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10-K 1 w09846e10vk.htm FORM 10-K e10vk

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)


x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED MARCH 31, 2005

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number

1-15681

webMethods, Inc.

(Exact name of Registrant as Specified in its Charter)


Delaware (State or Other Jurisdiction of Incorporation or Organization)		54-1807654 (I.R.S. Employer Identification No.)

3877 Fairfax Ridge Road, South Tower, Fairfax, Virginia (Address of Principal Executive Offices)		22030 (Zip Code)

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

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

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

Preferred Stock Purchase Rights

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

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

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

As of September 30, 2004, there were 53,101,682 shares of the registrant’s Common Stock outstanding. The aggregate market value of such shares held by non-affiliates of the registrant, based upon the closing sale price ($5.32) of such shares on the Nasdaq National Market for such date, was approximately $226,314,700. Shares of the registrant’s Common Stock held by each executive officer and director of the registrant, and by each entity publicly reporting that it owns 5% or more of the outstanding shares of the registrant’s Common Stock, have been excluded, as such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for any other purpose.

As of June 10, 2005, there were outstanding 53,371,621 shares of the registrant’s Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

Certain portions of the definitive Proxy Statement to be used in connection with the registrant’s 2005 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K to the extent stated. That Proxy Statement will be filed within 120 days of registrant’s fiscal year ended March 31, 2005.

WEBMETHODS, INC.

ANNUAL REPORT ON FORM 10-K

FOR THE YEAR ENDED MARCH 31, 2005

TABLE OF CONTENTS



Part I
Item 1.	Business	1
	Overview	1
	Strategy	2
	Products	4
	Services	6
	Sales and Marketing	7
	Product Development	7
	Partners and Strategic Relationships	8
	Competition	9
	Intellectual Property and Other Proprietary Rights	9
	Corporate Information	11
	Available Information	12
	Employees	12
	Executive Officers of webMethods	12
	Factors That May Affect Future Operating Results	14
Item 2.	Properties	24
Item 3.	Legal Proceedings	24
Item 4.	Submission of Matters to a Vote of Security Holders	24

Part II
Item 5.	Market for Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities	25
Item 6.	Selected Financial Data	26
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
	Overview	27
	Results of Operations	32
	Liquidity and Capital Resources	40
	Recently Issued Accounting Pronouncements	42
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	42
Item 8.	Financial Statements and Supplementary Data	43
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosures	43
Item 9A.	Controls and Procedures	43
Item 9B.	Other Information	46

Part III
Item 10.	Directors and Executive Officers of the Registrant	47
Item 11.	Executive Compensation	47
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	47
Item 13.	Certain Relationships and Related Transactions	48
Item 14.	Principal Accountant Fees and Services	48

Part IV
Item 15.	Exhibits, Financial Statement Schedules and Reports on Form 8-K	49
Signatures		51

PART I


Item 1.	BUSINESS

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

OVERVIEW

webMethods is a leading provider of business integration and optimization software. Our solutions enable organizations to deliver strategic applications to the business faster while allowing them to understand what is happening with their business in real-time and to predict what can be expected to happen. webMethods calls this Business Process Productivity^tm. We use the term “Business Process Productivity” to describe the desire of organizations to increase the efficiency of their activities, improve the ability of the enterprise to adapt to changing market conditions, and create competitive advantage through a focus on the business processes that run their organizations. We believe that our primary offering, the webMethods Fabric^tm product suite, is the only business integration and optimization suite on the market developed specifically to address the diverse and comprehensive requirements to achieve business process productivity.

webMethods Fabric gives customers the ability to integrate, assemble, and optimize their mission critical business processes. webMethods Fabric does this by helping organizations link their enterprise software applications and databases, connect electronically with their trading partners, automate and optimize the business processes that span these systems and interfaces, and implement software

applications that provide people with the information and capabilities necessary to run the business more effectively. Customer benefits include:


	•	eliminating significant costs from the organization’s information technology environment,

	•	automating and streamlining interactions with their customers and suppliers,

	•	becoming more competitive by capturing more market share in terms of increased revenue from new and existing customers,

	•	gaining more timely access to information to make better decisions about the business, and

	•	allowing staff to focus their attention on higher value business activities.

webMethods Fabric builds upon our history as a leader and innovator in the business integration market. Introduced in October 2004, the webMethods Fabric product suite unifies the enterprise application integration (“EAI”) and business-to-business (“B2B”) capabilities for which webMethods is widely known, with our existing Business Process Management (“BPM”) and workflow functionality and the Business Activity Monitoring (“BAM”), portal, and Web services technologies we acquired in October 2003. We believe that by integrating these particular capabilities into a single product suite, taking advantage of synergies between different elements of the solution, and merging the products to provide a seamless user experience, we have created a unique offering in the marketplace. By combining best-of-breed capabilities into one platform, we offer customers the ability to lower their total cost of ownership and to streamline the overall implementation process relative to using different stand-alone software products.

webMethods Fabric is based on a Service-Oriented Architecture (“SOA”) foundation. SOA enables organizations to extend the value of their existing IT assets, transforming them into reusable components that can be applied to new business needs. Customers who want “true SOA” need the infrastructure software to provide an integrated approach to the creation, organization, management, and security of Web services. webMethods Fabric incorporates an integrated registry and management, as well as security, for Web services. Our approach offers an alternative to custom software development, helping our customers deliver software applications to the business faster and with less risk, while real-time monitoring and patent-pending analytics gives organizations the insight necessary for achieving continuous process improvements in their business.

In addition to our webMethods Fabric product suite, we have a strategy to combine our software capabilities, professional services, strategic partnerships, and domain expertise into well-defined solutions that address specific horizontal and vertical industry problems. Our first planned solutions are in the areas of payment and lending processing in the financial services industry, integration in the retail industry and regulatory compliance requirements impacting many organizations.

We market and sell our products and solutions primarily to the largest 2,000 corporations worldwide (the “Global 2000”) and major government agencies. In our fiscal year ended March 31, 2005, we added approximately 145 new customers, with no single customer accounting for more than 10% of our revenue in any quarter of that fiscal year. As of March 31, 2005, we had approximately 1,300 customers around the world, distributed across our target verticals in manufacturing, process industries (such as chemicals, oil and gas, life sciences, metals, paper and plastics), financial services, consumer goods manufacturing and retail, government and telecommunications.

STRATEGY

Our goal is to be the provider of choice for business integration and optimization solutions in our target industries and markets, and to establish webMethods as the benchmark for companies in our class.

We believe that our strategy enables us to achieve these objectives. The key elements of this strategy include the following:


	•	Focus on Customer Success. A core part of our strategy is to ensure that customers are successful with our solutions. We invest in resources and programs to improve our customers’ success by reducing the time needed to deploy our software, minimizing long-term cost of ownership, and maximizing their return on investment for their integration projects. We attempt to accomplish this by working closely with customers to understand their business needs, timelines, and associated project risks, and supporting them to ensure they achieve their goals. As a measure of success, we track the number of customer projects that go into production. Ensuring that our customers successfully implement our software in a timely manner enables them to achieve a greater return on their investment and, in many cases, encourages them to purchase additional software for other projects. We believe that having satisfied customers who are willing to serve as references for prospective customers in our sales efforts is a significant competitive advantage.

	•	Extend the Value of Integration Solutions to Business Users. The role of integration software and solutions has historically been viewed as technical in nature and the principal domain of Information Technology personnel. However, through our investments and innovation in BPM and BAM, we are increasingly able to demonstrate and deliver value that directly touches business users within the enterprise. Through our integration and BPM capabilities, we are able to not only link systems together, but transparently integrate the human workflows involved in the business processes that span these systems. BAM provides real-time visibility into these business processes, giving users the ability to track key performance indicators of their business, as well as to anticipate exceptions requiring their attention. Together, BPM and BAM support a continuous process improvement cycle, with BPM providing the means to maximize process efficiencies and BAM providing the feedback necessary to enhance an organization’s processes. We believe that our BPM and BAM capabilities differentiate webMethods and provide us with important new selling opportunities with new and existing customers.

	•	Value Based Selling. In order to successfully market and sell software and service solutions to global organizations, we have implemented a value based sales methodology that focuses on the measurement and attainment of the business value being created by our solutions. This methodology allows us to work with our customers and prospects during the early stages of the sales cycle to identify the projects that would provide the most payback, or return on investment, to the individual lines of business. We then involve the business users in defining the ways the identified business process is to be improved or optimized. We often conduct a proof of concept, which allows the business owner to experience the proposed solution. This sales methodology enables us to build the business case or value to be attained from our proposed solution. Our Professional Services organization then provides an implementation plan targeted at the achievement of this value. This methodology allows our customers to understand the various cost components of the proposed solutions and the anticipated value they can receive by deploying it.

	•	Provide the Most Compelling Solution. We believe that we offer one of the broadest and most comprehensive business integration solutions currently available on the market. We have used a strategy of internal product development complemented with strategic technology acquisitions to round out our offerings. Furthermore, our approach has been to integrate our various product capabilities into a single, unified platform. We believe that while each one of our products individually brings value and shows technical leadership, it is the combination of these capabilities in one solution that differentiates us from our competition.

	•	Continued Leadership in Web Services and Service-Oriented Architecture. We believe that Web services will play an increasingly important role in integration solutions, and that support for related standards and SOA is an important requirement for success. webMethods was an early pioneer in the use of SOA for integration, as evidenced by our proposal to the World Wide Web Consortium (“W3C”) in 1997 to standardize the way that applications interact across the Internet using

service-oriented and XML-based protocols. We believe that we have successfully built upon this heritage with our continued involvement in various Web services standards bodies, our acquisition in October 2003 of a unique Web services management framework developed by The Mind Electric, and ongoing product innovation in the area of Web services quality-of-service monitoring. webMethods has been recognized as a leader in Web services by industry analysts, and we currently serve on the Board of Directors of the Web Services Interoperability organization (“WS-I”).

• Partner with Major Systems Integrators. We continue to expand and strengthen our alliances with major system integrators to increase our sales and services leverage. We have established a series of formal alliance relationships with major system integrators such as Accenture, Atos Origin, BearingPoint, Capgemini, CGI-AMS, Computer Sciences Corporation (“CSC”), Crowe Chizek, Deloitte, Electronic Data Systems Corporation (“EDS”), Hewlett-Packard (“HP”) and Tata Consulting Services (“TCS”). Many of these partners have established formal webMethods practices, increasing the number of webMethods-trained resources available to assist our customers in their implementations of our solutions. As a result of this expanded knowledge-base, as well as implementation successes on which the systems integrator partner and webMethods have worked jointly, these alliances form a virtual extension of our direct sales force. This results in the third-party introduction and subsequent endorsement of webMethods’ solutions in opportunities of which we may not otherwise be aware, or with customers or prospects of the partner with which we may not otherwise already be engaged.

• Leverage Strategic Software and Other Vendor Partnerships. We have relationships with enterprise application software and other vendors, such as Global eXchange Services (“GXS”), Oracle Corporation (including both the Peoplesoft and JD Edwards product lines), SAP AG and Siebel Systems, whereby they embed a limited-use implementation of webMethods’ software into their solutions and/or resell components of our product line. As a result, customers who license products in which our software is embedded receive access to our technology. We believe these customers are good candidates to purchase additional webMethods software, and that our association with the major enterprise application vendors distinguishes us from many of our competitors, providing us with an incumbency advantage that positions webMethods as the lowest risk option for customers of these software products.

PRODUCTS

webMethods Fabric™

Our primary offering is webMethods Fabric, a unified business integration and optimization product suite that we introduced in October 2004. webMethods Fabric combines into a single offering our existing product capabilities and features as well as previously acquired technologies. These include the EAI and B2B capabilities for which webMethods is widely known, our existing BPM and workflow functionality, and the technologies that we acquired in October 2003, which were comprised of a Web services deployment and management framework (from The Mind Electric), advanced BAM functionality (from The Dante Group), and a development environment (from the DataChannel assets owned by Netegrity), that allows end-users to build and deploy portal-based applications.

webMethods Fabric’s capabilities combine those of our four foundation product groupings: Enterprise Services Platform, BPM, BAM and Composite Application Framework.

Enterprise Services Platform

The webMethods Enterprise Services Platform^tm is the foundation of the webMethods Fabric product suite. Conceptually, it serves as the basis by which systems are integrated and made available as business

services, which can then be linked together into new business processes or assembled into new software applications. The key capabilities of the webMethods Enterprise Services Platform include the following:


	•	Proven business integration functionality (derived from our previous flagship offering, the webMethods Integration Platform) that provides customers a unified XML-based environment for addressing both application-to-application and business-to-business integration scenarios, including the ability to connect reliably to a variety of legacy systems and packaged applications, communicate securely across firewalls, perform data transformations and mappings, and manage a community of trading partners.

	•	An extensive library of adapters that provides customers a standard mechanism for integrating applications that have proprietary programming interfaces, such as those from vendors like Oracle Corporation, SAP AG and Siebel Systems. Using adapters, developers do not have to learn the technical intricacies of each interface; instead, they have a graphical interface for configuring the operations to be performed against a software application. An adapter development kit simplifies the creation of custom adapters for software applications that are not supported within our broad library of adapters.

	•	Support for a wide range of electronic commerce protocols, enabling customers to integrate their information systems with those of their customers and business partners and automate inter-company interactions, such as purchasing and procurement, supply chain management, and vendor-managed inventory. Supported protocols and e-business standards include EDI, EDIINT (AS1, AS2, and AS3), RosettaNet, CIDX, PIDX, FIX, SWIFT, and ebXML.

	•	High performance messaging middleware that serves as the communications layer for webMethods Fabric, and enables the real-time, event-driven interactions needed for BAM and other high-volume applications that require reliable message delivery and a scalable publish/subscribe architecture capable of processing thousands of messages per second. A Java Message Service (“JMS”)-compliant interface is also available.

	•	webMethods Glue™, a light-weight, high-performance Web services environment for creating standards-compliant Web services from Java. Using webMethods Glue, developers are able to make existing Java objects accessible as Web services without having to modify existing Java logic, or incurring the complexity and overhead of implementing these services on a J2EE platform.

	•	Web services enablement and management features that allow customers to make existing software application functions available as standard Web services, and then to manage the deployment of those services — and any other Web services in the environment, irrespective of where they originate, with enterprise-class quality of service. The Web services management capabilities, which are provided by the product called webMethods Servicenet^tm, include a UDDI-based service registry, security, load balancing, fail-over, and unique predictive monitoring enabled by webMethods’ patent-pending BAM technology.

Business Process Management (“BPM”)

webMethods’ BPM offerings have capabilities that facilitate the design, deployment, and monitoring of processes that involve interactions between computer systems as well as people. Some business processes are automated, requiring minimal manual intervention (often only to address exception situations), whereas other types of business processes, such as loan or claims processing, are primarily manual in nature. webMethods’ BPM offerings support both scenarios. By providing an easy-to-use process modeling environment that shields users from the underlying software applications and technical complexity, webMethods’ BPM offerings make it feasible for non-technical staff to play a productive role in defining business processes. The visual design environment allows customers to create workflow solutions, including the associated user interfaces for presenting users with tasks and information, with minimal software coding effort.

Business Activity Monitoring (“BAM”)

webMethods’ BAM offering has capabilities that are based on a patent-pending technology that provide customers with a real-time view into key business performance indicators (for example, order processing time), and the ability to be alerted proactively when results deviate from established norms (for instance, if orders start taking longer than normal to process). The integration between webMethods’ BPM and BAM capabilities means there is minimal incremental effort for the user to identify which metrics to monitor for a given business process. webMethods’ BAM offering further reduces the effort on the part of the user by automatically monitoring certain pre-identified metrics and using statistical analysis to establish normal patterns of behavior. This allows the system to alert the user to an exception to such patterns of behavior, through a unique feature called “fingerprinting”, enabled once the system observes current readings drifting away from previously-seen ranges. The advantage of our approach is that users are not required to define limits manually, and the system automatically adjusts thresholds based on actual data (for example, accommodating variations in order processing time depending on the time of day). The real-time nature of these capabilities enables customers to anticipate exceptions, allowing them to respond quickly and, potentially, to avoid impact to the business. The ability to do root-cause analysis is a further decision-making aid, helping customers determine the specific factors causing a deviation in a monitored business process metric.

Composite Application Framework (“CAF”)

The webMethods Composite Application Framework^tm enables customers to assemble new applications from the services and resources made available by the webMethods Enterprise Services Platform. The webMethods CAF provides an alternative to coding traditional client/server or Web applications from scratch and is especially advantageous when there is an inventory of existing business components from which to assemble new software applications. The webMethods Portal^tm serves as the primary delivery channel for these composite software applications, allowing people — both inside and outside the organization — to be provided with personalized, secure, access to the application functionality, information, and business processes that are relevant to their job function or relationship to the organization.

SERVICES

webMethods offers a range of professional services to assist our customers both during the initial deployment of our products and thereafter to address our customers’ needs through the entire project lifecycle. Our professional services consultants are located throughout the Americas, Europe/ Middle East/ Africa (“EMEA”), Japan and Asia Pacific regions, allowing us to provide localized, on-site support across our global customer base. Our services include “jump start” packages and full project implementations; advisory services, including architecture and performance assessments, and services concerning SOA strategy or best practices with regard to the establishment of integration competency centers; product training; and ongoing outsourced maintenance and operational support. We may provide these services directly or augment the efforts of a systems integration partner. Our professional services organization has developed GEAR, an integration methodology derived from our experience and specific to our products. GEAR provides customers with best practices, project templates, white papers, and other tools. Together, these resources assist in gathering requirements, capturing the scope of the project, defining the architecture, implementing a solution, and rolling out the finished system.

We offer training and continuing education to help ensure the success of our customer implementations. We provide a mix of classroom, onsite, and online training designed to best meet our users’ requirements. We have regularly scheduled courses covering our entire product line and more than 20 key topics of interest to developers, administrators, and business analysts.

We offer our customers a variety of support and maintenance plans designed to meet their specific needs, including the option of 24-hour coverage, seven days per week. We have established a “follow-the sun” support model with major support centers in Virginia and California in the United States, and in

Australia, Japan and the Netherlands. Our resellers and distributors generally provide initial software support to their customers, and we provide secondary support on more complicated issues. Our customers and partners also have access to the webMethods Advantage^tm extranet, which provides access to software, product documentation, discussion groups, implementation guides, technical advisories and access to our customer service management system that allows individuals to submit and monitor the status of any technical issues.

SALES AND MARKETING

We license our software and sell our services primarily through our direct sales organization. Secondary sales channels include our strategic software vendor partners, major systems integrators with whom we have strategic alliances, other partners and distributors. In Japan and our Asia Pacific region and, to a lesser extent, in EMEA and the Americas, we also license our software through resellers who may also sell our consulting and implementation services. We have relationships with a number of resellers or distributors with expertise in certain industry sectors or countries in which we do not currently have a significant number of direct sales personnel. We license our software primarily on a perpetual basis.

Our direct sales organization consists of sales representatives and pre-sales consultants supported by personnel with experience within the industries we target. At March 31, 2005, our sales and marketing personnel serving North America were located in our headquarters in Fairfax, Virginia, and in approximately 25 other offices in the United States and Canada. At that date, our sales and marketing personnel in EMEA were located in nine countries, and our sales and marketing personnel in Japan and our Asia Pacific region were located in Australia, Japan and six other countries. Information on revenue we derived from our Americas, EMEA, Japan and Asia Pacific operations, as well as long lived assets located in those geographic regions, is included in Note 18 of the Notes to Consolidated Financial Statements of webMethods, Inc., included elsewhere in this report. We expect to continue expanding our sales and marketing group through targeted recruitment of qualified individuals.

Our sales efforts are focused on customers, prospective customers and business partners in manufacturing, process industries (such as chemicals, oil and gas, life sciences, metals, paper and plastics), financial services, consumer goods manufacturing and retail, government and telecommunications.

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

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

PRODUCT DEVELOPMENT

We pursue a judicious mix of internal development, technology acquisition, and strategic partnerships to allow us to offer a compelling and differentiated solution. This strategy has at times allowed us to bring capabilities to market more quickly than some competitors who rely solely on internal development.

We focus our ongoing product development efforts on a combination of enhancing, broadening, and deepening the functionality of our core products to address new industries, marketplaces, geographies and software alliances as well as bringing about innovations to meet emerging opportunities. In October 2004, we introduced webMethods Fabric, unifying our existing product capabilities with the technologies which we acquired in October 2003. We have dedicated a significant amount of effort to integrating our various product capabilities to realize the vision of webMethods Fabric as a unified product suite. Our research and development expenses, including stock-based compensation, were $44.5 million, $45.0 million and $47.5 million in our fiscal years ended March 31, 2005, 2004 and 2003, respectively.

We maintain our primary development centers in Fairfax, Virginia and Sunnyvale, California and have additional development teams in Denver, Colorado and Seattle, Washington. In 2004, we established a development center in Bangalore, India.

PARTNERS AND STRATEGIC RELATIONSHIPS

We believe that our strategic alliances with systems integrators constitute a significant advantage over some of our competitors. We work closely with several major systems integrators including Accenture, Atos Origin, BearingPoint, Capgemini, CGI-AMS, Crowe Chizek, CSC, Deloitte, EDS, HP and TCS to support our customers’ integration needs and to expand the resources available to implement our software. We invest in education to assist our partners in staying knowledgeable in, and proficient with, our software products and solutions. We believe that our investment in these relationships is important because our partners’ promotion of our products as the most appropriate solution for their clients augments our direct sales force.

In November 2004, we announced a strategic partnership with Global eXchange Services (“GXS”), a leading global integration services provider, whereby the two companies agreed to jointly develop, market and resell end-to-end integration solutions based on our respective technologies and services. Through our combined offerings, enterprises utilizing GXS’ managed services will be able to extend the capabilities of the webMethods Fabric product suite more readily to their business partners, providing a deeper level of integration and shared visibility to streamline interactions between the organizations. We believe that our relationship with GXS may help us more effectively reach markets that we do not directly target, while providing prospective customers with an additional means for evaluating our technology as an embedded component of the GXS service.

We also believe that our other strategic relationships represent an advantage over our competition. We utilize our original equipment manufacturer partnerships with enterprise application software vendors, such as Oracle Corporation, SAP AG and Siebel Systems, as a differentiator when selling to a prospective customer that owns or plans to purchase products from these companies in which a license-limited version of our software may be embedded or utilized. We believe that this provides us with an incumbency advantage for many of the new business opportunities in which we compete. We expect to continue to benefit from these relationships through our partners’ indirect promotion of our products.

We have a relationship with Informatica to resell their PowerAnalyzer business intelligence product to provide management dashboards and reporting capabilities which complement the real-time monitoring functionality included in our BAM solution.

We believe our partners influenced, directly or indirectly, a significant portion of our license revenue during the fiscal year ending March 31, 2005 and in prior fiscal years, and we expect this to continue in future periods.

Under certain partnership arrangements, we may share license fees derived from joint selling opportunities with our partner; in these instances, we record the net license revenue we receive. In systems integrator and other partnership arrangements, we may pay a sales assistance fee to a partner who performs or assists in certain sales activities, which we include in our sales and marketing expenses, and that fee usually is paid once payment from the joint customer of license fees is received. Under certain partnerships with our enterprise application software vendor partners, the partner may embed or otherwise

utilize our software with their applications under limited use licenses for a license fee or royalty fee, which we include in our license revenue.

COMPETITION

The market for our software and services is extremely competitive and subject to rapid change. While we believe that we have a compelling offering in the webMethods Fabric product suite, broad integration experience, expertise in trading partner integration and management, a track record of innovation, and are a recognized leader in Web services, we compete with numerous other providers of integration software products. Our competitors include BEA Systems, Inc., International Business Machines Corporation (“IBM”), Microsoft Corporation, SAP AG, SeeBeyond Technology Corporation, Sterling Commerce Inc., TIBCO Software, Inc. and a wide range of companies associated with the capabilities that we offer. We may encounter additional competition from other emerging companies. In addition, we may face pricing pressures from our current competitors and new market entrants in the future. We believe that the competitive factors affecting the market for our software and services are numerous and the specific importance of any one of these factors varies significantly for each specific customer environment. These competitive factors include product functionality and features; performance and price; ease and cost of product implementation; vendor and product reputation; quality of customer support services; financial strength; customer training and documentation; and quality of professional services offerings. Although we believe that our software and services currently compete favorably with respect to such factors, we may not be able to maintain our competitive position against current and potential competitors.

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

INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS

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

For example, we take measures to avoid disclosure of our trade secrets, including, but not limited to, requiring all employees and certain consultants, customers, prospective customers, and others with which we have business relationships to execute confidentiality agreements that prohibit the unauthorized use and disclosure of our trade secrets and other proprietary materials and information. Further, we enter into license agreements with our customers, business partners, resellers and distributors that limit the unauthorized access to, use and distribution of our software, documentation and other proprietary information. Our license agreements with our customers, business partners, resellers and distributors impose restrictions on the use of our technology, including prohibiting the reverse engineering or de-compiling of our software, impose restrictions on the licensee’s ability to utilize the software and provide for specific remedies in the event of a breach of these restrictions. We also restrict access to our source code. While some of our license agreements require us to place the source code for our software in escrow

for the benefit of the licensee, these agreements generally provide these licensees with a limited, non-exclusive license to use this code in the event we cease to do business without a successor or there is a bankruptcy proceeding by or against webMethods; certain agreements may provide that the licensee can use the escrowed source code if we fail to provide the necessary software maintenance and support.

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

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

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

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

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

The software industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of other intellectual property rights. We believe that software developers in our market will increasingly be subject to infringement claims as

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

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

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

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

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

CORPORATE INFORMATION

webMethods, Inc. was organized in Delaware in 1996. We completed our initial public offering in February 2000. In August 2000, webMethods, Inc. acquired Active Software, Inc., a publicly-held software company that developed and delivered enterprise application integration software. In February 2001, we acquired IntelliFrame Corporation, its workflow technology and its research and development team. In October 2003, we acquired The Mind Electric, Inc., The Dante Group, Inc. and certain assets of Data Channel from Netegrity. References to “webMethods,” “we,” “us” or “our” include webMethods, Inc. and its subsidiaries unless a statement specifically refers to webMethods, Inc. Our executive offices are located

at 3877 Fairfax Ridge Road, South Tower, Fairfax, Virginia 22030, and our main telephone number is (703) 460-2500. We operate in a single segment of software and related services.

AVAILABLE INFORMATION

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

EMPLOYEES

As of March 31, 2005, we employed approximately 833 full-time employees. These included approximately 239 in sales and marketing, 204 in professional services and technical support, approximately 263 in research and development and approximately 127 in other administrative areas, including accounting, finance, human resources, facilities and information technology. Our future success will depend in part on our ability to attract, retain and motivate highly qualified technical and management personnel, for whom competition is intense. From time to time, we have employed, and will continue to employ, independent contractors and consultants to support research and development, marketing and sales, and business development. Our employees generally are not represented by a collective bargaining agreement, although employees in certain of our international subsidiaries have claimed membership in trade unions or sought to invoke union representation in certain personnel matters; we have never experienced a strike or similar work stoppage. We consider relations with our employees to be good.

EXECUTIVE OFFICERS OF WEBMETHODS

Our executive officers and their ages and positions as of May 31, 2005 are as follows:


Name	Age		Position

David Mitchell		40	President and Chief Executive Officer
Richard Chiarello		52	Executive Vice President, Worldwide Operations
Mary Dridi		44	Executive Vice President and Treasurer
Douglas W. McNitt		40	General Counsel, Executive Vice President and Secretary
Kristin Weller Muhlner		34	Executive Vice President, Product Development
Mark L. Wabschall		49	Senior Vice President, Finance and Chief Accounting Officer

David Mitchell began his career at webMethods in December 1997 as Vice President, Sales and served as Vice President, Worldwide Sales from September 1999 through December 1999. He served as Chief Operating Officer from January 2000 to October 2004, as President since January 2001 and as Chief Executive Officer since October 2004. Throughout his tenure at webMethods, Mr. Mitchell has played a major role in all facets of our business and in overseeing webMethods’ global sales organization, as well as our marketing, industry solutions, business development, and customer service operations. Prior to joining

webMethods, Mr. Mitchell held a variety of executive positions at various companies, including serving from 1993 to 1995 as President and Chief Executive Officer of VYCOR Corporation, which was acquired in 1995 by McAfee Software. Mr. Mitchell holds a B.S. in Marketing from Virginia Commonwealth University.

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

Mary Dridi joined webMethods in May 1998 as Chief Financial Officer and Treasurer. She became an Executive Vice President in January 2002. She resigned as Chief Financial Officer in May 2005. From July 1991 to April 1998, she served as the Controller and Vice President of Finance for SRA International, Inc., an information technology company. From 1987 to 1991, Ms. Dridi served as the Director of Finance at Geostar Corporation, a mobile satellite communications company. From 1983 to 1987, Ms. Dridi provided audit and other business services with the accounting firm of Peat Marwick. Ms. Dridi holds a B.S. in Commerce and Accounting from the University of Virginia.

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

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

Mark L. Wabschall, a Certified Public Accountant, joined webMethods as Senior Vice President, Finance in July 2004 and became Chief Accounting Officer in May 2005. He served as Vice President, Finance for Innovative Technology Application, Inc., a diversified technology firm, from 2003 to 2004, and he served as President of Delphi Business Solutions, LLC, a financial consulting firm from 2000 to 2003. From 1994 to 2000, he held senior financial and operational management positions with the Baan Company, including Senior Vice President of Operations, Vice President of Investor Relations and Chief Financial Officer of the Americas. He also served as an audit partner with Arthur Andersen, a major international public accounting firm. Mr. Wabschall holds a B.S. in Business Administration from the Ohio State University.

FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

You should consider the following risks and uncertainties when evaluating our statements in this report and elsewhere. webMethods is subject to risks and uncertainties in addition to those described below, which, at the date of this report, we may not be aware of or which we may not consider significant. Each of these factors may adversely affect our business, financial condition, results of operation or the market price of webMethods’ common stock, and investors may potentially lose all or part of their investment.

Our quarterly revenue — especially the amount of license revenue we recognize in a quarter — and operating results could fluctuate, which could significantly affect the market price of webMethods’ common stock.

Our quarterly operating results have fluctuated in the past and are likely to do so in the future. A significant reason for these fluctuations is variation in the level of our quarterly revenue — especially the amount of license revenue we recognize in a quarter — which is difficult to predict with certainty and which varies depending on a number of factors. These fluctuations may cause quarter-to-quarter or year-to-year comparisons of our financial results not to be reliable indicators of our future revenue, license revenue or operating results. If our quarterly or annual total revenue, license revenue or operating results fail to meet the guidance we provide publicly or the expectations of investors or securities analysts, there could be a material adverse effect on the market price of webMethods’ common stock. Our quarterly operating results have varied substantially in the past and may vary substantially in the future depending upon a number of factors, including:


	•	changes in demand for our software products and services;

	•	the timing and terms of large transactions with customers;

	•	the spending environment for business integration and optimization solutions;

	•	competitive pressures;

	•	fluctuations in the revenue and license revenue of our geographic regions;

	•	our ability to execute on our business strategy and sales strategies;

	•	a low number of quota bearing sales representatives experienced with our solutions, software products and sales processes;

	•	the timing and amount of revenue from acquired technologies or businesses;

	•	the amount and timing of operating costs;

	•	delays in the availability of new products or new releases of existing products;

	•	costs of legal compliance, including compliance with the Sarbanes-Oxley Act of 2002 and regulatory requirements and investigating or resolving pending or threatened legal claims; and

	•	changes that we may make in our business, operations and infrastructure.

In addition, economic conditions and other events beyond our control, such as economic uncertainties, geopolitical developments or uncertainties, travel limitations, terrorist acts and other major, unanticipated events may have significant negative impact on our quarterly revenue, license revenue or operating results and delay our ability to return to and maintain profitability on a basis determined in accordance with accounting principles generally accepted in the United States (“GAAP”). If our quarterly total revenue, license revenue or operating results are adversely impacted for any reason, that could have a material adverse effect on the market price of webMethods’ common stock.

We generally close a substantial number of license transactions in the last month of each quarter, which makes it difficult to predict with certainty the level of license revenue we will have in any quarter until near to, or after, its conclusion. Our operating expenses, which include sales and marketing, research

and development and general and administrative expenses, are based on our expectations of future revenue and are relatively fixed in the short term. If total revenue or license revenue falls below our expectations in a quarter and we are not able to quickly reduce our spending in response, our operating results for that quarter could be significantly below the guidance we provide publicly or expectations of investors or securities analysts. As a result, the market price of webMethods’ common stock may fall significantly.

If we fail accurately to forecast our future total revenue, license revenue or operating results, we may not satisfy the expectations of investors or securities analysts.

We forecast our future total revenue and license revenue and operating results based upon information from our sales organization, finance and accounting department and other groups within our organization. The information on which our forecasts are based reflect expectations of future performance, beliefs regarding continuation of trends and anticipated future achievements, which involve elements of speculation and are subject to a number of risks and uncertainties that we attempt to articulate for investors and securities analysts. We may fail to accurately forecast our future total revenue or license revenue due to a number of factors, including changes in customer demand, economic conditions, the timing and terms of large transactions with customers, competitive pressures, fluctuations in the total revenue and license revenue of our geographic regions, our ability to execute on our business strategy and sales strategies, a low number of quota bearing sales representatives experienced with our solutions, software products and sales processes, the timing and amount of revenue from acquired technologies or businesses, delays in the availability of new products or new releases of existing products, changes that we may make in our business, operations and infrastructure, seasonal factors or major, unanticipated events.

We also may experience delays or declines in expected total revenue or license revenue due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers, purchasing practices and requirements of prospective customers, including contract provisions or contingencies they may request, changes in demand for our software and services, changes that we may make in our business or operations, economic uncertainties, geopolitical developments or uncertainties, travel limitations, terrorist acts or other major unanticipated events. These periods of slower or no growth may lead to lower total revenue or license revenue or both, which could cause fluctuations in our quarterly operating results. In addition, variations in sales cycles may have an impact on the timing of our recognition of license revenue, which in turn could cause our quarterly total revenue and operating results to fluctuate. To successfully sell our software and services, we generally must educate our potential customers regarding their use and benefits, which can require significant time and resources. Any misperception by us in the needs of our customers and prospective customers or any delay in sales of our software and services could cause our revenue and operating results to vary significantly from our prior public forecasts. Any failure to achieve our prior public forecasts could cause us to fail to satisfy the expectations of investors or securities analysts, which could have a significant adverse effect on the market price of webMethods’ common stock.

The market price of webMethods’ common stock fluctuates as a result of factors other than our quarterly total revenue, license revenue and operating results, including actions taken by or performance of our competitors, estimates and recommendations of securities analysts, industry volatility and changes to accounting rules.

The market price for webMethods’ common stock has experienced significant fluctuation over the years and may continue to do so. From our initial public offering in February 2000 until June 13, 2005, the closing price of webMethods’ stock on the Nasdaq National Market has ranged from a high of $308.06 to a low of $3.96. In addition to our quarterly total revenue, license revenue or operating results, this volatility in the market price for webMethods’ common stock may be affected by a number of other factors, including:


	•	the overall volatility of the stock market, particularly the stock prices of software and technology companies;


	•	fluctuation in the levels of total revenue, license revenue and operating results of competitors;

	•	changes in securities analysts’ estimates and recommendations with respect to webMethods’ common stock or our industry;

	•	rapid developments within our industry; and

	•	changes to accounting rules.

If any of these market or industry-based factors has a significant negative impact on the market price for webMethods’ common stock, investors could lose all or part of their investment, regardless of our actual operating performance.

Our markets are highly competitive, and we may not compete effectively.

The markets for business integration solutions, SOA capabilities, BAM and BPM solutions and CAF capabilities are rapidly changing and intensely competitive. There are a variety of methods available to integrate software applications, monitor and optimize business processes and workflows, provide SOA, enable Web services and provide customers the capabilities to run, manage and optimize their enterprise. We expect that competition will remain intense as the number of entrants and new technologies increases. We do not know if our markets will widely adopt and deploy our SOA technology, our webMethods Fabric product suite or other solutions we offer or have announced. If our technology, software and solutions are not widely adopted by our markets or if we are not able to compete effectively against current or future competitors, our business, operating results and financial condition may be harmed.

Our current and potential competitors include, among others, large software vendors; companies that develop their own integration software or Web services technology; business integration software vendors; electronic data interchange vendors; vendors of proprietary enterprise application integration; vendors of portal products; and application server vendors. We also face competition from providers of various technologies to enable Web services. Further, we face competition for some aspects of our software and service offerings from major system integrators, both independently and in conjunction with corporate in-house information technology departments, which have traditionally been the prevalent resource for application integration. In addition, application software vendors with whom we have or had strategic relationships sometimes offer competitive solutions or may become or are competitors. Some of our competitors or potential competitors may have more experience developing technologies or solutions competitive with ours, larger technical staffs, larger customer bases, more established distribution channels, greater brand recognition and greater financial, marketing and other resources than we do. Our competitors may be able to develop products and services that are superior to our solutions, that achieve greater customer acceptance or that have significantly improved functionality or performance as compared to our existing solutions and future software and services. In addition, negotiating and maintaining favorable customer and strategic relationships is critical to our business. Our competitors may be able to negotiate strategic relationships on more favorable terms than we are able to negotiate or may preclude us from entering into or continuing strategic relationships. Many of our competitors may also have well-established relationships with our existing and prospective customers. Increased competition may result in reduced margins, loss of sales, decreased market share or longer sales cycles or sales processes involving more extensive demonstrations of product capabilities, which in turn could harm our business, operating results and financial condition.

Economic conditions could adversely affect our revenue growth and cause us not to achieve our forecasts of license revenue and total revenue.

Our ability to achieve revenue growth and profitability of our business depends on the overall demand for business integration and optimization software and services. Our business depends on overall economic conditions, the economic and business conditions in our target markets and the spending environment for information technology projects, and specifically for business integration and optimization solutions, in those markets. A weakening of the economy in one or more of our geographic regions, unanticipated major

events and economic uncertainties may make more challenging the spending environment for our software and services, reduce capital spending on information technology projects by our customers and prospective customers, result in longer sales cycles for our software and services or cause customers or prospective customers to be more cautious in undertaking larger license transactions. Those situations may cause a decrease in our license revenue and total revenue. A decrease in demand for our software and services caused, in part, by a continued weakening of the economy, domestically or internationally, may result in a decrease in our revenue and growth rates. In that event, we could fail to achieve our prior public forecasts of revenue and operating results or otherwise fail to satisfy the expectations of investors or securities analysts, which could have a significant adverse effect on the market price of webMethods’ common stock.

We rely on strategic alliances with major system integrators and other similar relationships to promote and implement our software.

We have established strategic relationships with system integration partners and others. These strategic partners provide us with important sales and marketing opportunities, create opportunities to license our solutions, and greatly increase our implementation capabilities. We also have similar relationships with resellers, distributors and other technology leaders. During our fiscal year 2005, our systems integrator partners directly or indirectly influenced a significant portion of our license revenue, and we expect that leverage to continue in future periods. If our relationships with our strategic business partners diminish or terminate or if we fail to work effectively with our partners or to grow our base of strategic partners, resellers and distributors, we might lose important opportunities, including sales and marketing opportunities, our business may suffer and our financial results could be adversely impacted. Our partners often are not required to market or promote our software and generally are not restricted from working with vendors of competing software or solutions or offering their own solutions providing similar capabilities. Accordingly, our success will depend on their willingness and ability to devote sufficient resources and efforts to marketing our software and solutions rather than the products of competitors or that they offer themselves. If these relationships are not successful or if they terminate, our revenue and operating results could be materially adversely affected, our ability to increase our penetration of our markets could be impaired, we may have to devote substantially more resources to the distribution, sales and marketing, implementation and support of our software than we would otherwise, and our efforts may not be as effective as those of our partners, which could harm our business, our operating results and the market price of webMethods’ common stock.

We have a history of operating losses, and our failure to achieve and sustain profitability may impact our prospect of achieving our growth targets and may have a material adverse effect on the market price of webMethods’ common stock.

During much of our history, we have sustained losses from operations. For a number of reasons described in other factors listed here, we may not be able to achieve our anticipated levels of total revenue and license revenue or to control our operating expenses, which could prevent us from achieving our forecasts of operating results, including returning to and sustaining profitability on a GAAP basis. That situation could have a material adverse effect on the market price of webMethods’ common stock. Further, the expensing of stock options in the future could add significant costs that may impede or delay our ability to return to and maintain profitability on a GAAP basis. If we do not generate sufficient revenue to achieve and maintain income from operations, our growth could be limited unless we are willing to incur operating losses that may be substantial and are able to fund those operating losses from our available assets or, if necessary, from the sale of additional capital through public or private equity or debt financings.

The Sarbanes-Oxley Act of 2002 requires that we undertake periodic evaluations of our internal control over financial reporting, which may identify material weaknesses that could harm our reputation and impact the market price of webMethods’ common stock.

The Sarbanes-Oxley Act of 2002 requires that our management establish and maintain internal control over financial reporting and periodically assess the effectiveness of our internal control over financial reporting and report the results of such assessment. Our management recently assessed the effectiveness of our internal control over financial reporting at March 31, 2005 and concluded, based upon their assessment, that our internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. We cannot predict the outcome of our assessments in future periods. If our management concludes in the future that our internal control over financial reporting is not effective due to material weakness, we expect that we must then change our internal control over financial reporting to remediate such material weakness. In that situation, investors and stock analysts may lose confidence in the reliability of our financial statements, we may not be successful in effecting the necessary remediation and we may be subject to investigation or sanctions by regulatory authorities. We also expect that we will continue to identify areas of internal control over financial reporting that require improvement, and that we will continue to enhance processes and controls to address those issues, which will involve additional expense and diversion of management’s time and may impact our results of operations.

Our disclosure controls and procedures and our internal control over financial reporting may not be effective to detect all errors or to detect and deter wrongdoing, fraud or improper activities in all instances.

While we believe we currently have adequate internal control over financial reporting, our management does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all errors and fraud. In designing our control systems, management recognizes that any control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the desired control objectives. Further the design of a control system must reflect the necessity of considering the cost-benefit relationship of possible controls and procedures. Because of inherent limitations in any control system, no evaluation of controls can provide absolute assurance that all control issues and instances of wrongdoing, if any, that may affect our operations have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, that breakdowns can occur because of simple error or mistake and that controls may be circumvented by individual acts by some person, by collusion of two or more people or by management’s override of the control. The design of any control system also is based in part upon certain assumptions about the likelihood of a potential future event, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in cost-effective control systems, misstatements due to error or wrongdoing may occur and not be detected. Over time, it is also possible that controls may become inadequate because of changes in conditions that could not be, or were not, anticipated at inception or review of the control systems. Any breakdown in our control systems, whether or not foreseeable by management, could cause investors to lose confidence in the accuracy of our financial reporting and may have an adverse impact on the market price for webMethods’ common stock.

If we fail to attract and retain key executive officers and other key personnel who are essential to our business, our ability to execute effectively on our business strategy or our results of operations or financial condition may be adversely affected.

Our success depends upon the continued service of key employees who are essential to our business, including our executive officers. None of our current executive officers or key employees is bound by an employment agreement for any specific term. In October 2004, our former chairman and chief executive officer, Phillip Merrick, resigned, and David Mitchell became our President and CEO and a member of our Board of Directors. In May 2005, our former chief financial officer, Mary Dridi, resigned from that

position, and we are currently conducting a search for a new chief financial officer. We are uncertain as to the ultimate impact of these departures; however, the loss of any key executive officers or key employees could potentially impede our ability to execute effectively on our business strategy and could also potentially harm our operating results or financial condition. Our future success will also depend in large part on our ability to attract and retain qualified executives and experienced technical, sales, professional services, marketing and management personnel.

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

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

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

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

Our success depends, in part, upon our proprietary technology and other intellectual property rights. To date, we have relied primarily on a combination of copyright, trade secret, trademark and patent laws, and nondisclosure and other contractual restrictions on copying and distribution to protect our proprietary technology. We have one patent and several pending patent applications for technology related to our software, but we cannot assure you that this patent is valid or that these applications will be successful. A small number of our agreements with customers and system integrators contain provisions regarding the

rights of third parties to obtain the source code for our software, which may limit our ability to protect our intellectual property rights in the future. Despite our efforts to protect our proprietary rights, unauthorized parties may copy aspects of our software and obtain and use information that we regard as proprietary. Competitors may use such information to enhance their own products or to create similar technology which directly competes with our products, potentially diminishing our market share. In addition, other parties may breach confidentiality agreements or other protective contracts we have entered into, and we may not be able to enforce our rights in the event of these breaches. Furthermore, we expect to continue increasing our international operations in the future, and the laws of certain foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States.

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

Our business strategy contemplates possible future acquisitions of companies or technologies that may result in disruptions to our business, integration difficulties, increased debt or contingent liabilities, dilution to our stockholders or other adverse effects on future financial results.

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

Treating stock options and employee stock purchase plan participation as a compensation expense could significantly impair our ability to return to and sustain profitability on a GAAP basis, and may affect our ability to attract and retain key personnel.

The Financial Accounting Standards Board has adopted SFAS 123R, “Share-Based Payment,” which will require us to measure compensation cost for all share-based payments (such as employee stock options and participation in our employee stock purchase plan) and record such compensation costs in our consolidated financial statements beginning in our three month period ending June 30, 2006. We grant stock options to our employees, officers and directors and we administer an employee stock purchase plan (“ESPP”). Information on our stock option plan and ESPP, including the shares reserved for issuance under those plans, the terms of options granted, the terms of ESPP participation, and the shares subject to outstanding stock options, is included in Note 14 of the Notes to Consolidated Financial Statements of webMethods, Inc. included in this Form 10-K. Although we have not completed our evaluation of the impact of SFAS 123R, we expect that it will have a material adverse impact on our results of operations by increasing our operating expenses and reducing our net income and earnings per share, which we expect to significantly impair our ability to return to and sustain profitability on a GAAP basis. That impact could have a material adverse effect on the market price of webMethods’ common stock. In addition, to the extent SFAS 123R makes it more difficult or costly to issue stock option grants to our executive officers and employees, we may be forced to alter our stock-based compensation plans in ways that reduce potential benefits to our employees and impede our ability to attract, retain and motivate executive officers and key personnel, which could adversely affect our business.

If we are unable to adapt and enhance our software products to meet rapid technological changes, to provide desired product interfaces or to conform to new industry standards, we could lose partners, customers and future revenue opportunities.

We expect that the rapid evolution of business integration and optimization software and related standards and technologies and protocols, as well as general technology trends such as changes in or introductions of operating systems or enterprise applications, will require us to adapt our software and solutions to remain competitive. Our software and solutions could become obsolete, unmarketable or less desirable to prospective customers if we are unable to adapt to new technologies or standards or if we fail to adapt our products to new platforms or provide desired product interfaces. If our software ceases to demonstrate technology leadership, conform to industry standards, adapt to new platforms or develop and maintain adapters or interfaces to popular products, we may have to increase our product development costs and divert our product development resources to address the issues. In addition, because our customers, prospective customers and certain partners depend on our adapting and enhancing of our software products to meet technological changes and to conform to new industry standards, any failure or perceived failure by us to do so could result in potential losses of customers, prospective customers, partners and future revenue opportunities.

Our business may be adversely impacted if we do not provide professional services to implement our solutions or if we are unable to establish and maintain relationships with third-party implementation providers.

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

We may face product liability claims, damage to the reputation of our software and a loss of revenue if our software products fail to perform as intended or contain significant defects.

Our software products are complex, and significant defects may be found during the period immediately following introduction of new software or enhancements to existing software or in product implementations in varied information technology environments. Internal quality assurance testing and customer testing may reveal product performance issues or desirable feature enhancements that could lead us to reallocate product development resources or postpone the release of new versions of our software. The reallocation of resources or any postponement could cause delays in the development and release of future enhancements to our currently available software, require significant additional professional services work to address operational issues, damage the reputation of our software in the marketplace and result in potential loss of revenue. Although we attempt to resolve all errors that we believe would be considered serious by our partners and customers, our software is not error-free. Undetected errors or performance problems may be discovered in the future, and known errors that we consider minor may be considered serious by our partners and customers. This could result in lost revenue or delays in customer deployment and would be detrimental to our reputation, which could harm our business, operating results and financial condition. If our software experiences performance problems or ceases to demonstrate technology leadership, we may have to increase our product development costs and divert our product development resources to address the problems. In addition, because our customers and certain partners depend on our software for their critical systems and business functions, any interruptions in operation of our software or

solutions could cause our customers and certain partners to initiate warranty or product liability suits against us.

Our financial statements may in the future be impacted by improper activities of our personnel.

As we have recently experienced with our restatements for the fiscal year ended March 31, 2004 and the three months ended June 30, 2004, our financial statements can be adversely impacted by our employees’ improper activities and unauthorized actions and their concealment of their activities. For instance, revenue recognition depends upon the terms of our agreements with our customers, among other things. Our personnel may act outside of their authority, such as by negotiating additional terms or modifying terms without the knowledge of management that could impact our ability to recognize revenue in a timely manner, and they could commit us to obligations or arrangements that may have a serious financial impact to our results of operations or financial condition. In addition, depending upon when we learn of any such improper activities or unauthorized actions, we may have to restate our financial statements for a previously reported period, which could have a significant adverse impact on our business, operating results and financial condition. We have implemented, and are implementing, new or additional steps to prevent such conduct, but we cannot be certain that these new or additional controls will be effective in deterring all improper conduct by our personnel.

We intend to continue expanding our international sales efforts, which could subject us to greater uncertainties and additional risk.

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

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

Because our software could interfere with the operations of our partners’ and customers’ other network and software applications, we may be subject to potential product liability and warranty claims by these partners and customers.

Our software enables customers’ and certain partners’ software applications to provide Web services, or to integrate with networks and software applications, and is often used for mission critical functions or applications. Errors, defects or other performance problems in our software or failure to provide technical support could result in financial or other damages to our partners and customers. Partners and customers could seek damages for losses from us, which, if successful, could have a material adverse effect on our business, operating results or financial condition. In addition, the failure of our software and solutions to

perform to partners’ and customers’ expectations could give rise to warranty claims. Although our license agreements typically contain provisions designed to limit our exposure to potential product liability claims, existing or future laws or unfavorable judicial decisions could negate these limitation of liability provisions. Although we have not experienced any product liability claims to date, sale and support of our software entail the risk of such claims. The use of our software to enable partners’ and customers’ software applications to provide Web services, and the integration of our software with our partners’ and customers’ networks and software applications, increase the risk that a partner or customer may bring a lawsuit against several suppliers if an integrated computer system fails and the cause of the failure cannot easily be determined. Even if our software is not at fault, a product liability claim brought against us, even if not successful, could be time consuming and costly to defend and could harm our reputation. In addition, although we carry general liability insurance, our current insurance coverage would likely be insufficient to protect us from all liability that may be imposed under these types of claims.

We may not have sufficient resources available to us in the future to take advantage of certain opportunities, potentially harming our operating results and financial condition.

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

Some provisions of the Delaware General Corporation Law, our certificate of incorporation and our bylaws, as well as our stockholder rights plan, may deter potential acquisition bids, discourage changes in our management or Board of Directors and have anti-takeover effects.

The certificate of incorporation, as amended, of webMethods and our bylaws contain certain provisions, as does the Delaware General Corporation Law, which may discourage, delay or prevent a change of control of webMethods or a change in our management or Board of Directors, including through a proxy contest. In addition, our Board of Directors in 2001 adopted a rights plan and declared a dividend distribution of one right for each outstanding share of webMethods’ common stock. Each right, when exercisable, entitles the registered holder to purchase certain securities at a specified purchase price, subject to adjustment. The rights plan may have the anti-takeover effect of causing substantial dilution to a person or group that attempts to acquire webMethods on terms not approved by our Board of Directors. The existence of the rights plan and the other provisions of the Delaware General Corporation Law, our certificate of incorporation and our bylaws could limit the price that certain investors might be willing to pay in the future for share of webMethods’ common stock, could discourage, delay or prevent a merger or acquisition of webMethods that stockholders may consider favorable and could make it more difficult for a third party to acquire us without the support of our Board of Directors, even if doing so would be beneficial to our stockholders.

Costs of legal investigations and regulatory compliance matters may increase our operating expenses and impact our operating results.

The investigation by our Audit Committee concerning certain activities of personnel in our Japanese subsidiary, as well as the investigation and resolution of a personnel matter, have resulted in significant expense and management time and attention, and we anticipate that we will incur additional expense relating to the ongoing informal investigation by the Securities and Exchange Commission. Further investigations or any future legal compliance or regulatory compliance matters could significantly increase

expense and demands on management time and attention, thereby potentially adversely impacting our operating results, which could materially impact the market price of webMethods’ common stock. In addition, we have incurred and will continue to incur significant additional expense related to our efforts to comply with the rules and regulations enacted pursuant to the Sarbanes-Oxley Act of 2002.

Item 2. PROPERTIES

Our principal administrative, sales, marketing and research and development facility is located in Fairfax, Virginia, and consists of approximately 106,000 square feet of office space held under a lease that expires in March 2016. We maintain offices for sales and research and development in Sunnyvale, California, Denver, Colorado and Bellevue, Washington and a development center in Bangalore, India. We also maintain small offices for sales, professional services and other personnel in the United States in California, Colorado, Georgia, Illinois, Indiana, Massachusetts, Michigan, Minnesota, New York, New Jersey, North Carolina, Ohio, Pennsylvania and Texas. We maintain offices outside the United States for sales, professional services and other personnel in Australia, Belgium, Canada, Hong Kong, France, Germany, Italy, Japan, Malaysia, the Netherlands, Peoples Republic of China, Singapore, South Korea, Spain, Sweden, Switzerland, Taiwan and the United Kingdom.

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

Item 3. LEGAL PROCEEDINGS

A purported class action lawsuit was filed in the U.S. District Court for the Southern District of New York in 2001 that named webMethods, several of our executive officers at the time of our initial public offering (IPO) and the managing underwriters of our initial public offering as defendants. This action made various claims, including that alleged actions by underwriters of webMethods’ IPO were not disclosed in the registration statement and final prospectus for webMethods’ IPO or disclosed to the public after webMethods’ IPO, and sought unspecified damages on behalf of a purported class of purchasers of webMethods’ common stock between February 10, 2000 and December 6, 2000. This action was consolidated with similar actions against more than 300 companies as part of In Re Initial Public Offering Securities Litigation. Claims against webMethods’ executive officer defendants have been dismissed without prejudice. A proposed settlement, which would settle all claims against webMethods, has been submitted to the court for preliminary approval. Under the proposed settlement, the plaintiffs would dismiss and release their claims against webMethods in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuers in the consolidated action and assignment or surrender to the plaintiffs by the settling issuers of certain claims that may be held against the underwriter defendants. We believe that any material liability on behalf of webMethods or its executive officers that may accrue under that settlement offer would be covered by our insurance policies.

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

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

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

PART II


Item 5.	MARKET FOR REGISTRANT’S COMMON STOCK, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

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


		High		Low

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


		High		Low

Year ended March 31, 2005:
	First Quarter (ended June 30, 2004)	$	10.80	$	7.85
	Second Quarter (ended September 30, 2004)		8.57		3.94
	Third Quarter (ended December 31, 2004)		7.50		5.25
	Fourth Quarter (ended March 31, 2005)		7.30		5.25

As of June 10, 2005, there were approximately 360 holders of record, and approximately 12,600 beneficial owners, of webMethods common stock. The number of holders of record of webMethods common stock does not reflect the number of beneficial holders whose shares are held by depositories, brokers or other nominees. As of June 10, 2005, the closing price of webMethods’ common stock was $5.07.

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

Item 6. SELECTED FINANCIAL DATA

The following selected historical consolidated financial data for webMethods should be read in conjunction with the Consolidated Financial Statements and notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this report. The historical consolidated statement of operations data for the years ended March 31, 2005, 2004 and 2003 and the historical consolidated balance sheet data as of March 31, 2005 and 2004 are derived from the consolidated financial statements of webMethods, which have been audited by PricewaterhouseCoopers LLP, independent registered public accounting firm for webMethods, and are included elsewhere in this report. The historical consolidated statement of operations data for the years ended March 31, 2002 and 2001 and the historical consolidated balance sheet data as of March 31, 2003, 2002 and 2001 are derived from audited consolidated financial statements of webMethods not contained in this report. Historical results are not necessarily indicative of future results.


				Year Ended March 31,

				2005			2004			2003			2002			2001

				(In thousands, except per share amounts)
Consolidated Statements of Operations Data:
Revenue:
	License			$	86,800		$	92,740		$	117,066		$	121,803		$	143,514
	Professional services				49,218			43,634			33,378			35,800			34,945
	Maintenance				64,583			53,167			46,310			38,393			23,498

			Total revenue		200,601			189,541			196,754			195,996			201,957

Cost of revenue:
	Amortization of intangibles				2,397			1,199			—			—			—
	License				1,252			2,211			1,937			2,335			5,189
	Professional services and maintenance:
		Stock based compensation			—			56			251			436			1,188
		Other professional services and maintenance			56,954			53,457			41,937			42,124			46,304

			Total cost of revenue		60,603			56,923			44,125			44,895			52,681

Gross profit					139,998			132,618			152,629			151,101			149,276

Operating expenses:
	Sales and marketing:
		Stock based compensation and warrant charge			2,645			2,769			3,761			2,865			4,813
		Other sales and marketing costs			81,668			91,664			92,958			106,377			100,154
	Research and development:
		Stock based compensation			—			15			97			12,526			12,447
		Other research and development costs			44,518			45,045			47,441			49,634			45,158
	General and administrative:
		Stock based compensation			—			7			47			433			1,640
		Other general and administrative costs			25,042			17,873			17,831			19,372			20,837
	Restructuring and related charges				5,849			3,920			2,155			7,243			—
	Acquisition related expenses				—			—			—			—			34,039
	Amortization of goodwill and intangibles				—			—			—			38,697			41,395
	In-process research and development				—			4,284			—			—			34,910
	Settlement of intellectual property matter				—			2,250			—			—			—

			Total operating expenses		159,722			167,827			164,290			237,147			295,393

Operating loss					(19,724	)		(35,209	)		(11,661	)		(86,046	)		(146,117	)
Interest income					2,487			2,851			4,732			9,116			14,894
Interest expense					(98	)		(205	)		(674	)		(553	)		(503	)
Other income (expense)					(124	)		(461	)		18			(26	)		112
Impairment of equity investments in private companies					(1,057	)		—			(1,000	)		(5,200	)		—

Loss before income taxes					(18,516	)		(33,024	)		(8,585	)		(82,709	)		(131,614	)
Provision for income taxes					235			—			—			—			—

Net loss					(18,751	)		(33,024	)		(8,585	)		(82,709	)		(131,614	)
Basic and diluted net loss per share				$	(0.35	)	$	(0.63	)	$	(0.17	)	$	(1.67	)	$	(2.81	)

Shares used in computing basic and diluted net loss per common share					53,103			52,137			51,282			49,493			46,860


	March 31,

	2005		2004		2003		2002		2001

	(In thousands)
Consolidated Balance Sheet Data:
Cash, cash equivalents and short-term and long-term marketable securities available for sale	$	150,054	$	155,947	$	201,626	$	211,842	$	206,389
Working capital		108,340		93,692		149,424		178,909		190,722
Total assets		275,344		283,650		304,436		324,063		375,288
Long-term liabilities		9,884		7,439		7,267		21,653		25,409
Total stockholders’ equity		184,532		197,137		218,559		215,544		265,609


Item 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

OVERVIEW

Background

webMethods is a leading provider of business integration and optimization software. Our solutions enable organizations to deliver strategic applications to the business faster while allowing them to understand what is happening with their business in real-time and to predict what can be expected to happen. webMethods calls this Business Process Productivity. We use the term “Business Process Productivity” to describe the desire of organizations to increase the efficiency of their activities, improve the ability of the enterprise to adapt to changing market conditions, and create competitive advantage through a focus on the business processes that run their organizations. We believe that our primary offering, the webMethods Fabric product suite, is the only business integration and optimization suite on the market developed specifically to address the diverse and comprehensive requirements to achieve business process productivity.


	•	eliminating significant costs from the organization’s information technology environment,

	•	automating and streamlining interactions with their customers and suppliers,


	•	becoming more competitive by capturing more market share in terms of increased revenue from new and existing customers,

	•	gaining more timely access to information to make better decisions about the business, and

	•	allowing staff to focus their attention on higher value business activities.

webMethods Fabric builds upon our history as a leader and innovator in the business integration market. Introduced in October 2004, the webMethods Fabric product suite unifies the enterprise application integration and business-to-business capabilities for which webMethods is widely known, with our existing Business Process Management and workflow functionality and the Business Activity Monitoring, portal, and Web services technologies we acquired in October 2003. We believe that by integrating these particular capabilities into a single product suite, taking advantage of synergies between different elements of the solution, and merging the products to provide a seamless user experience, we have created a unique offering in the marketplace. By combining best-of-breed capabilities into one platform, we offer customers the ability to lower their total cost of ownership and to streamline the overall implementation process relative to using different stand-alone software products.

webMethods Fabric is based on a Service-Oriented Architecture (SOA) foundation. SOA enables organizations to extend the value of their existing IT assets, transforming them into reusable components that can be applied to new business needs. Customers who want “true SOA” need the infrastructure software to provide an integrated approach to the creation, organization, management, and security of Web services. webMethods Fabric incorporates an integrated registry and management, as well as security, for Web services. Our approach offers an alternative to custom software development, helping our customers deliver software applications to the business faster and with less risk, while real-time monitoring and patent-pending analytics gives organizations the insight necessary for achieving continuous process improvements in their business.

Restatements

On February 3, 2005, we issued a press release and thereafter filed a Form 8-K announcing that we were restating our financial statements for our fiscal year ended March 31, 2004, as well as quarterly financial statements for each of the three interim quarterly reports in that fiscal year and for the three months ended June 30, 2004. That announcement related primarily to the recently completed independent investigation conducted by the Audit Committee of our Board of Directors into certain transactions of our Japanese subsidiary.

As a result of the investigation, our Audit Committee concluded that improper activities of certain employees of our Japanese subsidiary caused us to misstate revenue and expenses for the year ended March 31, 2004 and certain quarters therein and the three months ended June 30, 2004, as well as misstate accounts receivable, deferred revenue, debt and certain other items attributable to the operations of our Japanese subsidiary. Our Audit Committee’s investigation found that the improper activities included, among other things, engaging in improper licensing and professional services transactions and

misrepresenting the transactions to our management; causing our Japanese subsidiary to engage in undisclosed and unauthorized borrowings; failing to record expenses and recording improper expenses; and creating false documents in support of improper transactions. Our Audit Committee also determined that those employees of our Japanese subsidiary acted to conceal their improper activities from our management.

The adjustments to the our financial statements in the restatements fell into five general categories: (i) adjustments to license, professional services and maintenance revenue relating to improper activities of certain employees of our Japanese subsidiary; (ii) adjustments to deferred revenue with respect to certain of those revenue items that should have been deferred and recognized as revenue in subsequent periods; (iii) adjustments to properly record expenses of our Japanese subsidiary in the appropriate period; (iv) adjustments to debt (excluding the reclassification of interest expense, which was nominal) and accounts receivable as a result of certain unauthorized borrowings by our Japanese subsidiary that were improperly recorded by it as collections of receivables; and (v) elimination of a provision for tax expense based upon estimates of the taxable income of our Japanese subsidiary.

As a result of the foregoing, our consolidated financial statements for the year ended March 31, 2004 and certain quarters therein and for the three months ended June 30, 2004 and the related consolidated balance sheets as of those dates were restated in February 2005 from amounts previously reported. Consequently, the effects of the restatements have been reflected in our consolidated financial statements appearing in this Form 10-K, in “Selected Financial Data” and in the following portions of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Critical Accounting Policies and Estimates

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

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

Revenue Recognition

We enter into arrangements, which may include the sale of licenses of our software, professional services and maintenance or various combinations of each element. We recognize revenue based on Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended, and modified by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.” SOP 98-9 modified SOP 97-2 by requiring revenue to be recognized using the “residual method” if certain conditions are met. Revenue is recognized based on the residual method when an agreement has been signed by both parties, the fees are fixed or determinable, collection of the fees is probable, delivery of the product has occurred, vendor specific objective evidence of fair value exists for any undelivered element, and no other significant obligations remain. Revenue allocated to the undelivered elements is deferred using vendor-specific objective evidence of fair value of the elements and the remaining portion of the fee is allocated to the delivered elements (generally the software license). See Note 2 of the Notes to Consolidated Financial Statements of webMethods, Inc. included elsewhere in this report for a more comprehensive discussion of our revenue recognition policies. Judgments we make

regarding these items, including collection risk, can materially impact the timing of recognition of license revenue.

Policies related to revenue recognition require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. These sources may publish new authoritative guidance which might impact current revenue recognition policies. We continue to evaluate our revenue recognition policies as new authoritative interpretations and guidance are published, and where appropriate, may modify our revenue recognition policies. Application of our revenue recognition policy requires a review of our license and professional services agreements with customers and may require management to exercise judgment in evaluating whether delivery has occurred, payments are fixed or determinable, collection is probable, and where applicable, if vendor-specific objective evidence of fair value exists for undelivered elements of the contract. If we made different judgments or utilized different estimates for any period, material differences in the amount and timing of revenue recognized could result.

Allowance for Doubtful Accounts

We maintain allowances for doubtful accounts for estimated losses which may result from the inability of our customers to make required payments to us. These allowances are established through analysis of the credit-worthiness of each customer with a receivable balance, determined by credit reports from third parties, published or publicly available financial information, customers specific experience including payment practices and history, inquiries, and other financial information from our customers. The use of different estimates or assumptions could produce materially different allowance balances. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. At March 31, 2005 and 2004, the allowance for doubtful accounts was $1.9 million and $2.1 million respectively.

Business Combinations

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

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

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

Goodwill and Intangible Assets

We record goodwill and intangible assets when we acquire other businesses. The allocation of acquisition cost to intangible assets and goodwill involves the extensive use of management’s estimates and assumptions, and the result of the allocation process can have a significant impact on our future operating results. Financial Accounting Standards Board No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), which was issued during fiscal year 2002 and adopted by us on April 1, 2002, eliminated the amortization of goodwill and indefinite lived intangible assets. Intangible assets with finite lives are amortized over their useful lives while goodwill and indefinite lived assets are not amortized under SFAS 142, but are periodically tested for impairment. In accordance with SFAS 142, all of our goodwill is associated with our corporate reporting unit, as we do not have multiple reporting units. Accordingly on an annual basis we perform the impairment assessment required under SFAS 142 at the enterprise level. We

have used the Company’s total market capitalization to assess the fair value of the enterprise. If our estimates or the related assumptions change in the future, we may be required to record impairment charges to reduce the carrying value of these assets, which could be substantial.

Acquired In-process Research and Development

Costs to acquire in-process research and development technologies which have no alternative future use and which have not reached technological feasibility at the date of acquisition are expensed as incurred (see Note 12 of the Notes to Consolidated Financial Statements of webMethods, Inc. included elsewhere in this report).

Foreign Currency Effects

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

Accounting for Income Taxes

Although we believe that our future taxable income may be sufficient to utilize a substantial amount of the benefits of our net operating loss carryforwards and to realize our deferred tax assets, we have recorded a valuation allowance to completely offset the carrying value of the deferred tax assets as we have concluded that the realization of the deferred tax assets does not meet the “more likely than not” criterion. If we should determine that we would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

Restructuring and Related Charges

We have recorded restructuring and related charges to align our cost structure with changing market conditions. These restructuring and related charges consist of headcount reductions, consolidation and relocation of facilities and related impairment of fixed assets. Excess facility costs related to the consolidation and relocation of facilities are based on our contractual obligations, net of estimated sublease income based on current comparable lease rates. We reassess this liability each period based on market conditions. Revisions to our estimates of this liability could materially impact our operating results and financial position in future periods if anticipated events and key assumptions, such as the timing and amounts of sublease rental income, either change or do not materialize.

Litigation and Contingencies

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

RESULTS OF OPERATIONS

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


	Fiscal Year Ended

	March 31,			Percentage			March 31,			Percentage			March 31,
	2005			Change			2004			Change			2003

	($ in thousands)
Total revenue		200,601			5.8	%		189,541			(3.7	)%		196,754
Gross profit		139,998			5.6	%		132,618			(13.1	)%		152,629
% of total revenue		69.8	%					70.0	%					77.6	%
Total operating expenses		159,722			(4.8	)%		167,827			2.2	%		164,290
% of total revenue		79.6	%					88.5	%					83.5	%
Operating loss		(19,724	)		(44.0	)%		(35,209	)		202.0	%		(11,661	)
% of total revenue		(9.8	)%					(18.6	)%					(5.9	)%
Net loss		(18,751	)		(43.2	)%		(33,024	)		284.7	%		(8,585	)
% of total revenue		(9.3	)%					(17.4	)%					(4.4	)%

During fiscal year 2005, our total revenue increased to $200.6 million from $189.5 million in fiscal year 2004. The increase in total revenue was due to increases in professional services and maintenance revenue, partially offset by a decrease in our license revenue. The decrease in license revenue was due in part to a significant decrease in license revenue in the first fiscal quarter of 2005 as many enterprises unexpectedly became more cautious in their enterprise software spending. The decrease in license revenue can also be attributed in part to lower license revenue in Japan due to the disruption caused by the internal investigation and related management changes. During fiscal year 2004, our total revenue decreased approximately $7.2 million to $189.5 million from $196.8 million in fiscal year 2003 as a result of a decrease in license revenue, which was partially offset by increases in professional services and maintenance revenue. Our fiscal year 2004 license revenue was negatively impacted by lower-than-anticipated Americas license revenue.

In fiscal year 2005, total revenue included a $5.5 million positive foreign currency impact from certain international markets, which was partially offset by a $4.3 million negative foreign currency impact on total cost of revenue and operating expenses, resulting in a positive impact of $1.2 million to operating loss in fiscal year 2005. In fiscal year 2004, total revenue included an $8.8 million positive foreign currency impact from certain international markets, which was partially offset by a $7.5 million negative foreign currency impact on total cost of revenue and operating expenses, resulting in a positive impact of $1.3 million to operating loss in fiscal year 2004.

Our net loss decreased to $18.8 million in fiscal year 2005 from $33.0 million in fiscal year 2004 due primarily to an increase in total revenue and a decrease in sales and marketing expenses and other operating expenses. Our net loss increased to $33.0 million in fiscal year 2004 from $8.6 million in fiscal year 2003 due, primarily, to a decrease in license revenue, an increase in professional services costs, the addition of in-process research and development and intangibles amortization related to the acquisitions in October 2003 and the settlement of an intellectual property matter in March 2004.

Revenue

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


	Fiscal Year Ended

	March 31,		Percentage			March 31,		Percentage			March 31,
	2005		Change			2004		Change			2003

	($ in thousands)
License	$	86,800		(6.4	)%	$	92,740		(20.8	)%	$	117,066
Professional services		49,218		12.8	%		43,634		30.7	%		33,378
Maintenance		64,583		21.5	%		53,167		14.8	%		46,310

Total revenue	$	200,601		5.8	%	$	189,541		(3.7	)%	$	196,754

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


	Fiscal Year Ended

	March 31,		Percentage			March 31,		Percentage			March 31,
	2005		Change			2004		Change			2003

	($ in thousands)
Americas	$	119,610		4.5	%	$	114,507		(14.4	)%	$	133,756
EMEA		50,599		12.5	%		44,965		23.7	%		36,351
Japan		15,157		(2.0	)%		15,472		1.3	%		15,274
Asia Pacific		15,235		4.4	%		14,597		28.3	%		11,373

Total revenue	$	200,601		5.8	%	$	189,541		(3.7	)%	$	196,754

Our total revenue increased by $11.1 million, or 6%, in fiscal year 2005 from fiscal year 2004, and decreased by $7.2 million or 4%, in fiscal year 2004 from fiscal year 2003. License revenue decreased by $5.9 million or 6% in fiscal year 2005 from fiscal year 2004. Our ability to maintain our license revenue, a major component of revenue, continued to be impacted by the economic downturn and uncertainty in information technology spending, particularly in the first quarter of fiscal year 2005 as many enterprises unexpectedly became more cautious in their enterprise software spending. In addition, our license revenue was also impacted by our internal investigation of our Japanese subsidiary, which caused disruption in the business and related sales cycles in our third fiscal quarter and, to a lesser extent, in our fourth fiscal quarter. License revenue for fiscal year 2004 was similarly impacted by the spending environment, as well as the impact of our quota bearing sales representatives in the Americas being down approximately 10% at the beginning of fiscal year 2004 and lower-than-anticipated license revenue in the Americas, particularly in the first half of fiscal year 2004. License revenue included a positive foreign currency impact of $2.8 million and $4.8 million in fiscal years 2005 and 2004, respectively, from certain international markets.

Professional services revenue increased by $5.6 million, or 13%, to $49.2 million, for fiscal year 2005 compared to $43.6 million for fiscal year 2004. This increase was primarily due to an increase in the volume and size of customer engagements and to a lesser extent, a $1.1 million positive foreign currency impact. In fiscal year 2004, professional services revenue increased 31%, to $43.6 million, from $33.4 million in fiscal year 2003. This increase was primarily due to an increase in the volume and/or size of customer engagements, the increased use of subcontractors and, to a lesser extent, a $1.9 million positive foreign currency impact.

Maintenance revenue increased by $11.4 million, or 22%, from $53.2 million to $64.6 million in fiscal year 2005, and $6.9 million, or 15%, from $46.3 million to $53.2 million in fiscal year 2004. This increase is due primarily to the increase in customers licensing our software and the cumulative effect of agreements for post-contract maintenance and support, which is recognized as revenue ratably over the term of the contract. Additionally, more customers have moved to our 24x7 support plans given the mission critical nature of their projects involving our software. Furthermore, the increase in maintenance

revenue was partially due to a positive foreign currency impact of $1.6 million in fiscal year 2005 and $2.1 million in fiscal year 2004.

In fiscal year 2005, revenue from the Americas increased by $5.1 million, or 4.5%, from $114.5 million to $119.6 million due to increases in professional services and maintenance revenue, which was partially offset by a decrease in license revenue. Total revenue from EMEA, Asia Pacific and Japan (“international revenue”) increased $6.0 million to $81.0 million in fiscal year 2005, and included a $5.5 million positive foreign currency impact. International revenue accounted for 40% of our total revenue in fiscal year 2005 as compared to 40% and 32% in 2004 and 2003, respectively.

Gross margin

The following table summarizes our gross margin by type of revenue for each of the past three fiscal years:


	Fiscal Year Ended

	March 31,			March 31,			March 31,
	2005			2004			2003

License		96	%		96	%		98	%
Professional services and maintenance		50	%		45	%		47	%
Total revenue		70	%		70	%		78	%

Our total gross margin was 70% in fiscal year 2005 as compared to 70% in fiscal year 2004 and 78% in fiscal year 2003. The decrease in fiscal year 2004 was primarily due to a decrease in license revenue as a percent of total revenue, an increase in the total cost of professional services and maintenance as compared to fiscal year 2003 and an increase in cost of revenue due to amortization of intangibles of $1.2 million related to the October 2003 acquisitions.

Our cost of license revenue consists of royalties for products embedded in our software licensed from third parties. In addition, we acquired certain technology in fiscal year 2004 that resulted in amortization of intangibles in the amount of $2.4 million in fiscal year 2005 and $1.2 million in fiscal 2004, which is included in our license margin. The increase in amortization in fiscal year 2005 is due to the full year effect of such amortization.

Our cost of professional services and maintenance consists primarily of costs related to internal professional services and support personnel, and subcontractors hired to provide implementation and support services. Our gross margin on maintenance and services, excluding stock based compensation, was 50%, 45% and 47% in fiscal years 2005, 2004 and 2003, respectively. Our gross margin in fiscal year 2005 was positively impacted by a reduction in our use of subcontractors as well as certain nonbillable activities. Our gross profit in fiscal year 2004 was negatively impacted by an increase in subcontractor activity and nonbillable travel, training and other activities, as well as an effective decrease in average billing rates.

Operating expenses

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


	Fiscal Year Ended

	March 31,			Percentage			March 31,			Percentage			March 31,
	2005			Change			2004			Change			2003

	($ in thousands)
Operating Expenses:
Sales and marketing*	$	81,668			(10.9	)%	$	91,664			(1.4	)%	$	92,958
% of total revenue		40.7	%					48.4	%					47.2	%
Research and development*		44,518			(1.2	)%		45,045			(5.1	)%		47,441
% of total revenue		22.2	%					23.8	%					24.1	%
General and administrative*		25,042			40.1	%		17,873			0.2	%		17,831
% of total revenue		12.5	%					9.4	%					9.1	%
Stock based compensation and warrant charge**		2,645			(5.2	)%		2,791			(28.5	)%		3,905
% of total revenue		1.3	%					1.5	%					2.0	%
Restructuring and related charges		5,849			49.2	%		3,920			81.9	%		2,155
% of total revenue		2.9	%					2.1	%					1.1	%
In-process research and development		—			(100.0	)%		4,284			100.0	%		—
% of total revenue		0.0	%					2.3	%					0.0	%
Settlement of intellectual property matter		—			(100.0	)%		2,250			100.0	%		—
% of total revenue		0.0	%					1.2	%					0.0	%
Operating expense	$	159,722			(4.8	)%	$	167,827			2.2	%	$	164,290
% of total revenue		79.6	%					88.5	%					83.5	%


*	Excludes stock based compensation and warrant charge if applicable.

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

Our operating expenses are primarily classified as sales and marketing, research and development and general and administrative. Each category includes related expenses for compensation, employee benefits, professional fees, travel, communications and allocated facilities, recruitment and overhead costs. Our sales and marketing expenses also include expenses which are specific to our sales and marketing activities, such as commissions, trade shows, public relations, business development costs, promotional costs and marketing collateral. Also included in our operating expenses is the amortization of deferred stock compensation and deferred warrant charge, restructuring and related charges, amortization of goodwill and intangibles, settlement of intellectual property matter and in-process research and development.

Operating expenses, excluding stock based compensation and warrant charge, and restructuring and related charges, totaled $151.2 million in fiscal year 2005, as compared to $154.6 million in fiscal year 2004. The 2% decrease in those operating expenses in fiscal year 2005 was primarily due to our continued focus on expense management despite a $3.0 million negative foreign currency impact and more than $2.5 million in costs related to our internal investigation of our Japanese subsidiary and related costs.

Operating expenses, excluding stock based compensation and warrant charge, in-process research and development, settlement of intellectual property matter and restructuring and related charges, totaled $154.6 million in fiscal year 2004, a decrease of $3.6 million, or 2%, from fiscal year 2003 due to our continued focus on expense management despite a $5.1 million negative foreign currency impact.

Sales and marketing expense, excluding stock based compensation and warrant charge, was 41%, 48% and 47% of total revenue in fiscal years 2005, 2004 and 2003, respectively. In fiscal year 2005, sales and marketing expense, excluding stock based compensation and warrant charge, decreased to $81.7 million from $91.7 million in fiscal year 2004. This decrease was primarily due to a decrease in personnel costs and the associated allocated overhead costs, as well as decreases in travel expenses, marketing program costs and commission expense. These decreases were offset by a $2.6 million increase in expenses due to the foreign currency impact in fiscal year 2005. In fiscal year 2004, sales and marketing expense, excluding stock based compensation and warrant charge, decreased to $91.7 million from $93.0 million in fiscal year 2003. This decrease was primarily due to a decrease in personnel costs, commission expense, travel expense and sales assistance fees paid to partners offset by increases in marketing program costs, professional services and recruiting expenses. In addition, these decreases were further offset by a $4.7 million increase in expenses due to the foreign currency impact.

Research and development expense, excluding stock based compensation, was 22%, 24% and 24% of total revenue in fiscal years 2005, 2004 and 2003, respectively. In fiscal year 2005, research and development expense, excluding stock based compensation, was relatively flat as compared to fiscal year 2004. In fiscal year 2004, research and development expense, excluding stock based compensation, decreased $2.4 million primarily due to continued reduction in the use of outside contractors and reduced personnel costs offset by an increase in recruiting costs.

General and administrative expense, excluding stock based compensation, as a percentage of total revenue, was 12.5%, 9% and 9% for fiscal years 2005, 2004 and 2003, respectively. In fiscal year 2005, general and administrative expenses, excluding stock based compensation, increased $7.2 million from fiscal year 2004 to $25 million in fiscal year 2005 due primarily to costs associated with our internal investigation of our Japanese subsidiary as well as costs associated with Sarbanes Oxley compliance and, to a lesser extent, an increase in personnel related costs. In fiscal year 2004, general and administrative expense, excluding stock based compensation, increased $42,000 from fiscal year 2003 to $17.9 million.

Stock based compensation and warrant charge was $2.6 million, $2.8 million and $4.2 million in fiscal years 2005, 2004 and 2003, respectively, of which $56,000, and $251,000 was included in cost of sales in fiscal years 2004 and 2003 respectively. Deferred stock based compensation and warrant charge was recorded for the following transactions:

(i) In connection with the grant of stock options to employees and non-employee directors during the fiscal years ended March 31, 2000 and 1999, we recorded aggregate unearned compensation of $15.5 million, representing the difference between the deemed fair value of our common stock at the date of grant and the exercise price of such options.

(ii) As a result of the acquisitions of TransLink Software, Inc., Premier Software Technology, Inc. and Alier, Inc. we recorded a deferred stock compensation charge of $27.9 million related to restricted stock issued to stockholders of the acquired companies.

(iii) In connection with the acquisition of Active Software, in August 2000, 50% of Active Software’s remaining options vested upon consummation of the merger which resulted in an acceleration of amortization of deferred stock compensation.

(iv) In March 2001, we entered into an OEM/ Reseller agreement with i2 Technologies (“i2”) and issued a warrant which, as amended, permits i2 to purchase 710,000 shares of our common stock at an exercise price of $28.70 per share. The fair value of the warrant was based on the Black-Scholes valuation model was $23.6 million on the date of issuance, which has been recorded as a deferred warrant charge. As part of the agreement, i2 will pay us Original Equipment Manufacturer (“OEM”) fees of $10.0 million over the term of the OEM/ Reseller agreement, which will be recorded as a reduction to the deferred warrant charge and will not be recorded as revenue. In March 2004, we amended our OEM/ Reseller agreement with i2. We extended the term of the agreement by one year to March 2006 and also reduced the number of required webMethods on-site resources from 10 to 1, which resulted in a corresponding reduction of $1.3 million in OEM fees due under the agreement. Due to this change in the agreement, the

amortization of the remaining unamortized deferred warrant charge has been changed from 4 years to 5 years to coincide with the new payment schedule, resulting in a decrease in the annual amortization of $757,000 from $3,402,000 to $2,645,000. Additionally, we made changes relating to the sharing of revenue related to maintenance.

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

We have recorded restructuring and related charges to align our cost structure with changing market conditions. During fiscal year 2005, we recorded restructuring and related charges of $5.9 million, consisting of $2.8 million for headcount reductions and $3.1 million for excess facility costs related to the relocation of our headquarters. The estimated excess facility costs were based on our contractual obligations, net of estimated sublease income, based on current comparable lease rates. We reassess this liability each period based on market conditions. Revisions to the estimates of this liability could materially impact the operating results and financial position in future periods if anticipated events and key assumptions, such as the timing and amounts of sublease rental income, either change or do not materialize. During fiscal year 2004, we recorded restructuring and related charges of $3.9 million consisting of $2.2 million for headcount reductions and $1.7 million for consolidation of facilities and related impairment of fixed assets. The excess facility costs were based on our contractual obligations, net of sublease income. During fiscal year 2003, we recorded restructuring and related charges of $2.2 million for headcount reductions.

We incurred an in-process research and development charge of $4.3 million for fiscal year 2004. There was no in-process research and development charge for fiscal years 2005 and 2003. The $4.3 million charge during fiscal year 2004 consists of: (i) a one-time charge of $3.1 million recorded in connection with the acquisition and write-off of The Dante Group technology and (ii) a one-time charge of $1.2 million recorded in connection with the acquisition and write-off of The Mind Electric technology. We also incurred a $2.3 million charge in fiscal year 2004 related to the settlement of an intellectual property matter.

Interest income

Interest income decreased by $364,000 or 13% to $2.5 million for fiscal year 2005 from $2.9 million for fiscal year 2004 due primarily to the lower average balances of cash and marketable securities during fiscal year 2005 as compared to fiscal year 2004 given the use of cash in connection with the October 2003 acquisitions. For fiscal year 2004, interest income decreased by approximately $1.9 million or 40% to $2.9 million from $4.7 million for fiscal year 2003. This decrease was primarily attributable to lower interest rates on corporate paper, bonds and money market funds compared to those in the same period in the prior year.

Interest expense

Interest expense is primarily due to equipment leasing arrangements in the Americas. During fiscal year 2005, interest expense decreased to $98,000, as compared to $205,000 for fiscal year 2004 and $674,000 for fiscal year 2003. The decreases in fiscal year 2004 and 2005 are due to the completion of previously established leases and lower rates on leases initiated during fiscal 2004.

Other income (expense), net

Other expense, net, was $124,000 for fiscal year 2005 as compared to $461,000 in fiscal year 2004 and other income of $18,000 in fiscal 2003. These amounts relate primarily to losses and gains on foreign currency transactions and are primarily due to U.S. Dollar or other non-functional currency based contracts in EMEA and Asia Pacific and, to a lesser extent in fiscal year 2004, to U.S. Dollar cash accounts held by operating subsidiaries in EMEA and Japan.

Impairment of equity investment in private companies

We recognized an other-than-temporary decline in value of $1.0 million in private company investments in each of fiscal years 2003 and 2005.

Income taxes

During fiscal year 2005, our foreign subsidiaries incurred tax expense of $235,000 that we could not offset by utilizing those subsidiaries’ net operating losses generated in prior years.

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

As of March 31, 2005, we had net operating loss carry-forwards of approximately $230 million. These net operating loss carry-forwards are available to reduce future taxable income and begin to expire in fiscal year 2007. Under the provisions of the Internal Revenue Code, certain substantial changes in our ownership have limited the amount of net operating loss carry-forwards that could be utilized annually in the future to offset taxable income.

Quarterly results of operations

The following tables set forth consolidated statement of operations data for each of the eight quarters ended March 31, 2005, as well as that data expressed as a percentage of the total revenue for the quarters presented. This information has been derived from our unaudited consolidated financial statements. The unaudited consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements contained elsewhere in this report and include all adjustments, consisting only of normal recurring adjustments that we consider necessary for a fair statement of such information. You should read this information in conjunction with our annual audited consolidated financial statements and related notes appearing elsewhere in this report. Historical results may not be indicative of future results.


				Three Months Ended

				Mar. 31,		Dec. 31,		Sept. 30,		June 30,		Mar. 31,		Dec. 31,		Sept. 30,		June 30,
				2005		2004		2004		2004		2004		2003		2003		2003

				(In thousands)
Revenue:
	License			$	22,190	$	25,953	$	23,851	$	14,806	$	25,679	$	25,037	$	20,850	$	21,174
	Professional services				12,763		11,854		12,077		12,524		13,091		11,210		10,460		8,873
	Maintenance				17,982		17,156		14,838		14,607		14,066		13,785		12,766		12,550

			Total revenue		52,935		54,963		50,766		41,937		52,836		50,032		44,076		42,597

Cost of revenue:
	Amortization of intangibles				600		599		599		599		600		599		—		—
	License				135		252		245		620		588		601		555		467
	Professional services and maintenance:
		Stock based compensation			—		—		—		—		—		12		22		22
		Other professional services and maintenance			14,637		13,764		14,280		14,273		15,781		13,614		12,403		11,659

			Total cost of revenue		15,372		14,615		15,124		15,492		16,969		14,826		12,980		12,148

Gross profit					37,563		40,348		35,642		26,445		35,867		35,206		31,096		30,449


				Three Months Ended

				Mar. 31,			Dec. 31,			Sept. 30,			June 30,			Mar. 31,			Dec. 31,			Sept. 30,			June 30,
				2005			2004			2004			2004			2004			2003			2003			2003

				(In thousands)
Operating expenses:
	Sales and marketing:
		Stock based compensation and warrant charge			662			661			661			661			663			689			721			696
		Other sales and marketing			18,525			22,103			19,926			21,114			23,130			24,617			21,467			22,450
	Research and development:
		Stock based compensation			—			—			—			—			—			5			10			—
		Other research and development			11,771			10,877			10,820			11,050			11,542			11,446			10,857			11,200
	General and administrative:
		Stock based compensation			—			—			—			—			—			1			3			3
		Other general and administrative			8,008			7,093			4,868			5,073			4,593			4,333			4,524			4,423
	Restructuring and related charges				3,093			—			2,756			—			2,605			1,315			—			—
	In-process research and development				—			—			—			—			—			4,284			—			—
	Settlement of intellectual property matter				—			—			—			—			2,250			—			—			—

			Total operating expenses		42,059			40,734			39,031			37,898			44,783			46,690			37,582			38,772

Operating loss					(4,496	)		(386	)		(3,389	)		(11,453	)		(8,916	)		(11,484	)		(6,486	)		(8,323	)
Interest income					787			615			532			553			575			549			721			1,007
Interest expense					(15	)		(28	)		(29	)		(27	)		(42	)		(56	)		(17	)		(89	)
Other (expense)/income					(92	)		(27	)		(116	)		112			(290	)		(196	)		(5	)		28
Impairment of equity investments in private companies					—			—			(1,057	)		—			—			—			—			—

Net (loss)/income before taxes					(3,816	)		174			(4,059	)		(10,815	)		(8,673	)		(11,187	)		(5,787	)		(7,377	)

	Provision for income taxes				40			126			65			4

Net (loss)/income				$	(3,856	)	$	48		$	(4,124	)	$	(10,819	)	$	(8,673	)	$	(11,187	)	$	(5,787	)	$	(7,377	)


				As a Percentage of Total Revenue

				Mar. 31,			Dec. 31,			Sept. 30,			June 30,			Mar. 31,			Dec. 31,			Sept. 30,			June 30,
				2005			2004			2004			2004			2004			2003			2003			2003

				(In thousands)
Revenue:
	License				41.9	%		47.2	%		47.0	%		35.3	%		48.6	%		50.0	%		47.3	%		49.7	%
	Professional services				24.1			21.6			23.8			29.9			24.8			22.4			23.7			20.8
	Maintenance				34.0			31.2			29.2			34.8			26.6			27.6			29.0			29.5

			Total revenue		100.0			100.0			100.0			100.0			100.0			100.0			100.0			100.0

Cost of revenue:
	Amortization of intangibles				1.1			1.1			1.2			1.4			1.1			1.2			—			—
	License				0.3			0.5			0.5			1.5			1.1			1.2			1.3			1.1
	Professional services and maintenance:
		Stock based compensation			—			—			—			—			—			—			0.1			0.1
		Other professional services and maintenance			27.6			25.0			28.1			34.0			29.9			27.2			28.0			27.3

			Total cost of revenue		29.0			26.6			29.8			36.9			32.1			29.6			29.4			28.5

Gross profit					71.0			73.4			70.2			63.1			67.9			70.4			70.6			71.5


				As a Percentage of Total Revenue

				Mar. 31,			Dec. 31,			Sept. 30,			June 30,			Mar. 31,			Dec. 31,			Sept. 30,			June 30,
				2005			2004			2004			2004			2004			2003			2003			2003

				(In thousands)
Operating expenses:
	Sales and marketing:
		Stock based compensation and warrant charge			1.3			1.2			1.3			1.6			1.3			1.4			1.6			1.6
		Other sales and marketing			35.0			40.2			39.3			50.3			43.8			49.2			48.7			52.7
	Research and development:
		Stock based compensation			—			—			—			—			—			—			—			—
		Other research and development			22.2			19.8			21.3			26.4			21.8			22.9			24.7			26.3
	General and administrative:
		Stock based compensation			—			—			—			—			—			—			—			—
		Other general and administrative			15.1			12.9			9.6			12.1			8.7			8.7			10.3			10.4
	Restructuring and related charges				5.9			—			5.4			—			4.9			2.6			—			—
	In-process research and development				—			—			—			—			—			8.6			—			—
	Settlement of intellectual property matter				—			—			—			—			4.3			—			—			—

			Total operating expenses		79.5			74.1			76.9			90.4			84.8			93.4			85.3			91.0

Operating loss					(8.5	)		(0.7	)		(6.7	)		(27.3	)		(16.9	)		(23.0	)		(14.7	)		(19.5	)
Interest income					1.5			1.1			1.1			1.3			1.1			1.1			1.6			2.3
Interest expense					(—	)		(0.1	)		(0.1	)		(0.1	)		(0.1	)		(0.1	)		—			(0.2	)
Other (expense)/income					(0.2	)		—			(0.2	)		0.3			(0.5	)		(0.4	)		—			0.1
Impairment of equity investments in private companies					—			—			(2.1	)		—			—			—			—			—

Net (loss)/income before taxes					(7.2	)		0.3			(8.0	)		(25.8	)		(16.4	)		(22.4	)		(13.1	)		(17.3	)
Provision for income taxes					0.1			0.2			0.1			0.0			—			—			—			—

Net (loss)/income					(7.3	)%		0.1	%		(8.1	)%		(25.8	)%		(16.4	)%		(22.4	)%		(13.1	)%		(17.3	)%

LIQUIDITY AND CAPITAL RESOURCES

As of March 31, 2005 we had cash, cash equivalents and short-term and long-term securities available for sale in the amount of $150.1 million as compared to $155.9 million as of March 31, 2004 and $201.6 million as of March 31, 2003. The decrease in fiscal year 2004 was due in part to the use of $32.4 million of net cash in the acquisitions of two businesses and the purchase of technology in October 2003, as previously discussed.

Working capital as of March 31, 2005 improved to $108.3 million, as compared $93.7 million as of March 31, 2004, due primarily due to the reinvestment of certain marketable securities which were previously long term in nature but have now been reinvested for shorter terms.

Net cash provided by operating activities was $2.4 million in fiscal year 2005, resulting from a net loss of $18.8 million, offset by $12.5 million of non-cash charges and $8.7 million of net changes in assets and liabilities (net of acquisitions). The net changes in assets and liabilities included a $7.0 increase in deferred revenue and a $3.1 million increase in deferred rent related primarily to landlord leasehold improvement allowances received in connection with our new headquarters facility lease. Net cash used in operating activities was $20.0 million in fiscal year 2004, resulting from a net loss of $33.0 million and $4.0 million of net changes in assets and liabilities (net of acquisitions), partially offset by non-cash charges of $17.0 million. The net changes in assets and liabilities included a $6.7 million decrease in deferred revenue, and the non-cash charges included $4.3 million in write-offs of in-process research and development. Net cash used in operating activities was $12.8 million in fiscal year 2003, resulting from a net loss of $8.6 million and $19.8 million of net changes in assets and liabilities (net of acquisitions), partially offset by $15.6 million of non-cash charges.

Net cash used in investing activities was $21.2 million in fiscal year 2005 as compared to net cash provided by investing activities of $7.1 million in fiscal year 2004 and net cash used in investing activities of $11.7 million in fiscal year 2003. Cash used in investing activities in fiscal year 2005 and 2003 primarily

reflects purchases of property and equipment and net purchases of marketable securities. Cash provided by investing activities in fiscal year 2004 primarily reflects net sales of marketable securities offset by $32.4 million in cash used for the acquisition of businesses and technology and $2.7 million in capital expenditures. Capital expenditures were $8.4 million, $2.7 million, and $3.0 million in fiscal years 2005, 2004 and 2003, respectively. The increase in capital expenditures in fiscal year 2005 was due in part to the increase in leasehold improvements related to our new headquarters facility. Capital expenditures consisted of purchases of operating resources to manage operations, including computer hardware and software, office furniture and equipment and leasehold improvements. Since our inception, we have generally funded capital expenditures through the use of capital leases and working capital.

Net cash provided by financing activities was $55,000, $5.6 million and $4.4 million in fiscal years 2005, 2004 and 2003, respectively. These cash flows primarily reflect net cash proceeds from exercises of stock options, net cash proceeds from Employee Stock Purchase Plan (“ESPP”) common stock issuances and net cash proceeds from short-term borrowings by our Japanese subsidiary, offset by payments on capital leases and short-term borrowings. Net cash proceeds from exercises of stock options were $1.0 million, $3.0 million and $2.6 million in fiscal years 2005, 2004 and 2003, respectively. Net cash proceeds from ESPP common stock issuances were $2.0 million, $2.5 million and $3.0 million in fiscal years 2005, 2004 and 2003, respectively. Net cash proceeds from short-term borrowings by our Japanese subsidiary were $3.5 million and $5.9 million in fiscal years 2005 and 2004, respectively. Payments on short-term borrowings by our Japanese subsidiary were $6.1 million and $3.6 million in fiscal years 2005 and 2004, respectively. As of March 31, 2005 and 2004, our Japanese subsidiary had, respectively, $0 and $2.6 million in short-term borrowings outstanding. Payments on capital leases were $0.9 million, $3.3 million and $4.9 million in fiscal years 2005, 2004 and 2003, respectively.

As of March 31, 2005 we had a line of credit to borrow up to a maximum principal amount of $20,000,000 with a maturity date of April 30, 2005, which was subsequently extended to June 30, 2005. Any borrowings under the line of credit will bear interest at the bank’s prime rate per annum and are limited to 80% of eligible accounts receivable. As of March 31, 2005 there were no borrowings outstanding. In connection with the line of credit, we have letters of credit totaling approximately $2.6 million related to office leases. We expect to renew the line of credit by June 30, 2005.

We believe that our existing working capital and our line of credit will be sufficient to meet our working capital and operating resource expenditure requirements for at least the next twelve months. However, we may utilize cash resources to fund acquisitions or investments in complementary businesses, technologies or product lines.

The following table summarizes our significant contractual obligations at March 31, 2005, which are comprised of capital and operating leases. These obligations are expected to have the following effects on our liquidity and cash flows in future periods:


		Operating		Capital

		(In thousands)
Years ending March 31, 2006		$	11,431	$	502
	2007		10,124		143
	2008		6,535		—
	2009		3,043		—
	2010		2,741		—
	Thereafter		16,372		—

		$	50,246	$	645

Less amounts representing interest					(31	)

					614
Less current portion					(475	)

Capital lease obligation, net of current portion				$	139

We are not a party to any agreements with, or commitments to, any special-purpose entities that would constitute off-balance sheet financing.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In May 2005 the Financial Accounting Standards Board issued SFAS 154, “Accounting Changes and Error Corrections.” This statement replaces APB 20 and SFAS 3 and changes the requirements for the accounting for and reporting of a change in accounting principle. APB 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle. Adoption of this statement is not expected to have a material impact on our results of operations or financial condition.

In December 2004 the FASB issued revised SFAS 123R, “Share-Based Payment,” which sets forth accounting requirements for “share-based” compensation to employees and requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation. We currently provide pro forma disclosure of the effect on net income or loss and earnings or loss per share of the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation.” Under SFAS 123R, such pro forma disclosure will no longer be an alternative to financial statement recognition. SFAS 123R is effective for annual periods beginning after June 15, 2005 and, accordingly, we must adopt the new accounting provisions effective April 1, 2006 and recognize the cost of all share-based payments to employees, including stock option grants, in the income statement based on their fair values. We are currently evaluating the impact of the adoption of SFAS 123R on our financial position and results of operations, including the valuation methods and support for the assumptions that underlie the valuation of the awards. However, we currently believe that the adoption of SFAS 123R will have a material effect on our results of operations.

In December 2004, FASB issued SFAS 153, “Exchanges of Nonmonetary Assets — an amendment to APB Opinion No. 29”. This statement amends APB 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. Adoption of this statement is not expected to have a material impact on our results of operations or financial condition.

In December 2004, FASB Staff Position No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004” (“FSP FAS 109-2”) was issued, providing guidance under SFAS 109, “Accounting for Income Taxes” for recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004, enacted on October 22, 2004 (the “Jobs Act”). FSP FAS 109-2 allows time beyond the financial reporting period of enactment to evaluate the effects of the Jobs Act before applying the requirements of FSP FAS 109-2. Although we have not yet completed our evaluation of the impact of the repatriation provisions of the Jobs Act, we do not expect that these provisions will have a material impact on our consolidated financial position, consolidated results of operations, or liquidity. Accordingly, as provided for in FSP 109-2, we have not adjusted our tax expense or deferred tax liability to reflect the repatriation provisions of the Jobs Act.


Item 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

Interest rate risk. We maintain our funds in money market accounts, corporate bonds, commercial paper, Treasury notes and agency notes. Our exposure to market risk due to fluctuations in interest rates relates primarily to our interest earnings on our cash deposits. These securities are subject to interest rate

risk inasmuch as their fair value will fall if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from the levels prevailing as of March 31, 2005, the fair value of the portfolio would not decline by a material amount. We do not use derivative financial instruments to mitigate risks. However, we do have an investment policy that would allow us to invest in short-term and long-term investments such as money market instruments and corporate debt securities. Our policy attempts to reduce such risks by typically limiting the maturity date of such securities to no more than twenty-four months with a maximum average maturity to our whole portfolio of such investments at twelve months, placing our investments with high credit quality issuers and limiting the amount of credit exposure with any one issuer.

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

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


Item 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The consolidated financial statements of webMethods are submitted on pages F-1 through F-29 of this report.


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

None.


Item 9A.	CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures. We maintain disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), which are designed to ensure that informatio


		service-oriented and XML-based protocols. We believe that we have successfully built upon this heritage with our continued involvement in various Web services standards bodies, our acquisition in October 2003 of a unique Web services management framework developed by The Mind Electric, and ongoing product innovation in the area of Web services quality-of-service monitoring. webMethods has been recognized as a leader in Web services by industry analysts, and we currently serve on the Board of Directors of the Web Services Interoperability organization (“WS-I”).

	•	Partner with Major Systems Integrators. We continue to expand and strengthen our alliances with major system integrators to increase our sales and services leverage. We have established a series of formal alliance relationships with major system integrators such as Accenture, Atos Origin, BearingPoint, Capgemini, CGI-AMS, Computer Sciences Corporation (“CSC”), Crowe Chizek, Deloitte, Electronic Data Systems Corporation (“EDS”), Hewlett-Packard (“HP”) and Tata Consulting Services (“TCS”). Many of these partners have established formal webMethods practices, increasing the number of webMethods-trained resources available to assist our customers in their implementations of our solutions. As a result of this expanded knowledge-base, as well as implementation successes on which the systems integrator partner and webMethods have worked jointly, these alliances form a virtual extension of our direct sales force. This results in the third-party introduction and subsequent endorsement of webMethods’ solutions in opportunities of which we may not otherwise be aware, or with customers or prospects of the partner with which we may not otherwise already be engaged.

	•	Leverage Strategic Software and Other Vendor Partnerships. We have relationships with enterprise application software and other vendors, such as Global eXchange Services (“GXS”), Oracle Corporation (including both the Peoplesoft and JD Edwards product lines), SAP AG and Siebel Systems, whereby they embed a limited-use implementation of webMethods’ software into their solutions and/or resell components of our product line. As a result, customers who license products in which our software is embedded receive access to our technology. We believe these customers are good candidates to purchase additional webMethods software, and that our association with the major enterprise application vendors distinguishes us from many of our competitors, providing us with an incumbency advantage that positions webMethods as the lowest risk option for customers of these software products.