical support and software updates as
needed. Customers also have the option to purchase annual Software Subscriptions
that  extend the  covered  support  period for an  additional  12 month  period.
Software  Subscription  customers  receive  software  updates and  telephone  or
electronic  support from 6 a.m. to 6 p.m.  Pacific time.  Software  Subscription
annual fees are generally  equivalent to 18 percent of the current list price of
the products  under license to such  customers.  The Company also offers premium
technical support, which includes a one year contract covering five-day, 24-hour
technical phone support, one annual on-site review, and a monthly teleconference
with a  designated  Senior  Legato  Technical  Engineer  and Problem  Escalation
Manager.  Premium  technical  support  pricing  begins at $20,000  per year,  in
addition to the basic  software  subscription  fee.  Premium  technical  support
customers have the option to purchase seven-day, 24-hour technical phone support
for an incremental  cost of $10,000 per year.  The customer  service and support
organization  consists of an experienced  staff of technical  support  engineers
providing  telephone and electronic  support via electronic mail,  facsimile and
CompuServe  from the  Company's  offices in Palo Alto,  California  and Toronto,
Canada. The sales and customer support organizations at the Company work closely
together to ensure overall customer satisfaction.


     In  recent   years,   the  Company's   installed   base  of  customers  has
significantly  increased,  as have the number of customers  purchasing  software
subscription  contracts.  From  time to  time,  the  Company  receives  customer
complaints about the timeliness and accuracy of customer  support.  Although the
Company  plans to add customer  support  personnel  in order to address  current
customer  support  needs and intends to closely  monitor  progress in this area,
there can be no assurance that these efforts will be successful.


     Education and Training.  The Company  offers  education and training to end
users and resellers. Training classes are offered through in-house facilities at
the  Company's  offices  in Palo Alto,  as well as at  off-site  locations.  The
Company also provides on-site training services upon request by customers.  Fees
for education and training  services are charged  separately  from the Company's
software  products.  Although the Company  intends to add education and training
personnel in order to meet customer needs,  there can be no assurance that these
efforts will be  successful.  If the Company's  efforts are not  successful,  it
could have a  potential  adverse  effect on the  Company's  business,  operating
results and financial condition.

     Consulting.  The Company's  consultants  are available to work closely with
customers'   information  systems   organizations.   These  consulting  services
generally   consist  of   assisting   customers   in  setting  up  more  complex
installations  or tailoring the Company's  software  products to achieve  higher
performance or a higher degree of automation.  Fees for consulting  services are
charged  separately  from the  Company's  software  products.  While the Company
continues to allocate  resources in order to provide  customers with  additional
value-added  services,  there can be no  assurance  that these  efforts  will be
successful. Although the Company intends to add consulting personnel in order to
meet  customer  needs,  there can be no  assurance  that these  efforts  will be
successful.  If the  Company's  efforts  are not  successful,  it  could  have a
potential  adverse  effect on the  Company's  business,  operating  results  and
financial condition.


Research and Development

     Since its  inception,  the  Company  has made  substantial  investments  in
product  development.   In  addition,  the  Company  receives  the  benefits  of
additional  testing  and  product  enhancements  from  each  source  code  OEM's
development  group. The Company's future success will depend upon its ability to
develop  and  introduce   new  software   products   (including   new  releases,
applications   and   enhancements)  on  a  timely  basis  that  keep  pace  with
technological  developments  and  emerging  industry  standards  and address the
increasingly  sophisticated needs of its customers. In particular, the Company's
strategy is to continue to leverage the  NetWorker  architecture  to enhance the
functionality  of the product  through new  releases,  applications  and product
enhancements  to  meet  the  ongoing  storage  management  requirements  of  its
customers.  There can be no  assurance  that the Company will be  successful  in
developing  and marketing new products that respond to  technological  change or
evolving industry standards,  that the Company will not experience  difficulties
that  could  delay or  prevent  the  successful  development,  introduction  and
marketing of these new products,  or that its new products will  adequately meet
the  requirements  of the  marketplace  and achieve  market  acceptance.  If the
Company is unable, for technological or other reasons,  to develop and introduce
new products in a timely  manner in response to changing  market  conditions  or
customer requirements,  the Company's business,  operating results and financial
condition will be materially adversely affected.

     As part of the Company's ongoing development  process, the Company released
several new versions of NetWorker during 1997, and intends to release additional
versions of NetWorker,  generally on an annual basis.  In addition,  the Company
released several new products,  including new high  performance  database backup
modules,  called BusinesSuite,  for Oracle, Informix and SQL, as well as modules
for backup of SAP R/3  applications  and Microsoft  Exchange.  Also, the Company
released an expanded set of autoloader  support  including  mainframe  silos and
high speed  devices  aimed at  enterprise  installations.  Finally,  the Company
released  a new  optimized  server  platform,  Power  Edition,  for  very  large
databases.  Some of the Company's  competitors  currently offer certain of these
potential new products.  Due to the complexity of client/server software and the
difficulty in gauging the engineering effort required to produce these potential
new products,  such potential new products are subject to significant  technical
risks.  There can be no  assurance  that such  potential  new  products  will be
introduced on a timely basis or at all.


     The  Company has  development  centers in Palo Alto,  California,  Seattle,
Washington and Burlington,  Canada.  Total expenses for research and development
were $14.4  million,  $9.2  million  and $4.5  million  in 1997,  1996 and 1995,
respectively.   The  Company   anticipates  that  it  will  continue  to  commit
substantial  resources to research and  development in the future.  To date, the
Company's  development  efforts  have not resulted in any  capitalized  software
development costs.


Competition

     The network  storage  management  market is intensely  competitive,  highly
fragmented  and  characterized  by  rapidly  changing  technology  and  evolving
standards. Competitors vary in size and in the scope and breadth of the products
and services offered.  The Company's major competitors on the Novell NetWare and
Windows NT platforms include Computer Associates (Cheyenne Software) and Seagate
(Palindrome and Arcada);  on the Sun  Solaris/SunOS  platform  include  Veritas,
Peripheral Devices (Delta Microsystems),  Software Moguls, EMC2 (Epoch), Spectra
Logic and Computer Associates (Legent/Lachman); on the AIX platform include IBM;
and on the HP-UX platform include Hewlett Packard. In the future, as the Company
enters new markets,  the Company expects that such markets will have additional,
market-specific  competitors.  In  addition,  many  of  the  Company's  existing
competitors  are broadening  their platform  coverage.  The Company also expects
increased competition from systems and network management companies,  especially
those that have historically  focused on the mainframe market and are broadening
their focus to include the client/server market. In addition,  because there are
relatively  low barriers to entry in the software  market,  the Company  expects
additional competition from other established and emerging companies.  Increased
competition is likely to result in price  reductions,  reduced gross margins and
loss of  market  share,  any of which  could  materially  adversely  affect  the
Company's business, operating results and financial condition.

     The Company believes that the principal  competitive  factors affecting its
market   include   product   features  (such  as   heterogeneity,   scalability,
performance,  ease of use and central  administration),  brand name recognition,
quality,  price, customer service and support and the effectiveness of sales and
marketing  efforts.  Although the Company  believes that its products  currently
compete  favorably  with  respect to certain of these  factors,  there can be no
assurance that the Company can maintain its competitive position against current
and  potential   competitors,   especially  those  with  significantly   greater
financial, marketing, service, support, technical and other resources.

     Many of the Company's current and potential  competitors have significantly
greater financial, technical, marketing and other resources than the Company. As
a  result,  they  may be  able  to  respond  more  quickly  to  new or  emerging
technologies  and  changes  in  customer  requirements,  or  to  devote  greater
resources to the development, promotion, sale and support of their products than
the Company. The Company also expects that competition will increase as a result
of future software industry  consolidations,  which have occurred in the network
storage  management  market in the past.  In  addition,  current  and  potential
competitors have established or may establish  cooperative  relationships  among
themselves  or  with  third  parties.  Accordingly,  it  is  possible  that  new
competitors  or  alliances  among  competitors  may emerge and  rapidly  acquire
significant  market share. In addition,  network  operating system vendors could
introduce new or upgrade existing operating systems or environments that include
storage management  functionality offered by the Company's products, which could
render  the  Company's  products  obsolete  and  unmarketable.  There  can be no
assurance that the Company will be able to compete  successfully against current
or future  competitors or that  competitive  pressures faced by the Company will
not materially  adversely affect its business,  operating  results and financial
condition.

Employees

     As of December 31, 1997, the Company had a total of 457  employees.  Of the
total, 171 were in sales and marketing,  138 in research and development,  59 in
finance and administration, 57 in customer service and support, 19 in consulting
and  educational  services and 13 in  operations.  The Company's  future success
depends in significant part upon the continued  service of its key technical and
senior  management  personnel and its  continuing  ability to attract and retain
highly  qualified  technical  and  managerial  personnel.  Competition  for such
personnel is intense,  and there can be no assurance that the Company can retain
its key technical and managerial employees or that it can attract, assimilate or
retain other highly qualified technical and managerial  personnel in the future.
None of the Company's  employees are  represented by a labor union.  The Company
has not  experienced  any work  stoppages and  considers its relations  with its
employees to be good.

Risk Factors

     In addition to the other  information  in this Report,  the following  risk
factors  should be  considered  carefully  in  evaluating  the  Company  and its
business:

Fluctuations in Quarterly Operating Results; Future Operating Results Uncertain

     The Company's  quarterly  operating results have in the past varied and may
in the future vary significantly depending on a number of factors, including the
size and timing of significant orders; increased competition;  market acceptance
of new  products,  applications  and  product  enhancements;  changes in pricing
policies  by the  Company  and its  competitors;  the  ability of the Company to
timely  develop,  introduce  and market new products,  applications  and product
enhancements and to control costs; the Company's  success in expanding its sales
and marketing programs;  technological changes in the network storage management
market;  the mix of sales among the  Company's  channels;  deferrals of customer
orders in  anticipation of new products,  applications or product  enhancements;
changes in Company strategy; personnel changes; and general economic factors.


     The  Company's  future  revenues  are  difficult  to  predict.  The Company
operates with virtually no order backlog because its software products typically
are shipped shortly after orders are received. In addition, the Company does not
recognize revenues on sales to domestic distributors until the products are sold
through  to  end  users.  As a  result,  product  revenues  in any  quarter  are
substantially  dependent on orders booked and shipped and on sell-through to end
users in that quarter.  Revenues for any future quarter are not predictable with
any significant degree of certainty.  Product and software subscription revenues
are also difficult to forecast because the network storage  management market is
rapidly  evolving  and the  Company's  sales  cycle  varies  substantially  from
customer to customer.  Royalty and license revenues are substantially  dependent
upon sales by OEMs of their products that  incorporate  the Company's  software.
Accordingly,  royalty and license  revenues are subject to OEMs' product cycles,
which are also  difficult to predict.  Royalty and license  revenues are further
impacted by fluctuations in licensing activity from quarter-to-quarter,  because
initial license fees generally are non-recurring and recognized upon the signing
of the license  agreement.  The Company's  expense levels are based, in part, on
its   expectations  as  to  future   revenues.   If  revenue  levels  are  below
expectations,  operating results are likely to be adversely affected. Net income
may  be  disproportionately  affected  by a  reduction  in  revenues  because  a
proportionately  smaller  amount  of the  Company's  expenses  varies  with  its
revenues. As a result, the Company believes that period-to-period comparisons of
its  results of  operations  are not  necessarily  meaningful  and should not be
relied upon as  indications of future  performance.  Due to all of the foregoing
factors,  it is possible  that in some future  quarter the  Company's  operating
results may be below the  expectations  of public market analysts and investors.
In such  event,  the  price  of the  Company's  common  stock  would  likely  be
materially adversely affected.


Product Concentration

     The Company currently  derives a substantial  majority of its revenues from
its NetWorker  software products and related  services,  and the Company expects
that  revenues  from  NetWorker  will  continue to account for a majority of the
Company's  revenues  for the  foreseeable  future.  Broad market  acceptance  of
NetWorker is, therefore,  critical to the Company's future success. As a result,
a decline in unit prices of or demand for NetWorker, or failure to achieve broad
market acceptance of NetWorker, as a result of competition, technological change
or otherwise,  would have a material  adverse effect on the business,  operating
results and financial  condition of the Company.  The life cycle of NetWorker is
difficult  to  estimate  due in large  measure  to the recent  emergence  of the
Company's  market,   the  effect  of  new  products,   applications  or  product
enhancements,   technological   changes  in  the  network   storage   management
environment in which NetWorker  operates and future  competition.  The Company's
future financial performance will depend in part on the successful  development,
introduction  and market  acceptance of new products,  applications  and product
enhancements.  There can be no assurance  that the Company  will  continue to be
successful in marketing  NetWorker or any new products,  applications or product
enhancements.

Competition


     The network  storage  management  market is intensely  competitive,  highly
fragmented  and  characterized  by  rapidly  changing  technology  and  evolving
standards. Competitors vary in size and in the scope and breadth of the products
and services offered.  The Company's major competitors on the Novell NetWare and
Windows NT platforms include Computer Associates (Cheyenne Software) and Seagate
(Palindrome and Arcada);  on the Sun  Solaris/SunOS  platform  include  Veritas,
Peripheral Devices (Delta Microsystems),  Software Moguls, EMC2 (Epoch), Spectra
Logic and Computer Associates (Legent/Lachman); on the AIX platform include IBM;
and on the HP-UX platform include Hewlett Packard. In the future, as the Company
enters new markets,  the Company expects that such markets will have additional,
market-specific  competitors.  In  addition,  many  of  the  Company's  existing
competitors  are broadening  their platform  coverage.  The Company also expects
increased competition from systems and network management companies,  especially
those that have historically  focused on the mainframe market and are broadening
their focus to include the client/server market. In addition,  because there are
relatively  low barriers to entry in the software  market,  the Company  expects
additional competition from other established and emerging companies.  Increased
competition is likely to result in price  reductions,  reduced gross margins and
loss of  market  share,  any of which  could  materially  adversely  affect  the
Company's business, operating results and financial condition.

     Many of the Company's current and potential  competitors have significantly
greater financial, technical, marketing and other resources than the Company. As
a  result,  they  may be  able  to  respond  more  quickly  to  new or  emerging
technologies  and  changes  in  customer  requirements,  or  to  devote  greater
resources to the development, promotion, sale and support of their products than
the Company. The Company also expects that competition will increase as a result
of future software industry  consolidations,  which have occurred in the network
storage  management  market in the past.  In  addition,  current  and  potential
competitors have established or may establish  cooperative  relationships  among
themselves  or  with  third  parties.  Accordingly,  it  is  possible  that  new
competitors  or  alliances  among  competitors  may emerge and  rapidly  acquire
significant  market share. In addition,  network  operating system vendors could
introduce new or upgrade existing operating systems or environments that include
storage management  functionality offered by the Company's products, which could
render  the  Company's  products  obsolete  and  unmarketable.  There  can be no
assurance that the Company will be able to compete  successfully against current
or future  competitors or that  competitive  pressures faced by the Company will
not materially  adversely affect its business,  operating  results and financial
condition.


Dependence on New Software Products; Rapid Technological Change

     The  network  storage   management   market  is   characterized   by  rapid
technological  change,  changing  customer needs,  frequent new software product
introductions  and evolving  industry  standards.  The  introduction of products
embodying new  technologies  and the emergence of new industry  standards  could
render the Company's existing products obsolete and unmarketable.  The Company's
future  success  will  depend  upon its  ability to develop  and  introduce  new
software products  (including new releases,  applications and enhancements) on a
timely  basis  that keep  pace  with  technological  developments  and  emerging
industry  standards  and address  the  increasingly  sophisticated  needs of its
customers.  There can be no  assurance  that the Company will be  successful  in
developing and marketing new products that respond to  technological  changes or
evolving industry standards,  that the Company will not experience  difficulties
that  could  delay or  prevent  the  successful  development,  introduction  and
marketing of these new products,  or that its new products will  adequately meet
the  requirements  of the  marketplace  and achieve  market  acceptance.  If the
Company is unable, for technological or other reasons,  to develop and introduce
new products in a timely  manner in response to changing  market  conditions  or
customer requirements,  the Company's business,  operating results and financial
condition will be materially adversely affected. The Company currently has plans
to  introduce  and market  several  potential  new  products  in the next twelve
months.  Some of the  Company's  competitors  currently  offer  certain of these
potential new products.  Due to the complexity of client/server software and the
difficulty in gauging the engineering effort required to produce these potential
new products,  such potential new products are subject to significant  technical
risks.  There can be no  assurance  that such  potential  new  products  will be
introduced on a timely basis or at all. In the past, the Company has experienced
delays  in  the  commencement  of  commercial  shipments  of its  new  products,
resulting in customer  frustrations  and delay or loss of product  revenues.  If
potential  new products  are delayed or do not achieve  market  acceptance,  the
Company's business, operating results and financial condition will be materially
adversely  affected.  The Company has also, in the past,  experienced  delays in
purchases of its products by customers  anticipating  the launch of new products
by the  Company.  There can be no assurance  that  material  order  deferrals in
anticipation of new product introductions will not occur.

     Software  products  as complex as those  offered by the Company may contain
undetected  errors or failures  when first  introduced  or as new  versions  are
released.  The Company has in the past discovered  software errors in certain of
its new products after their  introduction  and has  experienced  delays or lost
revenues  during the period  required  to correct  these  errors.  Although  the
Company has not experienced  material  adverse  effects  resulting from any such
errors to date,  there can be no assurance that,  despite testing by the Company
and by current and potential customers, errors will not be found in new products
after  commencement  of commercial  shipments,  resulting in loss of or delay in
market acceptance, which could have a material adverse effect upon the Company's
business, operating results and financial condition.

Risks Associated with Strategy of Expanding OEM Channel; Reliance on Resellers

     An integral part of the Company's strategy is to increase the proportion of
the Company's  customers  licensed  through OEMs. There can be no assurance that
such  customers  will  continue to account for a  significant  percentage of the
Company's  revenues  in the  future.  The Company is  currently  investing,  and
intends to continue to invest,  significant  resources to develop this  channel,
which could materially  adversely affect the Company's operating margins.  There
can be no  assurance  that the  Company  will be  successful  in its  efforts to
increase the revenues represented by this channel. The Company is dependent upon
its OEMs' ability to develop new products, applications and product enhancements
on a timely and cost-effective  basis that will meet changing customer needs and
respond to emerging industry standards and other technological changes. There is
no assurance that the Company's OEMs will effectively  meet these  technological
challenges.  These  OEMs  are  not  within  the  control  of  the  Company,  may
incorporate  into their products the technologies of other companies in addition
to those of the Company and are not  obligated  to  purchase  products  from the
Company. In addition,  the Company's OEMs generally have exclusive rights to the
Company's technology on their respective  platforms,  subject to certain minimum
royalty  obligations.  There can be no assurance  that any OEM will  continue to
carry the  Company's  products,  and the  inability to recruit,  or the loss of,
important  OEMs  could  materially  adversely  affect  the  Company's  business,
operating results and financial condition.


     The  Company  also  relies  significantly  on  its  distributors,   systems
integrators  and  value  added  resellers  (collectively,  "resellers")  for the
marketing and  distribution  of its  products.  The  Company's  agreements  with
resellers  are  generally  not  exclusive and in many cases may be terminated by
either party without cause. Many of the Company's  resellers carry product lines
that are competitive  with those of the Company.  There can be no assurance that
these  resellers  will give a high  priority to the  marketing of the  Company's
products (they may, in fact, give a higher priority to other products, including
the products of  competitors)  or that they will continue to carry the Company's
products. Events or occurrences of this nature could materially adversely affect
the Company's business, operating results and financial condition. The Company's
results of operations could also be materially  adversely affected by changes in
reseller inventory strategies, which could occur rapidly, and in many cases, may
not be related to end user demand.  There can be no  assurance  that the Company
will retain any of its current  resellers,  nor can there be any assurance that,
in such event,  the Company will be successful in recruiting  replacement or new
organizations  to represent it. Any such changes in the  Company's  distribution
channels could  materially  adversely affect the Company's  business,  operating
results and financial condition.


International Operations; Risks Associated with International Sales

     The Company  believes  that its  continued  growth and  profitability  will
require  further  expansion  of  its  international   operations.  In  order  to
successfully expand  international  sales, the Company must establish additional
foreign   operations,   hire   additional   personnel  and  recruit   additional
international resellers.  This will require significant management attention and
financial  resources  and  could  materially   adversely  affect  the  Company's
operating  margins.  To the extent  that the  Company is unable to effect  these
additions in a timely manner,  the Company's  growth,  if any, in  international
sales  will be  limited,  and the  Company's  business,  operating  results  and
financial condition could be materially adversely affected.  In addition,  there
can be no  assurance  that the  Company  will be able to  maintain  or  increase
international   market  demand  for  the  Company's   products.   The  Company's
international  sales are currently  denominated in U.S. dollars.  An increase in
the value of the U.S.  dollar  relative  to  foreign  currencies  could make the
Company's products more expensive and,  therefore,  potentially less competitive
in those markets.  In some markets,  localization  of the Company's  products is
essential to achieve market penetration. The Company may incur substantial costs
and experience delays in localizing its products,  and there can be no assurance
that any localized product will ever generate significant revenues. In addition,
the Company relies  significantly  on its  distributors  and other  resellers in
international  sales efforts.  Since these  distributors and other resellers are
not employees of the Company and  typically do not offer the Company's  products
exclusively,  there can be no  assurance  that they will  continue to market the
Company's  products.  Additional  risks inherent in the Company's  international
business   activities   generally  include   unexpected  changes  in  regulatory
requirements,  tariffs and other trade barriers, lack of acceptance of localized
products,  if any, in foreign  countries,  longer  accounts  receivable  payment
cycles,  difficulties in managing international operations,  potentially adverse
tax consequences including restrictions on the repatriation of earnings, and the
burdens  of  complying  with a wide  variety of  foreign  laws.  There can be no
assurance  that such  factors  will not have a  material  adverse  effect on the
Company's future international sales and, consequently,  the Company's business,
operating results and financial condition.

Management of Expanding Operations

     The Company has recently  experienced a period of significant  expansion of
its operations that has placed a significant  strain upon its management systems
and resources.  In addition, the Company has recently hired a significant number
of employees,  and plans to further  increase its total  headcount.  The Company
also plans to expand the geographic  scope of its customer base and  operations.
This expansion has resulted and will continue to result in  substantial  demands
on the Company's management  resources.  From time to time, the Company receives
customer  complaints  about the  timeliness  and  accuracy of customer  support.
Although the Company plans to add customer support personnel in order to address
current  customer  support needs and intends to closely monitor progress in this
area,  there can be no assurance that these efforts will be  successful.  If the
Company's efforts are not successful, the Company's business,  operating results
and financial condition could be materially  adversely  affected.  The Company's
ability to compete effectively and to manage future expansion of its operations,
if any,  will  require the Company to  continue  to improve  its  financial  and
management  controls,  reporting  systems and  procedures  on a timely basis and
expand, train and manage its employee work force. There can be no assurance that
the Company will be able to do so successfully.  The Company's  failure to do so
could have a material  adverse  effect upon the  Company's  business,  operating
results and financial condition.

Dependence Upon Key Personnel

     The Company's future  performance also depends in significant part upon the
continued service of its key technical and senior management personnel,  none of
whom is bound by an  employment  agreement.  The loss of the  services of one or
more of the  Company's  officers  or other key  employees  could have a material
adverse  effect on the  Company's  business,  operating  results  and  financial
condition.  The Company's future success also depends on its continuing  ability
to attract and retain  highly  qualified  technical  and  managerial  personnel.
Competition  for such  personnel is intense,  and there can be no assurance that
the Company can retain its key technical and managerial employees or that it can
attract,  assimilate or retain other highly  qualified  technical and managerial
personnel in the future.

Dependence on Growth in the Network Storage Management Market;
General Economic and Market Conditions

     All of the Company's  business is in the network storage management market,
which is still an emerging market.  The Company's  future financial  performance
will  depend in large part on  continued  growth in the number of  organizations
adopting network storage management solutions for their client/server  computing
environments.  There can be no  assurance  that the market for  network  storage
management will continue to grow. If the network storage management market fails
to grow or  grows  more  slowly  than the  Company  currently  anticipates,  the
Company's   business,   operating  results  and  financial  condition  would  be
materially  adversely  affected.  During recent years,  segments of the computer
industry  have  experienced  significant  economic  downturns  characterized  by
decreased product demand, production overcapacity, price erosion, work slowdowns
and layoffs. The Company's  operations may in the future experience  substantial
fluctuations from  period-to-period  as a consequence of such industry patterns,
general economic conditions affecting the timing of orders from major customers,
and other factors  affecting  capital  spending.  There can be no assurance that
such factors will not have a material adverse effect on the Company's  business,
operating results or financial condition.

Dependence on Proprietary Technology; Risks of Infringement


     The Company depends significantly upon proprietary technology.  The Company
relies  on a  combination  of  copyright  and  trademark  laws,  trade  secrets,
confidentiality procedures and contractual provisions to protect its proprietary
rights.  The Company  seeks to protect  its  software,  documentation  and other
written  materials  under trade  secret and  copyright  laws,  which afford only
limited  protection.  There can be no  assurance  that the Company  will develop
proprietary products or technologies that are patentable, that any issued patent
will  provide  the  Company  with  any  competitive  advantages  or will  not be
challenged  by third  parties,  or that the  patents  of others  will not have a
material  adverse  effect on the Company's  ability to do business.  Despite the
Company's efforts to protect its proprietary  rights,  unauthorized  parties may
attempt  to  copy  aspects  of the  Company's  products  or to  obtain  and  use
information that the Company regards as proprietary.  Policing  unauthorized use
of the Company's  products is  difficult,  and although the Company is unable to
determine the extent to which piracy of its software  products exists,  software
piracy can be expected to be a persistent problem. In selling its products,  the
Company  relies  primarily  on  "shrink  wrap"  licenses  that are not signed by
licensees,  and, therefore, such licenses may be unenforceable under the laws of
certain  jurisdictions.  In addition,  the laws of some foreign countries do not
protect the Company's proprietary rights to as great an extent as do the laws of
the  United  States.  There  can be no  assurance  that the  Company's  means of
protecting  its  proprietary  rights  will be  adequate  or that  the  Company's
competitors will not  independently  develop similar  technology,  duplicate the
Company's  products  or design  around  patents  issued to the  Company or other
intellectual property rights of the Company.


     There has also been  substantial  amounts  of  litigation  in the  software
industry  regarding  intellectual  property rights. The Company has from time to
time received claims that it is infringing third parties'  intellectual property
rights,  and there can be no assurance that third parties will not in the future
claim  infringement  by the Company with respect to current or future  products,
trademarks  or other  proprietary  rights.  The Company  expects  that  software
product  developers will  increasingly be subject to infringement  claims as the
number of products and competitors in the Company's  industry  segment grows and
the functionality of products in different industry segments overlaps.  Any such
claims,  with or  without  merit,  could be  time-consuming,  result  in  costly
litigation,  cause product  shipment delays or require the Company to enter into
royalty or  licensing  agreements.  Such  royalty or  licensing  agreements,  if
required,  may not be  available on terms  acceptable  to the Company or at all,
which  could  have a  material  adverse  effect  upon  the  Company's  business,
operating results and financial condition.

Product Liability


     The  Company's  license  agreements  with its customers  typically  contain
provisions  designed  to limit  the  Company's  exposure  to  potential  product
liability  claims.  In selling its  products,  the Company  relies  primarily on
"shrink wrap" licenses that are not signed by licensees,  and,  therefore,  such
licenses  may be  unenforceable  under the laws of certain  jurisdictions.  As a
result  of these and other  factors,  the  limitation  of  liability  provisions
contained  in  the  Company's  license  agreements  may  not be  effective.  The
Company's products can be used to manage data critical to organizations, and, as
a result, the sale and support of products by the Company may entail the risk of
product liability  claims. A successful  product liability claim brought against
the Company could have a material  adverse  effect upon the Company's  business,
operating results and financial condition.


Year 2000 Compliance


     Many currently  installed  computer systems and software products are coded
to accept only two digit entries in the date code field.  These date code fields
will need to accept four digit  entries to  distinguish  21st century dates from
20th century dates. As a result, in less than two years, computer systems and/or
software  used by many  companies  will need to be  upgraded to comply with such
"Year  2000"   requirements.   Systems  that  do  not  properly  recognize  such
information could generate erroneous data or cause a system to fail. Significant
uncertainty  exists in the software  industry  concerning the potential  effects
associated with such compliance. Management does not anticipate that the Company
will incur  significant  operating  expenses or be required to invest heavily in
computer  systems  improvements to be Year 2000 compliant.  Although the Company
believes  its  software  products  are  Year  2000  compliant,  there  can be no
assurance  that  the  Company's  software  products  contain  all the  necessary
software routines and programs for the accurate  calculation,  display,  storage
and  manipulation  of data  involving  dates.  The  Company  believes  that  the
purchasing patterns of customers and potential customers may be affected by Year
2000 issues as companies expend significant  resources to correct or patch their
current software systems for Year 2000 compliance. These expenditures may result
in reduced  funds  available to purchase  products  such as those offered by the
Company.  The occurrence of any of the foregoing  could have a material  adverse
effect on the Company's business, operating results or financial condition.

     Although the Company  believes the software and hardware it uses internally
comply with Year 2000 requirements and is not aware of any material  operational
issues or costs  associated  with  preparing  its  internally  used software and
hardware for the Year 2000, there can be no assurances that the Company will not
experience serious,  unanticipated  negative  consequences and/or material costs
caused by undetected  errors or defects in the  technology  used in its internal
systems.  The occurrence of any of the foregoing  could have a material  adverse
effect on the Company's business, operating results or financial condition.


Possible Volatility of Stock Price


     The trading  price of the  Company's  common stock has been subject to wide
fluctuations  in 1997. The trading price of the Company's  common stock could be
subject to wide  fluctuations in the future in response to quarterly  variations
in  operating  results,   announcements  of  technological  innovations  or  new
products,   applications   or  product   enhancements  by  the  Company  or  its
competitors,  changes in financial  estimates by  securities  analysts and other
events or factors. In addition, the stock market has experienced volatility that
has  particularly  affected the market prices of equity  securities of many high
technology  companies  and  that  often  has  been  unrelated  to the  operating
performance of such  companies.  These broad market  fluctuations  may adversely
affect the market price of the Company's common stock.

<PAGE>
ITEM 2.  PROPERTIES


     The Company's  principal  administrative,  sales,  marketing,  research and
development  facility is located in approximately 96,000 square feet of space in
Palo Alto,  California.  This facility is leased  through  September  2006.  The
Company  currently  leases other  domestic  sales offices  throughout the United
States, as well as international offices in Australia, Belgium, Canada, England,
France, Germany, Holland, Hong Kong, Japan and Sweden.


ITEM 3. LEGAL PROCEEDINGS


     The  Company is engaged in  certain  legal and  administrative  proceedings
incidental to the Company's business,  the outcome of which,  individually or in
the  aggregate,  is not  expected  to  have a  material  adverse  effect  on the
Company's business, results of operations or financial condition.


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

     The Company did not submit any matters to a vote of security holders during
the fourth quarter of the fiscal year ended December 31, 1997.

ITEM 4a.  EXECUTIVE OFFICERS OF THE REGISTRANT

     Set forth below are biographical summaries of the executive officers of the
Company as of December 31, 1997:


     Louis C. Cole, 54, joined the Company as President, Chief Executive Officer
and a Director  in June 1989.  Since  April  1995,  Mr.  Cole has also served as
Chairman of the Board.  Before  joining the Company,  from March 1987 until July
1988, Mr. Cole served as Executive Vice President  responsible for all operating
divisions of Novell, Inc.  ("Novell"),  a publicly held manufacturer of computer
networking and software products. Mr. Cole serves as a director of Qualix Group,
Inc. and Rogue Wave Software,  both publicly held software  companies.  Mr. Cole
holds a B.S. in mathematics and education from Pennsylvania  State University at
Edinboro.

     Kent D.  Smith,  48,  has  served as  Executive  Vice  President  and Chief
Operating  Officer of the Company  since May 1996.  He served as Executive  Vice
President of Customer Operations from March 1995 to May 1996. Before joining the
Company, from March 1994 until March 1995, Mr. Smith served as Vice President of
Emerging  Markets at VeriFone,  Inc.  ("VeriFone"),  a publicly held transaction
automation company.  Prior to joining VeriFone,  Mr. Smith held a range of sales
and marketing  positions in the United States and overseas with IBM  Corporation
("IBM"),  a publicly held manufacturer of computers and related  products,  from
1974 to 1994. Mr. Smith holds a B.A. in German from California  State University
at Fullerton and an M.B.A. from the University of Southern California.


     Stephen C. Wise,  43,  joined the Company in September  1996 as Senior Vice
President of Finance and  Administration  and Chief  Financial  Officer.  Before
joining the Company, Mr. Wise served as Senior Vice President, Finance at Novell
from  December  1993 to September  1996.  He was Vice  President  and  Corporate
Controller of Novell from January 1991 to December 1993 and was Vice  President,
Accounting and Planning from January 1990 to January 1991. Mr. Wise holds a B.S.
in  Accounting  from San Jose State  University  and an M.B.A.  from Santa Clara
University.

     Nora M.  Denzel,  35,  joined the  Company in January  1997 as Senior  Vice
President of Product Operations.  Before joining the Company,  Ms. Denzel served
as the director of IBM's storage  management  software products and held a range
of operations,  development and marketing  positions with IBM from 1984 to 1996.
Ms.  Denzel holds a B.S. in Computer  Science from the State  University  of New
York and an M.B.A. from Santa Clara University.


     John  Ferraro,  36,  joined the  Company in  December  1997 as Senior  Vice
President of Worldwide Sales Operations. Before joining the Company, Mr. Ferraro
held the  position of Vice  President of Sales for Unison  Software,  a publicly
held  network  management  software  company,   where  he  was  responsible  for
developing  the North  America sales  organization  on both a direct and channel
basis  from  December  1994 to  December  1997.  Prior  to that,  Mr.  Ferraro's
experience includes seven years in sales and management at Computer  Associates,
as Vice President of the Systems Management  division.  Mr. Ferraro holds a B.S.
in Accounting from the University of Colorado.


                                                      PART II

ITEM 5.    MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

     The common  stock of the  Company is traded on the Nasdaq  National  Market
under the symbol LGTO.  The Company  completed its initial  public  offering and
commenced  trading of its common stock on July 6, 1995. The following table sets
forth the high and low closing sales prices of the  Company's  common stock from
July 6, 1995 through  December 31, 1997.  Such prices  represent  prices between
dealers,  do not include retail mark-ups,  mark-downs or commissions and may not
represent actual transactions.

     Share  prices have been  adjusted to reflect the  two-for-one  split of the
Company's common stock which was effected July 5, 1996.
                                                  High                Low
           Fiscal 1995
           Third Quarter*                        $14.75              $11.50
           Fourth Quarter                        $19.88              $11.50
           Fiscal 1996
           First Quarter                         $21.50              $11.63
           Second Quarter                        $27.50              $17.50
           Third Quarter                         $48.00              $18.25
           Fourth Quarter                        $47.00              $26.75

           Fiscal 1997
           First Quarter                         $32.88              $16.13
           Second Quarter                        $24.88              $11.00
           Third Quarter                         $35.75              $17.38
           Fourth Quarter                        $46.63              $32.25


           *Commencing July 6, 1995

     As of February 28, 1998,  there were  approximately 75 holders of record of
the Company's common stock.  The Company  believes that a significant  number of
beneficial owners of its common stock hold shares in street name.

     The Company has never paid a cash dividend on its common stock and does not
intend to pay cash dividends on its common stock in the foreseeable future.


<PAGE>



ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA
<TABLE>
Five Year Summary

<CAPTION>
                                                                           December 31,
                                                      1997       1996           1995          1994          1993
                                                  --------      --------      --------       -------       -----
                                                                (in thousands, except per share amounts)

<S>                                               <C>           <C>           <C>            <C>           <C>
Revenues........................................  $ 81,834      $ 54,249      $ 29,777       $16,405       $ 12,152
Gross profit....................................    72,675        49,132        26,734        14,403          9,796
Income from operations..........................    22,690        13,334         7,382         1,574            268
Net income......................................    15,658         8,620         5,831         1,773            176
Net income per share - basic (1)................      0.90          0.52          0.59          0.46           0.05
Shares used in per share calculations - basic (1)   17,410        16,549         9,962         3,850          3,796
Net income per share - diluted (1)..............      0.83          0.46          0.39          0.15           0.01
Shares used in per share calculations-diluted (1)   18,863        18,771        15,109        11,836         11,864
Cash, cash equivalents and investments..........    71,409        57,081        49,526         4,031          1,173
Working capital.................................    70,871        51,925        38,896         3,113          1,409
Total assets....................................   113,765        83,142        58,827         8,274          4,883
Retained earnings (accumulated deficit).........    27,466        11,808         3,188        (2,643)        (4,416)
Total stockholders' equity......................    92,792        68,388        50,542         4,145          2,347

----------
<FN>
(1) See Note 1 of Notes to Consolidated Financial Statements
</FN>
</TABLE>


ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
           RESULTS OF OPERATIONS


     The  discussion  in this  report  on  Form  10-K  contains  forward-looking
statements  that involve risks and  uncertainties.  The statements  contained in
this Report that are not purely historical are 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,  including
statements  regarding  the  Company's  expectations,   beliefs,   intentions  or
strategies regarding the future. All forward-looking statements included in this
document are based on  information  available to the Company on the date hereof,
and the  Company  assumes  no  obligation  to  update  any such  forward-looking
statements.  The Company's  actual  results could differ  materially  from those
discussed.  Factors that could cause or contribute to such differences  include,
but are not limited to,  those  discussed  elsewhere in item 1 under the heading
"Risk  Factors" as well as those  discussed  elsewhere in this  Report,  and the
risks discussed in the Company's Securities Exchange Commission filings.


Results of Operations

Overview


     The Company  develops,  markets and  supports  network  storage  management
software products for heterogeneous  client/server computing  environments.  The
Company's NetWorker family of software products,  from which the Company derives
a substantial majority of its revenues,  supports many storage management server
platforms  and can  accommodate  a variety of  servers,  clients,  applications,
databases  and  storage  devices.  The Company  licenses  its  products  through
resellers and directly to end users in North  America,  Europe and Asia Pacific.
The Company also licenses its source code in exchange for initial licensing fees
to original equipment manufacturers ("OEMs") and receives ongoing royalties from
the OEMs' product sales. Substantially all of the OEMs are large computer system
and software suppliers located in the United States, Europe and Asia Pacific.


     Selected elements of the Company's  consolidated  financial  statements are
shown below for the last three years as a percentage of total  revenues and as a
percentage change from year to year.

<TABLE>
<CAPTION>
                                                                                                % Increase
                                                         % of Total Revenues                 1997          1996
                                                      Years Ended December 31,            Compared     Compared
                                                  1997          1996           1995        to 1996       to 1995
                                                ----------    ----------    ----------    --------       -------

<S>                                                   <C>           <C>          <C>            <C>           <C>
Revenues:
    Product and other                                 60.3%         59.3%         57.0%         54%           89%
    Royalty and license                               20.4          23.7          28.4          29            52
    Software subscription                             19.3          17.0          14.6          71           112
                                                ----------    ----------    ----------      ------        ------
       Total revenues                                100.0         100.0         100.0          51            82

Cost of revenues:
    Product and other                                  5.8           3.8           4.7         126            49
    Software subscription                              5.4           5.6           5.5          46            84
                                                ----------    ----------    ----------      ------        ------

Gross profit                                          88.8          90.6          89.8          48            84

Operating expenses:
    Research and development                          17.6          17.0          15.0          57           106
    Sales and marketing                               34.5          31.7          36.4          64            59
    General and administrative                         7.6          11.9          13.6          (4)           59
    Amortization of intangibles                        1.4           2.0            --           2            --
    In-process research and development                 --           3.4            --        (100)           --
                                                ----------    ----------    ----------      -------       ------
       Total operating expenses                       61.1          66.0          65.0          40            85
                                                ----------    ----------    ----------      ------        ------

Income from operations                                27.7          24.6          24.8          70            81

Interest income, net                                   2.6           3.3           4.0          21            52

Provision for income taxes                            11.2          12.0           9.2          41           138
                                                ----------    ----------    ----------      ------        ------

Net income                                            19.1%         15.9%         19.6%         82%           48%
                                                ==========    ==========    ==========      ======        ======
</TABLE>


Revenues

     Total revenues were $81.8 million, $54.2 million and $29.8 million in 1997,
1996 and 1995, respectively, representing an increase of 51 percent from 1996 to
1997  and 82  percent  from  1995 to 1996.  The  increases  principally  reflect
increased  licensing  of the  Company's  products,  increased  sales of software
subscriptions, as well as increased royalty revenue.

     Product and Other Revenues.  Product and other revenues were $49.4 million,
$32.1  million  and  $17.0  million  in  1997,  1996  and  1995,   respectively,
representing  increases of 54 percent from 1996 to 1997 and 89 percent from 1995
to 1996.  The increases in product and other revenues from 1996 to 1997 and from
1995 to 1996  primarily  represent  the  continued  acceptance  of the Company's
products.  Other revenues were less than 5 percent of product and other revenues
in 1997, 1996 and 1995. Product revenues are generally  recognized upon shipment
of the product, unless the Company has significant future obligations,  in which
case revenues are  recognized  when such  obligations  are  satisfied.  Sales to
domestic  distributors  are recognized  upon sale by the  distributors  to their
customers.  Other revenues are generally recognized when services are performed.
Prior  growth  rates  of the  Company's  product  and  other  revenues  are  not
indicative of future software  subscription  revenue growth rates and may not be
sustainable in the future.


     Royalty and License  Revenues.  Royalty  and  license  revenues  were $16.7
million,  $12.9 million and $8.4 million in 1997,  1996 and 1995,  respectively,
representing  increases of 29 percent from 1996 to 1997 and 52 percent from 1995
to 1996.  Royalty  fees were $15.9  million,  $11.2  million and $7.6 million in
1997, 1996 and 1995,  respectively,  and license fee revenue was $750,000,  $1.7
million and  $850,000 in 1997,  1996 and 1995,  respectively.  The  increases in
royalty and license  revenues  from 1996 to 1997  primarily  relate to increased
royalties  from product sales by SunSoft and other OEMs. The increase in royalty
and license  revenues from 1995 to 1996 is attributable  to increased  royalties
from product sales by SunSoft and increased  licenses from new OEMs and licenses
from existing OEMs adding NetWorker for the Windows NT platform to their product
offerings.  Generally,  the Company's license  agreements provide for an initial
non-recurring  license fee, with subsequent  royalty  payments based upon future
sales  of the  licensees'  product.  There  is  typically  a time  lag  from the
consummation of the license  arrangement  until the receipt of royalty payments,
due to the OEMs' product development cycles.  Initial license fees are generally
recognized  upon  shipment of the  product,  unless the Company has  significant
future obligations,  in which case revenues are recognized when such obligations
are satisfied. Royalty revenues are recognized upon receipt of quarterly royalty
reports from source code OEMs and SunSoft with  respect to their  product  sales
for the  previous  quarter.  Prior  growth  rates of the  Company's  royalty and
license  revenues are not  indicative of future  software  subscription  revenue
growth rates and may not be sustainable in the future.


     Software Subscriptions.  Software subscription revenues were $15.8 million,
$9.2 million and $4.4 million in 1997, 1996 and 1995, respectively, representing
increases  of 71 percent  from 1996 to 1997 and 112  percent  from 1995 to 1996.
This  growth was  primarily  due to the  increase  in the  number of  registered
customers for the Company's  products  electing to subscribe to maintenance  and
support  contracts  as well as the renewal of software  subscriptions  after the
initial one-year term and increased internal staffing for software  subscription
sales.  Software  subscription  fees for  ongoing  customer  support and product
updates are collected in advance and are  recognized  ratably over the period of
the contract. Prior growth rates of the Company's software subscription revenues
are not indicative of future software  subscription revenue growth rates and may
not be sustainable in the future.

     International  product sales  accounted  for 24 percent,  20 percent and 16
percent of total revenues in 1997, 1996 and 1995,  respectively.  The increasing
volume of international  sales was primarily  attributable to an increase in the
market acceptance of the Company's products overseas,  an increase in the number
of international  sales offices,  and an increase in the number of international
distributors  and resellers  marketing the Company's  products.  The majority of
international  sales  during these  periods were made in Europe and Canada.  The
Company  established  a sales office in Germany  during 1994,  sales  offices in
France,  England and  Australia  during  1995,  sales  offices in Canada and the
Netherlands  during 1996, and sales offices in Japan and Sweden during 1997. The
Company  believes  that its  continued  growth and  profitability  will  require
further  expansion of its  international  operations.  In order to  successfully
expand  international  sales in 1998 and  subsequent  periods,  the Company must
continue to establish  additional foreign operations,  hire additional personnel
and recruit additional  international  resellers.  This will require significant
management  attention and financial  resources  and could  materially  adversely
affect the Company's operating results. To the extent that the Company is unable
to effect these additions in a timely manner,  the Company's  growth, if any, in
international  sales will be  limited,  and the  Company's  business,  operating
results and financial  condition  could be  materially  adversely  affected.  In
addition, there can be no assurance that the Company will be able to maintain or
increase  international market demand for the Company's products.  The Company's
international  sales are currently  denominated in U.S. dollars.  An increase in
the value of the U.S.  dollar  relative  to  foreign  currencies  could make the
Company's products more expensive and,  therefore,  potentially less competitive
in those markets.  In some markets,  localization  of the Company's  products is
essential to achieve market penetration. The Company may incur substantial costs
and experience delays in localizing its products,  and there can be no assurance
that any localized product will ever generate significant revenues.

Gross Profit

     Gross  profit  was  $72.7   million,   $49.1  million  and  $26.7  million,
representing  88.8 percent,  90.6 percent and 89.8 percent of total  revenues in
1997,  1996 and 1995,  respectively.  The  increases  in total gross profit were
attributable  to the  higher  levels of  revenues  from all  sources,  including
royalties and licenses, which do not generate any material cost of revenues.

     Gross  profit from  product and other  revenues  was $44.7  million,  $30.1
million and $15.6  million,  representing  90.4  percent,  93.5 percent and 91.8
percent of product  and other  revenues  in 1997,  1996 and 1995,  respectively.
Gross  profit  from  product  and other  revenues  consists of product and other
revenues  less the related  cost,  which  consists  primarily of product  media,
documentation  and packaging costs, and the costs of providing  certain training
and consulting.  The decrease in gross profit from product and other revenues as
a percentage of product and other  revenues in 1997 from the same period in 1996
was primarily due to increases in training and  consulting  costs.  In the first
three  quarters of 1996,  product  costs  include  clinical  research  expenses,
reflecting  the principal  activity of Innovus,  Inc.,  which was acquired along
with Innovus  Technologies,  Inc. in January 1996.  Substantially all of the net
assets of Innovus, Inc., the Company's clinical research business,  were sold in
September  1996  and  the  Company  has  discontinued   all  clinical   research
activities.  The  discontinuance  did  not  have  a  significant  effect  on the
operating results of the Company.

     Gross profit from software  subscription  revenues was $11.4 million,  $6.2
million and $2.7 million in 1997, 1996 and 1995, representing 71.9 percent, 67.2
percent  and  62.3  percent  of the  related  revenue  in 1997,  1996 and  1995,
respectively.  Gross  profit from  software  subscription  revenues  consists of
software  subscription  revenues less the related cost, which consists primarily
of personnel-related costs incurred in providing telephone support and the costs
of  providing  software  updates.  The  increase in gross  profit from  software
subscriptions as a percentage of the related revenue was primarily  attributable
to the Company's leveraging of its installed base through subscription renewals,
as well as more efficient utilization of resources devoted to this activity.

Operating Expenses

     Research  and  Development.   Research  and  development  expenses  consist
primarily of  personnel-related  costs.  Research and development  expenses were
$14.4 million,  $9.2 million and $4.5 million,  representing 17.6 percent,  17.0
percent and 15.0 percent of total revenues in 1997, 1996 and 1995, respectively.
Research and development expenses increased 57 percent from 1996 to 1997 and 106
percent from 1995 to 1996,  reflecting increased staffing and associated support
for engineers  necessary to expand and enhance the Company's  product line.  The
Company  believes  that  research  and  development  expenses  will  continue to
increase in dollar  amounts from the levels  experienced  in 1997 as the Company
continues to invest in the development of new products, applications and product
enhancements.


     Sales and  Marketing.  Sales and marketing  expenses  consist  primarily of
salaries and  commissions  for sales and  marketing  personnel  and  promotional
expenses.  Sales and marketing  expenses were $28.2  million,  $17.2 million and
$10.8 million, representing 34.5 percent, 31.7 percent and 36.4 percent of total
revenues  in 1997,  1996 and  1995,  respectively.  The  increases  in sales and
marketing expenses in 1997 and 1996 were primarily attributable to the growth of
the Company's sales force and associated support personnel,  increased marketing
and promotional  activities and increased commission  expenses.  The decrease in
1996,  as a percentage  of total  revenues,  was  primarily  due to  promotional
expenses increasing  significantly less than the increase in total revenues. The
Company  believes  that sales and  marketing  expenses  will  increase in dollar
amounts as the Company continues to expand its sales and marketing staff.


     General and Administrative. General and administrative expenses include the
personnel and other costs of the finance,  human resources,  information systems
and  administrative  departments  of the  Company.  General  and  administrative
expenses were $6.2  million,  $6.4 million and $4.0  million,  representing  7.6
percent,  11.9  percent,  and 13.6 percent of total  revenues in 1997,  1996 and
1995,  respectively.  The decreases in general and administrative  expenses as a
percentage  of total  revenues  were  attributable  to  leveraging  general  and
administrative  expenses  over a larger  revenue  base.  The  decrease in dollar
amount in 1997  from the same  period  in 1996 was due to  allocating  a greater
amount of  central  operating  expenses  to  benefiting  departments  within the
Company. The increase in dollar amount of general and administrative expenses in
1996 from the same period in 1995 was  attributable  to  increased  staffing and
related  costs  required  to manage and  support  the  Company's  expansion.  In
addition,  1995 includes  litigation  related costs in connection with a lawsuit
settled in November  1995. The Company  expects that general and  administrative
expenses will increase in dollar amount as the Company expands its staffing.

Interest Income, Net

         Interest income, net, was $2.2 million,  $1.8 million, and $1.2 million
for 1997, 1996 and 1995,  respectively.  The increases in interest income relate
primarily  to  interest  earned  from the  investment  of  available  cash  from
operations and the proceeds from the Company's  initial public offering in July,
1995.

<PAGE>

Provision for Income Taxes

     The provisions for income taxes for 1997,  1996 and 1995 were $9.2 million,
$6.5 million and $2.7  million,  respectively.  The effective tax rates in 1997,
1996 and 1995 were 37  percent,  43 percent and 32  percent,  respectively.  The
effective  tax rate for 1996,  excluding  the  effect  of a  non-tax  deductible
write-off of  in-process  research  and  development,  was 38 percent.  The 1997
effective  tax  rate   decreased   from  1996  primarily  as  a  result  of  the
reinstatement of the federal  research and experimental tax credit.  The Company
anticipates no significant change in its tax rate for 1998.

Liquidity and Capital Resources

     The Company's cash, cash equivalents and investments  totaled $71.4 million
at December 31, 1997 and  represented 63 percent of total assets.  Cash and cash
equivalents  are highly liquid  investments  with original  maturities of ninety
days or less.  Investments  consist mainly of short-term and long-term municipal
securities.  At  December  31,  1997,  the  Company  had no  long-term  debt and
stockholders' equity was $92.8 million.


     Cash  generated  from  operations  and  sales  of  common  stock  has  been
sufficient  to  finance  the  Company's  operations.  Cash and cash  equivalents
increased $7.1 million during 1997. Net cash provided by operating activities of
$18.0 million was derived primarily from net income of $15.7 million.  Cash used
in investing  activities of $14.7 million primarily reflected the acquisition of
property  and  equipment of $7.2 million and  purchases of  available-for-  sale
securities,  net of maturities and sales of  available-for-sale  securities,  of
$7.2 million.  Cash from financing  activities of $3.8 million reflects proceeds
received from the issuance of common stock under the Company's stock plans.


     The  Company  believes  its  current  cash  balances  and  cash  flow  from
operations,  if any, will be sufficient to meet its working  capital and capital
expenditure requirements for at least the next twelve months.

Year 2000 Compliance


     Many currently  installed  computer systems and software products are coded
to accept only two digit entries in the date code field.  These date code fields
will need to accept four digit  entries to  distinguish  21st century dates from
20th century dates. As a result, in less than two years, computer systems and/or
software  used by many  companies  will need to be  upgraded to comply with such
"Year  2000"   requirements.   Systems  that  do  not  properly  recognize  such
information could generate erroneous data or cause a system to fail. Significant
uncertainty  exists in the software  industry  concerning the potential  effects
associated with such compliance. Management does not anticipate that the Company
will incur  significant  operating  expenses or be required to invest heavily in
computer  systems  improvements to be Year 2000 compliant.  Although the Company
believes  its  software  products  are  Year  2000  compliant,  there  can be no
assurance  that  the  Company's  software  products  contain  all the  necessary
software routines and programs for the accurate  calculation,  display,  storage
and  manipulation  of data  involving  dates.  The  Company  believes  that  the
purchasing patterns of customers and potential customers may be affected by Year
2000 issues as companies expend significant  resources to correct or patch their
current software systems for Year 2000 compliance. These expenditures may result
in reduced  funds  available to purchase  products  such as those offered by the
Company.  The occurrence of any of the foregoing  could have a material  adverse
effect on the Company's business, operating results or financial condition.

     Although the Company  believes the software and hardware it uses internally
comply with Year 2000 requirements and is not aware of any material  operational
issues or costs  associated  with  preparing  its  internally  used software and
hardware for the Year 2000, there can be no assurances that the Company will not
experience serious,  unanticipated  negative  consequences and/or material costs
caused by undetected  errors or defects in the  technology  used in its internal
systems.  The occurrence of any of the foregoing  could have a material  adverse
effect on the Company's business, operating results or financial condition.

Subsequent Event

     In March 1998, the Company announced that its Board of Directors approved a
two-for-one  stock  split  (in  the  form of a  dividend)  that  is  payable  to
stockholders of record on April 3, 1998 and will be effective on April 17, 1998.
Share and per share data presented here have not been adjusted to give effect to
this two-for-one split.


ITEM 8.  CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                   Index to Consolidated Financial Statements

Consolidated Balance Sheets at December 31, 1997 and 1996 ................    22

Consolidated Statements of Income for each of the three years
     in the period ended December 31, 1997 ...............................    23

Consolidated Statements of Stockholders' Equity for each of the
     three years in the period ended December 31, 1997 ...................    24

Consolidated Statements of Cash Flows for each of the
     three years in the period ended December 31, 1997 ...................    25

Notes to the Consolidated Financial Statements ...........................    26

Report of Independent Accountants ........................................    38


ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
           FINANCIAL DISCLOSURE

    Not applicable.

<PAGE>
<TABLE>
                              LEGATO SYSTEMS, INC.

                           CONSOLIDATED BALANCE SHEETS

                    (in thousands, except per share amounts)

<CAPTION>
                                                                                             December 31,
                                                                                        1997              1996
                                                                                     ----------        -------

                             ASSETS

<S>                                                                                  <C>               <C>
Current assets:
     Cash and cash equivalents ...................................................   $   34,763        $  27,673
     Short-term investments.......................................................       28,147           22,391
     Accounts receivable, net.....................................................       21,109            9,839
     Other current assets.........................................................        4,355            2,870
     Deferred tax asset...........................................................        2,702            2,652
                                                                                     ----------        ---------
         Total current assets.....................................................       91,076           65,425
Long-term investments.............................................................        8,499            7,017
Property and equipment, net.......................................................       10,397            6,029
Intangible assets, net............................................................        3,431            4,470
Other assets......................................................................          362              201
                                                                                     ----------        ---------
              Total assets........................................................   $  113,765        $  83,142
                                                                                     ==========        =========

                  LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
     Accounts payable.............................................................   $    2,025        $   1,205
     Accrued compensation and benefits............................................        3,874            2,394
     Accrued liabilities..........................................................        2,216            2,320
     Deferred revenues............................................................       12,090            7,581
                                                                                     ----------        ---------
         Total current liabilities................................................       20,205           13,500
Deferred tax liability............................................................          768            1,254

Commitments (Note 4)

Common stock, $.0001 par value: 50,000 shares authorized and
   17,774 and 16,938 shares issued and outstanding at December 31, 1997
   and 1996, respectively.........................................................            2                2
Additional paid-in capital........................................................       65,316           56,592
Retained earnings.................................................................       27,466           11,808
Deferred stock compensation.......................................................          (22)             (40)
Unrealized gain on investments, net...............................................           30               26
                                                                                     ----------        ---------
         Total stockholders' equity...............................................       92,792           68,388
                                                                                     ----------        ---------
              Total liabilities and stockholders' equity..........................   $  113,765        $  83,142
                                                                                     ==========        =========
</TABLE>

              The accompanying  notes are an integral part of these consolidated
financial statements.
<PAGE>
<TABLE>
                                               LEGATO SYSTEMS, INC.

                                         CONSOLIDATED STATEMENTS OF INCOME

                                       (in thousands, except per share data)


<CAPTION>
                                                                                  Year Ended December 31,
                                                                           1997            1996           1995
                                                                         ---------      ---------       ------

<S>                                                                      <C>            <C>             <C>
Revenues:
    Product and other................................................    $  49,375      $  32,138       $ 16,972
    Royalty and license..............................................       16,661         12,872          8,443
    Software subscription............................................       15,798          9,239          4,362
                                                                         ---------      ---------       --------
       Total revenues................................................       81,834         54,249         29,777
Cost of revenues:
    Product and other................................................        4,725          2,087          1,398
    Software subscription............................................        4,434          3,030          1,645
                                                                         ---------      ---------       --------
       Total cost of revenues........................................        9,159          5,117          3,043
                                                                         ---------      ---------       --------
Gross profit.........................................................       72,675         49,132         26,734
Operating expenses:
    Research and development.........................................       14,428          9,199          4,464
    Sales and marketing..............................................       28,228         17,210         10,839
    General and administrative.......................................        6,211          6,443          4,049
    Amortization of intangibles......................................        1,118          1,097             --
    In-process research and development..............................           --          1,849             --
                                                                         ---------      ---------       --------
       Total operating expenses......................................       49,985         35,798         19,352
                                                                         ---------      ---------       --------
Income from operations...............................................       22,690         13,334          7,382
Interest income, net.................................................        2,164          1,790          1,178
                                                                         ---------      ---------       --------
Income before provision for income taxes.............................       24,854         15,124          8,560
Provision for income taxes...........................................        9,196          6,504          2,729
                                                                         ---------      ---------       --------
Net income...........................................................    $  15,658      $   8,620       $  5,831
                                                                         =========      =========       ========
Net income per share - basic.........................................    $    0.90      $    0.52       $   0.59
                                                                         =========      =========       ========
Net income per share - diluted.......................................    $    0.83      $    0.46       $   0.39
                                                                         =========      =========       ========
Shares used in per share calculations - basic........................       17,410         16,549          9,962
                                                                         =========      =========       ========
Shares used in per share calculations - diluted......................       18,863         18,771         15,109
                                                                         =========      =========       ========
</TABLE>

              The accompanying  notes are an integral part of these consolidated
financial statements.
<PAGE>
<TABLE>
                              LEGATO SYSTEMS, INC.

                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

                                 (in thousands)


<CAPTION>
                                                                              Retained   Deferred     Unrealized
                                  Convertible-                 Additional     Earnings/    Stock     Gain (Loss)
                                 Preferred Stock  Common Stock   Paid-in    (Accumulated Compen-     on Invest-
                                 Shares Amount   Shares Amount   Capital       Deficit)   sation     ments, Net    Total

<S>                              <C>     <C>     <C>      <C>    <C>         <C>         <C>         <C>          <C>
Balances, December 31, 1994....   3,600  $ --    3,884    $ --   $  6,788    $ (2,643)   $     --    $     --     $ 4,145

Stock issued under option plans      --    --      382      --        147          --          --          --         147
Stock issued in IPO, net of
   issuance costs of $3,883....      --    --    4,600       1     39,814          --          --          --      39,815
Conversion of preferred stock
   to common stock.............  (3,600)   --    7,200       1         --          --          --          --           1
Tax benefit from exercise of
   stock options...............      --    --       --      --        560          --          --          --         560
Deferred stock compensation....      --    --       --      --         74          --         (58)         --          16
Unrealized gain on investments.      --    --       --      --         --          --          --          27          27
Net income.....................      --    --       --      --         --       5,831          --          --       5,831
                                 ------  ----   ------    ----   --------    --------    --------    --------     -------
Balances, December 31, 1995....      --    --   16,066       2     47,383       3,188         (58)         27      50,542

Stock issued under option plans      --    --      767      --      1,044          --          --          --       1,044
Stock issued under employee
   stock purchase plan.........      --    --      105      --        887          --          --          --         887
Tax benefit from exercise of
   stock options...............      --    --       --      --      7,115          --          --          --       7,115
Deferred stock compensation....      --    --       --      --        163          --          18          --         181
Unrealized loss on investments.      --    --       --      --         --          --          --          (1)         (1)
Net income.....................      --    --       --      --         --       8,620          --          --       8,620
                                 ------  ----   ------    ----   --------    --------    --------    --------     -------
Balances, December 31, 1996....      --    --   16,938       2     56,592      11,808         (40)         26      68,388

Stock issued under option plans      --    --      705      --      2,335          --          --          --       2,335
Stock issued under employee
   stock purchase plan.........      --    --      131      --      1,419          --          --          --       1,419
Tax benefit from exercise of
   stock options...............      --    --       --      --      4,970          --          --          --       4,970
Deferred stock compensation....      --    --       --      --         --          --          18          --          18
Unrealized loss on investments.      --    --       --      --         --          --          --           4           4
Net income.....................      --    --       --      --         --      15,658          --          --      15,658
                                 ------  ----   ------    ----   --------    --------    --------    --------     -------
Balances, December 31, 1997....      --  $ --   17,774    $  2  $  65,316    $ 27,466    $    (22)   $     30     $92,792
                                 ======  ====   ======    ====  =========    ========    ========    ========     =======
</TABLE>

              The accompanying  notes are an integral part of these consolidated
financial statements.
<PAGE>
<TABLE>
                              LEGATO SYSTEMS, INC.

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                                 (in thousands)


<CAPTION>
                                                                                  Year Ended December 31,
                                                                           1997            1996           1995
                                                                         ---------      ---------       ------

<S>                                                                      <C>            <C>             <C>
Cash flows from operating activities:
     Net income......................................................    $  15,658      $   8,620       $  5,831
     Adjustments to reconcile net income to net cash provided by
         operating activities:
         Net deferred tax assets.....................................         (536)        (1,308)        (1,169)
         Depreciation and amortization...............................        3,948          2,130            677
         Write-off of in-process research and development............           --          1,849             --
         Provision for doubtful accounts.............................          260            197            440
         Tax benefit from exercise of stock options..................        4,970          7,115            560
         Other.......................................................           --            163             --
         Changes in operating assets and liabilities:
              Accounts receivable....................................      (11,530)        (3,725)        (3,359)
              Other current assets...................................       (1,485)        (1,790)          (775)
              Accounts payable.......................................          820            354            376
              Deferred revenues......................................        4,509          2,530          2,220
              Accrued expenses.......................................        1,376            981          1,883
                                                                         ---------      ---------       --------
              Net cash provided by operating activities..............       17,990         17,116          6,684
Cash flows from investing activities:
     Purchase of available-for-sale securities.......................      (44,066)       (47,943)      (163,570)
     Maturities and sales of available-for-sale securities...........       36,832         38,228        143,914
     Acquisition of property and equipment...........................       (7,198)        (5,412)        (1,260)
     Payment for purchase of subsidiaries, net of cash acquired......           --         (5,924)            --
     Other...........................................................         (240)          (173)            54
                                                                         ----------     ---------       --------
              Net cash used in investing activities..................      (14,672)       (21,224)       (20,862)
Cash flows from financing activities:
     Proceeds from issuance of common stock..........................        3,754          1,931         39,963
     Other...........................................................           18             18             16
                                                                         ---------      ---------       --------
              Net cash provided by financing activities..............        3,772          1,949         39,979
                                                                         ---------      ---------       --------
              Net increase (decrease) in cash and cash equivalents...        7,090         (2,159)        25,801
Cash and cash equivalents at beginning of period.....................       27,673         29,832          4,031
                                                                         ---------      ---------       --------
Cash and cash equivalents at end of period...........................    $  34,763      $  27,673       $ 29,832
                                                                         =========      =========       ========

Supplemental Cash Flow Information:

Cash transaction:
     Cash paid for income taxes......................................    $   4,910      $   3,080       $  1,017
Non-cash transactions
     Conversion of preferred stock...................................           --             --          6,785
     Deferred tax liability..........................................           --          1,568             --
</TABLE>

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



<PAGE>

                              LEGATO SYSTEMS, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.  Summary of Significant Accounting Policies

Nature of Operations


     The Company  develops,  markets and  supports  network  storage  management
software products for  heterogeneous  client/server  computing  environments and
large scale  enterprises.  The Company's  NetWorker family of software products,
from which the Company derives a substantial majority of its revenues,  supports
many  storage  management  server  platforms  and can  accommodate  a variety of
clients,  servers,  applications,  databases  and storage  devices.  The Company
licenses  its  products  through  resellers  and  directly to end users in North
America,  Europe and Asia Pacific.  The Company also licenses its source code in
exchange for initial licensing fees to original equipment manufacturers ("OEMs")
and receives ongoing  royalties from the OEMs' product sales.  Substantially all
of the OEMs are large  computer  system and  software  suppliers  located in the
United States, Europe and Asia Pacific.


Basis of Presentation

     The consolidated  financial  statements include the accounts of the Company
and  its  wholly  owned   subsidiaries  and  branch  offices.   All  significant
intercompany   balances  and  transactions   have  been   eliminated.   Accounts
denominated  in foreign  currencies  have been  remeasured  into the  functional
currency,  using the U. S. dollar as the functional  currency.  Foreign currency
gains and losses from remeasurement, which have been insignificant, are included
in the consolidated statements of income.

Use of Estimates

     The  preparation  of financial  statements  in  conformity  with  generally
accepted  accounting  principles  requires  management  to  make  estimates  and
assumptions  that affect the  reported  amounts of assets and  liabilities,  the
disclosure of  contingent  assets and  liabilities  at the date of the financial
statements  and the  reported  amounts  of  revenues  and  expenses  during  the
reporting period. Actual results could differ from those estimates.

Financial Instruments

     Cash  equivalents are highly liquid  investments with original or remaining
maturities of three months or less as of the date of purchase.  Cash equivalents
present insignificant risk of changes in value because of interest rate changes.
The Company  maintains its cash balances at a variety of financial  institutions
and has not experienced any material losses relating to such instruments.

     Short-term and long-term investments on the balance sheet are classified as
available-for-sale  and are carried at fair value,  with the unrealized gains or
losses, net of tax, reported in stockholders' equity. The amortized cost of debt
securities is adjusted for  amortization  of premiums and accretion of discounts
to maturity,  both of which are included in interest income.  Realized gains and
losses are recorded on the specific identification method.

     The amounts reported for cash equivalents,  receivables and other financial
instruments  are  considered to  approximate  fair values based upon  comparable
market information  available at the respective  balance sheet dates.  Financial
instruments that  potentially  subject the Company to  concentrations  of credit
risks comprise principally cash, investments and trade accounts receivable.  The
Company invests its excess cash in accordance with its investment policy that is
approved by the Board of Directors and reviewed  periodically to minimize credit
risk.  The  policy  authorizes  the  investment  of  excess  cash in  government
securities,  tax exempt municipal  securities,  Eurodollar notes and bonds, time
deposits, certificates of deposit, commercial paper rated Aa or better and other
specific money market and corporate  instruments of similar liquidity and credit
quality.
<PAGE>

                              LEGATO SYSTEMS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


Property and Equipment

     Property and equipment are stated at cost.  Depreciation  is provided using
the  straight-line  method over the  estimated  useful  lives of the  respective
assets, which is generally three years.

Intangible Assets


     Intangible  assets include goodwill and purchased  technology,  recorded in
connection with the acquisition of Innovus, Inc., Innovus Technologies, Inc. and
815598 Ontario, Inc.  (collectively  "Innovus"),  which are being amortized on a
straight-line  basis over five years.  The  Company  periodically  assesses  the
recoverability of intangible  assets by determining  whether the amortization of
the asset balance over its remaining life can be recovered through  undiscounted
future operating cash flows of the acquired operation. The amount of impairment,
if any, is measured based on projected  discounted  future  operating cash flows
and is recognized as a write down of the asset to a net realizable value.


Revenue Recognition


     The  Company's  revenues  are  derived  from  three  sources,  across  many
industries:  (i) product and other  revenues,  which are derived  primarily from
product  sales to  resellers  and end users,  as well as from  services  such as
consulting;  (ii) royalty and license revenues, which are derived primarily from
initial  license fees and ongoing  royalties  from product  sales by source code
OEMs; and (iii) software subscription revenues, which are derived primarily from
contracts  providing for software updates,  maintenance and support to end users
and which are charged separately from the Company's software products.


     The  Company  recognizes  product  revenues  and  license  fees,  including
advanced  royalty   payments,   upon  shipment  if  remaining   obligations  are
insignificant,  collection of the resulting receivables is probable, and product
returns are  reasonably  estimable,  except for sales to domestic  distributors,
which are recognized upon sale by the distributors to their customers. Estimated
sales returns are recorded upon  recognition of revenues from  customers  having
rights of return,  including  exchange  rights for unsold  products  and product
upgrades.   Provisions  for  estimated  warranty  costs,   insignificant  vendor
obligations and anticipated  retroactive  price  adjustments are recorded at the
time products are shipped.

     Royalty  revenues that are contingent  upon sale to an end user by OEMs are
recognized upon receipt of a report of sale by the Company from the OEM.

     Customer maintenance fees for ongoing customer support and product updates,
including such fees bundled with the initial license fee, are recognized ratably
over the period of the  contract.  Payments for  maintenance  fees are generally
made in advance and are  non-refundable.  Other service revenue is recognized as
the related service is performed.

     The Company performs ongoing credit evaluations of its customers' financial
condition and does not require collateral.  The Company maintains allowances for
potential   credit  losses  and  such  losses  have  been  within   management's
expectations.

Research and Development Costs

     Costs incurred in the research and development of new software products are
expensed as incurred until  technological  feasibility is established.  To date,
the  establishment  of technological  feasibility of the Company's  products and
general release substantially coincide.

<PAGE>
Income Taxes

     The  Company's  provision  for income taxes is comprised of its current tax
liability  and the change in deferred tax assets and  liabilities.  Deferred tax
assets and liabilities  are determined  based on differences  between  financial
reporting  and tax bases of assets and  liabilities  and are measured  using the
enacted  tax rates and laws that  will be in  effect  when the  differences  are
expected to reverse.

Advertising and Promotional Costs

     The  Company  expenses  advertising  and  promotional  costs  as  they  are
incurred. Advertising expense for 1997, 1996 and 1995 was $2,209,000, $1,749,000
and $1,475,000, respectively.

Computation of Net Income Per Share


     The Company has adopted the provisions of Statement of Financial Accounting
Standards No. 128,  "Earnings Per Share",  ("SFAS 128")  effective  December 31,
1997.  SFAS 128  requires the  presentation  of basic and diluted net income per
share.  Basic net income per share is computed by dividing net income  available
to  common  stockholders  by  the  weighted  average  number  of  common  shares
outstanding  for the period.  Diluted  net income per share is  computed  giving
effect to all dilutive  potential common shares that were outstanding during the
period.  Dilutive  potential common equivalent shares consist of the incremental
common shares issuable upon conversion of convertible preferred stock (using the
"if  converted"  method) and exercise of stock options and  warrants.  All prior
period net income per share amounts have been restated to comply with SFAS 128.


     In   accordance   with  the   disclosure   requirements   of  SFAS  128,  a
reconciliation  of the numerator and denominator of basic and diluted net income
per share is provided as follows (in thousands, except per share amounts):

<TABLE>
                                                                                  Year Ended December 31,
                                                                           1997            1996           1995
                                                                         ---------      ---------       ------
<S>                                                                      <C>            <C>             <C>
Numerator - Net income per share, basic and diluted
     Net income......................................................    $  15,658      $   8,620       $  5,831
                                                                         =========      =========       ========

Denominator - Net income per share, basic
     Weighted average common shares outstanding......................       17,410         16,549          9,962
                                                                         ---------      ---------       --------
     Net income per share - basic....................................    $   0.90       $    0.52       $   0.59
                                                                         ========       =========       ========

Denominator - Net income per share, diluted
     Weighted average common shares outstanding......................       17,410         16,549          9,962
     Effect of dilutive securities:..................................
              Common stock options...................................        1,453          2,222          1,547
              Convertible preferred shares...........................           --             --          3,600
                                                                         ---------      ---------       --------
     Weighted average common and common equivalent shares............       18,863         18,771         15,109
                                                                         ---------      ---------       --------
     Net income per share - diluted..................................    $   0.83       $    0.46       $   0.39
                                                                         ========       =========       ========
</TABLE>

Options  to  purchase  96,000,  38,000 and  20,000  shares of common  stock were
outstanding  at December 31,  1997,  1996 and 1995,  respectively,  but were not
included in the calculation of diluted net income per share because the options'
exercise price was greater than the average market price of the common shares.

<PAGE>
Recent Pronouncements


     In June 1997,  the  Financial  Accounting  Standards  Board  (FASB)  issued
Statement  of  Financial   Accounting   Standards  No.  130,   "Accounting   for
Comprehensive  Income." This statement  establishes  standards for reporting and
display  of  comprehensive  income  and  its  components   (including  revenues,
expenses,  gains  and  losses)  in  a  full  set  of  general-purpose  financial
statements.  This  statement  is  effective  for fiscal  years  beginning  after
December 15, 1997.

     In June 1997, the Financial  Accounting Standards Board issued Statement of
Financial  Accounting  Standards  No.  131,  "Disclosures  about  Segments of an
Enterprise and Related Information." ("SFAS 131"), which supercedes Statement of
Financial Accounting Standards,  "Financial Reporting for Segments of a Business
Enterprise"  ("SFAS 14").  SFAS 131 changes  current  practice  under SFAS 14 by
establishing  a new  framework  on  which  to base  segment  reporting  and also
requires interim reporting of segment  information.  This statement is effective
for fiscal years beginning after December 15, 1997.

     In October  1997,  the  Accounting  Standards  Executive  Committee  issued
Statement of Position 97-2,  Software Revenue  Recognition  ("SOP 97-2"),  which
delineates the accounting for software  product and  maintenance  revenues.  SOP
97-2  supersedes  the  Accounting  Standards  Executive  Committee  Statement of
Position 91-1, Software Revenue  Recognition,  and is effective for transactions
entered into in fiscal years  beginning  after December 15, 1997. The Company is
evaluating  the  requirements  of SOP  97-2  and the  effects,  if  any,  on the
Company's current revenue recognition policies.


Reclassifications


     Certain  reclassifications  were  made to the 1995  and  1996  consolidated
financial statements to conform to the 1997 presentation.  The reclassifications
have no significant effect on previously reported financial position, results of
operations or cash flows.


2.  Consolidated Balance Sheet Detail
<TABLE>
                                                                                             December 31,
                                                                                        1997              1996
                                                                                     ----------        -------
                                                                                           (in thousands)
<S>                                                                                  <C>               <C>
Accounts receivable:
     Trade accounts receivable....................................................   $   21,908        $  10,651
     Allowance for doubtful accounts..............................................         (799)            (812)
                                                                                     -----------       ---------
                                                                                     $   21,109        $   9,839
                                                                                     ==========        =========

Property and equipment:
     Computer equipment...........................................................   $    9,606        $   5,670
     Furniture and fixtures.......................................................        2,065            1,663
     Office equipment.............................................................        1,448            1,040
     Leasehold improvements.......................................................        2,671              936
                                                                                     ----------        ---------
                                                                                         15,790            9,309
     Accumulated depreciation.....................................................       (5,393)          (3,280)
                                                                                     -----------       ---------
                                                                                     $   10,397        $   6,029
                                                                                     ==========        =========
</TABLE>

<PAGE>


3.  Investments

     The following  table  summarizes  the fair value and  unrealized  gains and
losses of debt  securities  at December 31, 1997 and 1996.  All debt  securities
have been classified as available-for-sale:


<TABLE>
<CAPTION>
                                                                        Gross           Gross
                                                                      Unrealized    Unrealized     Estimated
                                                           Cost          Gains         Losses      Fair Value
                                                                             (in thousands)
December 31, 1997:

<S>                                                     <C>           <C>            <C>           <C>
    Municipal securities............................    $  29,001     $       47     $       (2)   $   29,046
    U.S. government agency securities...............        5,000             --             --         5,000
    Auction rate receipts...........................        2,600             --             --         2,600
                                                        ---------     ----------     ----------    ----------
                                                        $  36,601     $       47     $       (2)   $   36,646
                                                        =========     ==========     ==========    ==========

December 31, 1996:

    Municipal securities............................    $  26,570     $       41     $       (3)   $   26,608
    Auction rate receipts...........................        2,800             --             --         2,800
                                                        ---------     ----------     ----------    ----------
                                                        $  29,370     $       41     $       (3)   $   29,408
                                                        =========     ==========     ==========    ==========
</TABLE>

 The amortized cost and estimated  fair value of investments in debt  securities
at December 31, 1997 and 1996, by contractual maturity, are as follows:
<TABLE>
                                                                                                   Estimated
                                                                                    Cost          Fair Value
                                                                                       (in thousands)
December 31, 1997:

<S>                                                                             <C>              <C>
    Due in 1 year or less..................................................     $     28,125     $     28,147
    Due in 1 - 3 years.....................................................            8,476            8,499
                                                                                ------------     ------------
    Total investment in debt securities....................................     $     36,601     $     36,646
                                                                                ============     ============


December 31, 1996:

    Due in 1 year or less..................................................     $     22,362     $     22,391
    Due in 1 - 3 years.....................................................            7,008            7,017
                                                                                ------------     ------------
    Total investment in debt securities....................................     $     29,370     $     29,408
                                                                                ============     ============
</TABLE>

4.  Commitments

     The Company leases its operating facilities under non-cancelable  operating
leases  that expire at various  dates  through  September  2006.  Minimum  lease
commitments at December 31, 1997 were as follows:

                       1998                                      $   2,891
                       1999                                          2,877
                       2000                                          2,883
                       2001                                          2,940
                       2002 and thereafter                          11,535
                                                                 ---------
                       Total minimum lease commitments           $  23,126
                                                                 =========

     Rent  expense  for  1997,  1996  and 1995 was  $2,780,000,  $1,852,000  and
$1,200,000, respectively.

<PAGE>
     The  Company is engaged in  certain  legal and  administrative  proceedings
incidental  to its  normal  business  activities.  While it is not  possible  to
determine  the  ultimate  outcome  of these  actions  at this  time,  management
believes that any liabilities  resulting from such proceedings,  or claims which
are pending or known to be threatened,  will not have a material  adverse effect
on the Company's financial position or results of operations.

5.  Acquisition of Innovus


     On January 5, 1996, the Company completed its acquisition of Innovus, Inc.,
Innovus Technologies,  Inc. and 815598 Ontario, Inc.  (collectively  "Innovus"),
each based in Canada, for approximately $6,687,000, including acquisition costs.
Prior to the acquisition,  Innovus (except for 815598 Ontario,  Inc.) was in the
business of (i) the porting of licensed software for Hewlett-Packard  HP9000 and
HP3000 series  computers and the sale and  distribution of such ported software,
and (ii)  supplying  clinical  trials and  research  services on contract in the
Canadian pharmaceutical industry. Prior to the acquisition, 815598 Ontario, Inc.
did not conduct  any  business  other than  holding  shares of capital  stock of
Innovus, Inc. The acquisition was accounted for using the purchase method and on
that  basis,  resulted  in a one-time  write-off  of  $1,849,000  for  purchased
in-process  research and development  for which there was no alternative  future
use and  technological  feasibility  was not  established.  The  balance  of the
purchase  price in excess of net assets  acquired  was  allocated  to  purchased
technology and goodwill totaling  $4,060,000.  Additional goodwill of $1,568,000
arises as a result of  recording  a  deferred  tax  liability  related to timing
differences  in the  amortization  of  purchased  technology  for  book  and tax
purposes.  The Company is  amortizing  purchased  technology  and  goodwill on a
straight-line  basis over five years. The operating results of Innovus have been
consolidated   with  the  Company's   operating  results  beginning  as  of  the
acquisition  date.  Substantially  all of the net assets of Innovus,  Inc.,  the
Company's  clinical  research   business,   were  sold  in  September  1996  for
approximately  $150,000,  which  approximated  the carrying  amount of those net
assets.  The Company has  discontinued  all clinical  research  activities.  The
discontinuance did not have a significant effect on the operating results of the
Company. At December 31, 1997 and 1996, purchased  technology and goodwill,  net
of accumulated  amortization of $2,186,000 and  $1,067,000,  were $3,351,000 and
$4,470,000, respectively.


     Pro forma results of operations of the Company for the year ended  December
31, 1995,  assuming the  acquisition of Innovus had occurred at the beginning of
that period,  include  revenues of $33.2  million,  net income of $3.5  million,
basic net income per share of $0.35 and diluted net income per share of $0.23.

6.  Stockholders' Equity

Preferred Stock

     The Company is authorized  to issue  5,000,000  shares of preferred  stock,
none of  which  are  issued  or  outstanding.  The  Board of  Directors  has the
authority to issue the preferred  stock in one or more series and to fix rights,
preferences,  privileges and restrictions, and the number of shares constituting
any series and the  designation  of such  series,  without any  further  vote or
action by the stockholders.

Stock Option/Stock Issuance Plan


     The Company's  1995 Stock  Option/Stock  Issuance Plan (the "1995 Plan") is
the successor  equity  incentive  program to the Company's 1989 Stock Option and
Restricted  Stock  Plan and  became  effective  on July 5,  1995.  Approximately
4,184,000  shares of common stock were  authorized  for issuance  under the 1995
Plan. The share reserve will automatically  increase on the first trading day in
each calendar  year,  beginning  with the 1997  calendar  year, by the number of
shares  equal to three  percent of the total  number of shares of the  Company's
common stock  outstanding on December 31 of the immediately  preceding  calendar
year.  Options  to  purchase  shares  may be  granted  and  shares may be issued
directly under the 1995 Plan.  Options must have an exercise price not less than
100% and 85% of fair market  value of the common  stock on the date of grant for
incentive  stock options and  non-statutory  stock  options,  respectively.  The
purchase  price  for  shares  issued  directly  may not be less than 85% of fair
market value on the date of grant.  Options  generally  vest over four years and
terminate ten years after their original grant dates.


     The  1995  Plan  is  divided  into  three  separate  components:   (i)  the
Discretionary  Option Grant Program under which  employees,  non-employee  Board
members  who  are  not  serving  on the  Company's  Compensation  Committee  and
consultants  may, at the discretion of the  Compensation  Committee,  be granted
options to purchase  shares of common  stock,  (ii) the Stock  Issuance  Program
under which such persons may, at the  Compensation  Committee's  discretion,  be
issued shares of common stock  directly,  through the purchase of such shares or
in consideration  of the past  performance of services,  and (iii) the Automatic
Option Grant  Program under which option  grants will  automatically  be made at
periodic intervals to eligible  non-employee Board members to purchase shares of
common  stock at an  exercise  price  equal to 100  percent of their fair market
value on the  grant  date.  Under  the  Automatic  Option  Grant  Program,  each
non-employee  Board member received an option grant to purchase 24,000 shares on
the effective date of the initial public  offering  (IPO).  Each  individual who
first becomes a non-employee Board member thereafter will receive a 24,000 share
option  grant on the  date  such  individual  joins  the  Board,  provided  such
individual has not been previously employed by the Company. In addition, at each
Annual  Stockholders  Meeting,  each individual who has served as a non-employee
Board member for at least six months prior to such Annual  Meeting and who is to
continue to serve as a non-employee  Board member after the meeting will receive
an additional option grant to purchase 6,000 shares of common stock,  whether or
not such individual has been in the prior employ of the Company.

     Options  granted under the 1995 plan generally  become  exercisable  over a
four year period,  whereby 25 percent of the shares become  exercisable one year
after the grant date and  ratably  thereafter  over 36 months.  Options  granted
prior to July 5, 1995 contain provisions allowing for early exercise of unvested
options.  Shares  issued  upon such early  exercise  are  subject to vesting and
repurchase  rights by the Company.  At December  31, 1997 and 1996,  none of the
shares  outstanding  were subject to repurchase by the Company.  Upon  exercise,
approximately  494,000 and  1,013,000  option shares under grant were subject to
repurchase by the Company at December 31, 1997 and 1996 respectively.

     The following is a summary of option activity:

<TABLE>
                                                    Number           Weighted                    Options
                                                      of           Average Price                  Price
                                                    Shares           Per Share                  Per Share
                                                (in thousands)

<S>                                                    <C>           <C>                    <C>          <C>
    Outstanding at December 31, 1994                   1,940         $   0.74               $  0.05 -    $ 1.75
       Options granted                                 1,392         $   4.64               $  1.75 -    $18.75
       Options exercised                                (382)        $   0.39               $  0.05 -    $ l.75
       Options canceled                                 (149)        $   2.25               $  0.13 -    $18.75
                                                   ---------
    Outstanding at December 31, 1995                   2,801         $   2.84               $  0.05 -    $18.75
       Options granted                                   695         $  21.12               $ 11.84 -    $44.50
       Options exercised                                (767)        $   1.36               $  0.05 -    $18.75
       Options canceled                                 (146)        $   8.99               $  0.75 -    $44.50
                                                   ---------
    Outstanding at December 31, 1996                   2,583         $   7.85               $  0.10 -    $44.50
       Options granted                                 1,244         $  28.00               $ 12.13 -    $46.63
       Options exercised                                (705)        $   3.30               $  0.10 -    $24.00
       Options canceled                                 (454)        $  22.06               $  0.75 -    $44.50
                                                   ---------
    Outstanding at December 31, 1997                   2,668         $  16.03               $  0.10 -    $46.63
                                                   =========
</TABLE>


     At December 31, 1997, approximately 376,000 shares of common stock remained
available  for grant under the 1995 Plan.  At December 31, 1997,  1996 and 1995,
approximately   816,000,   813,000  and  957,000   options   were   exercisable,
respectively.  Approximately  3,044,000 shares of common stock were reserved for
future issuance as of December 31, 1997.
<PAGE>


     The options  outstanding  and currently  exercisable  by exercise  price at
December 31, 1997 are as follows:

<TABLE>
<CAPTION>
                                 Options Outstanding                             Options Exercisable
                                       Weighted
                                        Average           Weighted                                 Weighted
                                      Remaining           Average                                   Average
         Exercise         Number      Contractual         Exercise            Number               Exercise
          Prices        Outstanding       Life             Price             Exercisable               Price
                                  (in thousands, except per share amounts)


<S> <C>       <C>                <C>          <C>         <C>                       <C>           <C>
    $ 0.10  - $ 1.75             300          5.87        $   1.18                  257           $    1.08
    $ 2.25  - $ 3.13             638          7.14        $   3.11                  286           $    3.12
    $ 5.63  - $13.50             423          7.78        $  10.53                  191           $   10.31
    $13.88  - $23.75             682          8.92        $  22.53                   76           $   21.58
    $24.00  - $34.00             446          9.70        $  30.54                    6           $   24.52
    $34.44  - $46.63             179          9.84        $  39.07                    0           $    0.00
                      --------------                                         ----------

                               2,668                                                816
                      ==============                                         ==========
</TABLE>

     The Company has elected to continue to follow the  provisions of Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees", for
financial reporting purposes and has adopted the  disclosure-only  provisions of
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation"  ("SFAS  123").   Accordingly,   no  compensation  cost  has  been
recognized  for the options  granted under the 1995 Plan.  The fair value of the
Company's  stock  options was estimated  using a  Black-Scholes  option  pricing
model.  The  Black-Scholes  option  pricing  model  was  developed  for  use  in
estimating the fair value of traded  options which have no vesting  restrictions
and are fully  transferable.  In addition,  the Black-Scholes model requires the
input of highly  subjective  assumptions  including  the  expected  stock  price
volatility.  Since  the  Company's  stock  options  granted  to  employees  have
characteristics  significantly  different  from  those of  traded  options,  and
because  changes in the subjective  assumptions  can materially  affect the fair
value estimate,  in management's opinion, the existing models do not necessarily
provide a reasonable single measure of the fair value of its stock options.  The
fair value of each option  grant is  estimated on the date of grant using a type
of  Black-Scholes  option pricing model with the following  assumptions used for
grants:


<TABLE>
                                                                           1997            1996           1995
                                                                         ---------      ---------       ------
<S>                                                                         <C>             <C>            <C>
     Expected volatility.............................................       0.647           0.645          0.645
     Weighted-average risk-free interest rate........................        6.18%           6.12%          6.61%
     Expected life (from vesting date)...............................       1 year         1 year         1 year
     Expected dividends..............................................           --             --             --
</TABLE>

     Based on the above  assumptions,  the  aggregate  fair  value and  weighted
average fair value of options granted in 1997,  1996 and 1995 were  $16,237,000,
$7,283,000 and $3,296,000, and $14.00, $10.47 and $2.37, respectively.

     For pro  forma  purposes,  had  compensation  cost for the 1995  Plan  been
determined  based on the fair value at the grant  date for awards in 1997,  1996
and 1995  consistent  with the  provisions  of SFAS No. 123, the  Company's  net
income,  basic and  diluted  net income per share for 1997,  1996 and 1995 would
have been as follows:


<PAGE>

<TABLE>
                                                                           1997            1996           1995
                                                                         ---------      ---------       ------
                                                                         (in thousands, except per share data)

<S>                                                                      <C>            <C>             <C>
     Net income - as reported........................................    $  15,658      $   8,620       $  5,831
                                                                         =========      =========       ========
     Net income - pro forma..........................................    $  11,928      $   6,798       $  5,261
                                                                         =========      =========       ========
     Net income per share - basic as reported........................    $   0.90       $    0.52       $   0.59
                                                                         ========       =========       ========
     Net income per share - basic pro forma..........................    $   0.69       $    0.41       $   0.53
                                                                         ========       =========       ========
     Net income per share - diluted as reported......................    $   0.83       $    0.46       $   0.39
                                                                         ========       =========       ========
     Net income per share - diluted pro forma........................    $   0.63       $    0.36       $   0.35
                                                                         ========       =========       ========
</TABLE>

     As the  provisions  of SFAS 123 are only applied to stock  options  granted
after  January 1, 1995 in the above pro forma  amounts,  the impact of pro forma
stock  compensation  cost will likely continue to increase as the vesting period
for the Company's  options and the period over which the stock  compensation  is
charged to expense is generally four years.

Employee Stock Purchase Plan


     The Company maintains an Employee Stock Purchase Plan (the "Purchase Plan")
under which 800,000 shares of common stock are reserved for future issuance. The
Purchase Plan is administered over offering periods of 24 months each, with each
offering  period  divided  into  four  consecutive  six-month  purchase  periods
beginning August 1 and February 1 of each year. Eligible employees may designate
not more than 10 percent  of their cash  compensation  to be  deducted  each pay
period  for  the  purchase  of  common  stock  under  the  Purchase   Plan,  and
participants  may not  purchase  more  than  1,000  shares  of  stock in any one
six-month  purchase  period.  On the last business day of each purchase  period,
shares of common stock are  purchased  with the  employee's  payroll  deductions
accumulated during the six months,  generally at a price per share of 85 percent
of the market  price of the  common  stock on the  employee's  entry date of the
applicable  offering period or the last day of the applicable  purchase  period,
whichever is lower.  For the year ended December 31, 1997 and 1996,  131,000 and
105,000 shares were issued under the plan,  respectively.  At December 31, 1997,
564,000 shares were reserved for future issuance under the plan.


     Under SFAS 123,  compensation cost is also recognized for the fair value of
employee's  purchase  rights under the Employee Stock  Purchase Plan,  which was
estimated using the following assumptions for 1997, 1996 and 1995, respectively:
a weighted-average expected life of 2.0 years, 0.9 years and 1.3 years; expected
volatility of 0.647,  0.645 and 0.645; and  weighted-average  risk-free interest
rates of 6.05 percent,  5.86 percent and 5.85  percent.  The fair value of those
purchase  rights  granted in 1997,  1996 and 1995 was  $2,437,000,  $298,000 and
$839,000, respectively.

7.  Employee Benefit Plans

Profit Sharing Plan

     The Company has a 401(k) Profit Sharing Plan (the Plan) covering all of its
employees. Under the Plan, participating employees may elect to contribute up to
15 percent  of their cash  compensation,  subject  to certain  limitations.  The
Company may make  contributions  to the Plan at the  discretion  of the Board of
Directors.   In  1997,  the  Company  contributed   $260,000  to  the  Plan.  No
contributions were made to the Plan for 1996 and 1995.

<PAGE>
8.  Income Taxes

     The provision for income taxes consists of the following:
<TABLE>
<CAPTION>
                                                                           1997            1996           1995
                                                                         ---------      ---------       ------
                                                                                      (in thousands)
<S>                                                                      <C>            <C>             <C>
Current:
     Federal.........................................................    $   7,342      $   5,855       $  2,935
     State...........................................................        1,990          1,514            878
     Foreign.........................................................          400            443             74
                                                                         ---------      ---------       --------
                                                                             9,732          7,812          3,887
Deferred:
     Federal.........................................................         (194)          (937)        (1,114)
     State...........................................................          (28)           (57)           (44)
     Foreign.........................................................         (314)          (314)            --
                                                                         ----------     ---------       --------
                                                                              (536)        (1,308)        (1,158)
                                                                         ----------     ---------       --------

                                                                         $   9,196      $   6,504       $  2,729
                                                                         =========      =========       ========
</TABLE>

      In 1997, income before provision for income taxes consisted of $24,648,000
of income from U.S.  operations and $206,000 of income from foreign  operations.
In 1996,  income before  provision for income taxes  consisted of $17,321,000 of
income from U.S.  operations and  $2,197,000 of losses from foreign  operations.
Substantially  all of the Company's  income before provision for income taxes in
the year ended December 31, 1995 was generated by domestic  operations.  The tax
benefit  associated  with  dispositions  from employee stock plans reduced taxes
currently  payable  for  1997,  1996  and  1995 by  $4,970,000,  $7,115,000  and
$560,000, respectively. Such benefit was recorded to additional paid-in capital.

     The Company's  effective tax rate differs from the statutory federal income
tax rate as follows:

<TABLE>
                                                                           1997            1996           1995
                                                                         ---------      ---------       ------

<S>                                                                         <C>             <C>            <C>
     Statutory federal income tax rate...............................       35.0%           35.0%          34.0%
     State income taxes, net of federal benefit......................        5.1             5.4            5.7
     Tax exempt interest income......................................       (2.9)           (3.4)          (1.1)
     Research and experimental credit................................       (1.6)           (0.8)          (1.0)
     Benefit of operating loss and tax credit carryforwards..........          --             --           (7.2)

     Change in valuation allowance...................................          --             --           (1.7)
     Other...........................................................        1.4             2.1            3.2
                                                                         -------        --------        -------
         Subtotal....................................................       37.0%           38.3%          31.9%
     In-process research and development.............................          --            4.7             --
                                                                         --------       --------        -------
         Effective tax rate..........................................       37.0%           43.0%          31.9%
                                                                         =======        ========        =======
</TABLE>

<PAGE>
     Significant components of the Company's deferred tax assets and liabilities
are as follows:

<TABLE>
<CAPTION>
                                                                                             December 31,
                                                                                        1997              1996
                                                                                     ----------        -------
                                                                                            (in thousands)
     Deferred tax assets:
<S>                                                                                  <C>               <C>
         Allowances, accrued liabilities and other................................   $    1,073        $   1,247
         Accrued compensation and benefits........................................          360              394
         State taxes..............................................................          567              461
         Deferred revenue.........................................................          874              550
                                                                                     ----------        ---------
                                                                                          2,874            2,652
     Deferred tax liabilities:
         Intangible asset - purchased technology..................................         (940)          (1,254)
                                                                                     -----------       ---------

     Net deferred tax asset.......................................................   $    1,934        $   1,398
                                                                                     ==========        =========
</TABLE>


9.  Industry and Geographic Segment Information


     The Company operates in a single industry segment developing, marketing and
supporting  network  storage  management  software  products  for  heterogeneous
client/server  computing  environments and large scale enterprises.  The Company
markets its products and  services to  customers in the United  States,  Canada,
Europe and Asia  Pacific.  Net revenues  from export  sales were $19.8  million,
$10.7  million,  and $4.7  million  in 1997,  1996 and 1995,  respectively.  The
majority of export sales were made to Europe and Canada.


     One customer  accounted for 11 percent of total revenues for 1997, 1996 and
1995.


10.  Selected Quarterly Financial Data (unaudited)

<TABLE>
<CAPTION>
                                                             First       Second           Third        Fourth
                                                           Quarter      Quarter        Quarter         Quarter
                                                                     (in thousands, except per share data)

1997:

<S>                                                        <C>          <C>            <C>           <C>
Total revenues........................................     $ 16,620     $   18,150     $   21,436    $   25,627
Gross profit..........................................       14,878         16,173         18,940        22,683
Net income............................................        3,164          3,132          4,352         5,010
Net income per share - basic..........................     $   0.18     $    0.18      $     0.25    $     0.28
Net income per share - diluted........................     $   0.17     $    0.17      $     0.23    $     0.26

1996:

Total revenues........................................     $ 10,925     $   12,573     $   14,549    $   16,202
Gross profit..........................................        9,749         11,393         13,132        14,858
Net income (loss).....................................         (127)         2,343          2,961         3,443
Net income (loss) per share - basic...................     $  (0.01)    $    0.14      $     0.18    $     0.20
Net income (loss) per share - diluted.................     $  (0.01)    $    0.13      $     0.16    $     0.18
</TABLE>

<PAGE>

11.  Subsequent Event (unaudited)

     In March 1998, the Company announced that its Board of Directors approved a
two-for-one  stock  split  (in  the  form of a  dividend)  that  is  payable  to
stockholders of record on April 3, 1998 and will be effective on April 17, 1998.
Share and per share data presented here have not been adjusted to give effect to
this two-for-one split.


     The pro forma  shares  used in  calculating  net  income  per share and the
resulting  basic and  diluted  net income per share if the stock  split had been
effective for the periods ended December 31, 1997, 1996 and 1995 would have been
as follows:

<TABLE>
                                                                           1997            1996           1995
                                                                         ---------      ---------       ------
                                                                         (in thousands, except per share data)


<S>                                                                      <C>            <C>             <C>
Net income per share - basic.........................................    $    0.45      $    0.26       $   0.29
                                                                         =========      =========       ========
Net income per share - diluted.......................................    $    0.42      $    0.23       $   0.19
                                                                         =========      =========       ========
Shares used in per share calculations - basic........................       34,820         33,098         19,924
                                                                         =========      =========       ========
Shares used in per share calculations - diluted......................       37,726         37,542         30,218
                                                                         =========      =========       ========
</TABLE>

<PAGE>
                        REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders
Legato Systems, Inc.:

     We have audited the consolidated balance sheets of Legato Systems, Inc. and
subsidiaries  as of  December  31, 1997 and 1996,  and the related  consolidated
statements of income,  stockholders' equity and cash flows for each of the three
years in the period ended December 31, 1997. 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 in accordance  with  generally  accepted  auditing
standards.  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.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

     In our opinion,  the consolidated  financial  statements  referred to above
present fairly, in all material respects, the consolidated financial position of
Legato Systems,  Inc. and subsidiaries as of December 31, 1997 and 1996, and the
consolidated  results of their  operations  and their cash flows for each of the
three years in the period ended  December 31, 1997 in conformity  with generally
accepted accounting principles.


                                                        COOPERS & LYBRAND L.L.P.


San Jose, California
January 19, 1998

<PAGE>

                                    PART III


ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT


     The information  regarding  directors is  incorporated  herein by reference
from the section  entitled  "Election of Directors" of the Company's  definitive
Proxy  Statement  to be  filed  pursuant  to  Regulation  14A of the  Securities
Exchange  Act of 1934,  as  amended,  for the  registrant's  Annual  Meeting  of
Stockholders  to be held on May 14,  1998  (the  "Proxy  Statement").  The Proxy
Statement  is  anticipated  to be filed  within  120 days  after  the end of the
registrant's  fiscal year ended  December 31, 1997.  For  information  regarding
executive  officers of the  Company,  see the  information  appearing  under the
caption "Executive Officers of the Registrant" in Part I, Item 4a of this Report
on Form 10K.



ITEM 11.  EXECUTIVE COMPENSATION


     Information  regarding  executive  compensation is  incorporated  herein by
reference  from the  section  entitled  "Executive  Compensation"  of the  Proxy
Statement.



ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT


     Information  regarding  security ownership of certain beneficial owners and
management is incorporated  herein by reference from the section entitled "Stock
Ownership of Certain Beneficial Owners and Management" of the Proxy Statement.



ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS


     Information  regarding certain  relationships  and related  transactions is
incorporated   herein  by   reference   from  the  section   entitled   "Certain
Relationships and Related Transactions" of the Proxy Statement.

<PAGE>


                                     PART IV


ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K

(a) (1)  Financial Statements

     The consolidated  financial statements of the registrant as set forth under
Item 8 are filed as part of this Annual Report on Form 10-K.

(a) (2)  Financial Statement Schedule

     Schedule II - Valuation and Qualifying Accounts is filed on page 43 of this
Report on Form 10-K.

     All  other  schedules  for  which  provision  is  made  in  the  applicable
accounting  regulations of the  Securities  and Exchange  Commission are omitted
because  they  are  not  required   under  the  related   instructions   or  are
inapplicable.

     The  independent  accountant's  report  with  respect  to the above  listed
financial statements and financial statement schedule listed in Items 14 (a) (1)
and 14 (a) (2), respectively, is filed on page 38 of this Report on Form 10-K.

 (a) (3) Exhibits

2.1  (3) Stock  Purchase  Agreement,  dated as of  January  5,  1996,  among the
     Registrant,  Innovus,  Inc.,  815598  Ontario,  Inc., the  stockholders  of
     Innovus, Inc., and the stockholders of 815598 Ontario, Inc.

2.2  (3) Stock  Purchase  Agreement,  dated as of  January  5,  1996,  among the
     Registrant,  Innovus  Technologies,  Inc., and the  stockholders of Innovus
     Technologies, Inc.

3.1  (6) Amended and Restated Certificate of Incorporation of the Registrant, as
     amended to date


3.2  (8) Amended and Restated Bylaws of the Registrant adopted on May 23, 1997

3.3  (9) Form of  Certificate  of  Designation  filed in connection  with Rights
     Agreement, dated May 23, 1997


4.2  (1) Specimen Common Stock certificate

4.6  (1) Restated Investor Rights Agreement,  dated September 8, 1993, among the
     Registrant  and the investors and the founders  named  therein,  as amended
     January 28, 1994 and February 13, 1995


4.7  (9) Rights  Agreement,  dated May 23,  1997  between the Company and Harris
     Trust and Savings Bank,  including the Certificate of Designation of Series
     A Junior  Participating  Preferred  Stock,  Form of Right  Certificate  and
     Summary of Rights to Purchase  Preferred Shares attached thereto as Exhibit
     A, B and C, respectively.

10.1 (1) Form of  Indemnification  Agreement entered into between the Registrant
     and it directors and officers

10.3 (1) (5) The Registrant's 1995 Stock Option/Stock Issuance Plan

10.4 (1) (5) The Registrant's Employee Stock Purchase Plan

10.6 (1) Form of United States  Reseller  Terms and  Conditions  for Purchase of
     Legato Products

10.7 (1) Form of International Authorized Systems Integrator Agreement

10.8 (1) Form of Shrinkwrap License Agreement

10.9 (1) (2) Technology  License and Distribution  agreement,  dated January 20,
     1994, between the Registrant and SunSoft, Inc.

10.10(1) Master Software  License and Support  Agreement  between the Registrant
     and Open Software Foundation

10.11(1) License Agreement,  dated February 24, 1989, between the Registrant and
     The Regents of the University of California

10.12(1) Software Agreement,  dated January 20, 1989, between the Registrant and
     AT&T Information Systems, Inc.

10.13 (4) (5) The Registrant's International Employee Stock Purchase Plan


10.14(6) Lease  agreement  dated  March 14,  1996  between  the  Registrant  and
     Coherent,  Inc.,  a Delaware  corporation,  and  Legato  Systems,  Inc.,  a
     Delaware  corporation,  regarding  the space  located at 3210 Porter Drive,
     Palo Alto, California


21.1 Subsidiaries of the Registrant

23.1 Consent of Coopers and Lybrand L.L.P., Independent Accountants

27.1 Financial Data Schedule

(1)  Incorporated  by reference to the  registrant's  Registration  Statement on
     Form S-1, filed May 9, 1995 (File No. 33-92072).

(2)  Confidential treatment requested as to certain portions of this exhibit.

(3)  Incorporated by reference to the  registrant's  Current Report on Form 8-K,
     dated January 19, 1996.

(4)  Incorporated  by reference to the  registrant's  Registration  Statement on
     Form S-8, filed March 14, 1996 (File No. 333-2378).

(5)  Compensatory plan or arrangement.

(6)  Incorporated by reference to the  registrant's  definitive  Proxy Statement
     for Special Meeting of Stockholders, dated May 31, 1996.

(7)  Incorporated by reference to the registrant's Quarterly Report on Form 10Q,
     dated August 7, 1996.

(8)  Incorporated by reference to the  registrant's  Current Report on Form 8-K,
     dated June 6, 1997.

(9)  Incorporated by reference to the registrant's Form 8-A, dated May 30, 1997.

(b)  Reports on Form 8-K

No reports on Form 8-K were filed by the Registrant during the fourth quarter of
the fiscal year ended December 31, 1997.

(c)  Exhibits

See  (a) (3) above.

(d)  Financial Statement Schedule

See  (a) (2) above.
<PAGE>
                     REPORT ON FINANCIAL STATEMENT SCHEDULE

         Our report on the consolidated  financial statements of Legato Systems,
Inc. is included on page 38 of this Form 10-K. In connection  with our audits of
such  financial  statements,  we have  also  audited  the  related  consolidated
financial statement schedule listed in Item 14 (a)(2) of this Form 10-K.

         In our opinion, the consolidated  financial statement schedule referred
to above,  when  considered  in  relation  to the basic  consolidated  financial
statements  taken as a whole,  present  fairly,  in all material  respects,  the
information required to be included therein.




                                                   /S/ COOPERS & LYBRAND L.L.P.





San Jose, California
January 19, 1998

<PAGE>


<TABLE>
                                                    SCHEDULE II

                                         VALUATION AND QUALIFYING ACCOUNTS

                                                  (in thousands)

                                              Balance at        Charged to                         Balance at
                                             Beginning of        Costs and                           End of
Description                                     Period           Expenses       Deductions           Period

Allowance for Doubtful Accounts:


<S>                                         <C>                 <C>           <C>                <C>
Year ended December 31, 1995                $   (293)           $   (440)     $     66           $   (667)


Year ended December 31, 1996                    (667)               (197)           52               (812)

Year ended December 31, 1997                    (812)               (260)          273               (799)
</TABLE>

<PAGE>


                                   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.

                         LEGATO SYSTEMS, INC.

                         By:  /s/ Louis C. Cole                 March 27, 1998
                              --------------------              --------------
                         Louis C. Cole                          Date
                         Chairman of the Board, President
                         and Chief Executive Officer




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

<TABLE>
Signature                                   Title                                              Date

<S>                                         <C>                                                <C>
/s/ Louis C. Cole                           Chairman of the Board, President and Chief         March 27, 1998
-------------------                         Executive Officer (Principal Executive Officer)
Louis C. Cole



/s/ Stephen C. Wise                         Senior Vice President of Finance and               March 27, 1998
-------------------                         Administration and Chief Financial Officer
Stephen C. Wise                             (Principal Financial and Accounting Officer)




/s/ Eric A. Benhamou                        Director                                           March 27, 1998
--------------------
Eric A. Benhamou



/s/ Kevin A. Fong                           Director                                           March 27, 1998
-----------------
Kevin A. Fong



/s/ David N. Strohm                         Director                                           March 27, 1998
-------------------
David N. Strohm



/s/ Phillip E. White                        Director                                           March 27, 1998
--------------------
Phillip E. White
</TABLE>

<PAGE>
                                                                    EXHIBIT 21.1

                              LEGATO SYSTEMS, INC.
                         SUBSIDIARIES OF THE REGISTRANT





              Legato Systems Deutschland GmbH - Germany

              LGTO S.A.R.L. - France

              Legato Systems Pty. Ltd. - Australia

              Legato Systems (Canada), Inc. - Canada

              Legato Systems International, Inc. - Barbados

              Legato Systems KK - Japan

<PAGE>
                                                                  EXHIBIT 23.1


                       CONSENT OF INDEPENDENT ACCOUNTANTS

      We consent to the incorporation by reference in the Registration Statement
of  Legato  Systems,  Inc.  on Form  S-8  (File  No.  333-28405,  333-02378  and
333-94306)  of  our  reports  dated  January  19,  1998  on  our  audits  of the
consolidated financial statements of Legato Systems, Inc. and subsidiaries as of
December 31, 1997 and 1996,  and for each of the three years in the period ended
December 31, 1997 and of our reports  dated January 19, 1998 on our audit of the
consolidated financial statement schedule, both of which reports are included in
this Annual Report on Form 10-K.


                                                    /S/ COOPERS & LYBRAND L.L.P.



San Jose, California

March 27, 1998