WEBMETHODS INC - 10-K Annual Report


x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED MARCH 31, 2002

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

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

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. o

The aggregate market value of webMethods Common Stock held by non-affiliates of the registrant as of June 12, 2002, based upon the closing price of webMethods Common Stock on the Nasdaq National Market for such date, was $423,510,111.

As of June 12, 2002, there were outstanding 50,681,681 shares of webMethods, Inc. Common Stock.

Certain portions of the definitive Proxy Statement to be used in connection with webMethods’ annual meeting of stockholders, to be held in August 2002, and to be mailed to stockholders in July 2002, are incorporated by reference into Part III of this Form 10-K.

Readers are advised that this report 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. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those indicated by the forward-looking statements. Statements using the words “believes,” “anticipates,” “plans,” “expects,” “intends,” “may,” “will,” “should,” “estimates,” “predicts,” “continue” and similar expressions are intended to identify forward-looking statements. 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 and projections regarding the market for integration software, (ii) statements of the plans or objectives of webMethods, Inc. or its management, including the development or enhancement of software, development and continuation of strategic partnerships and alliances, implementation and effect of sales and marketing initiatives by webMethods, focus on geographic or specific vertical markets and allocation of resources to them, predictions of the timing and type of customer or market reaction to those initiatives, the ability to control expenses, future hiring, webMethods’ business strategy and the execution on it and actions by customers and competitors, (iii) statements of future economic performance or economic conditions and (iv) statements of assumptions underlying other statements or statements about webMethods or its business.

This report also identifies important factors that could cause actual results to differ materially from those indicated by the forward-looking statements. These risks and uncertainties include those factors discussed below under the caption “Factors that May Affect Future Operating Results.” Forward-looking statements are beyond the ability of webMethods to control, and in many cases, webMethods cannot predict what factors may cause actual results to differ from those indicated by the forward-looking statements. webMethods disclaims any obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

webMethods, Inc. is a leading provider of software and services for comprehensive end-to-end integration solutions. We develop and deliver software products and provide related services that give large organizations the ability, seamlessly and in real-time, to integrate disparate information resources, to connect customers, vendors and business partners with the organization and its employees, to view and manage the connected information resources, data, business processes and human workflows and to provide web services at the enterprise level. Our integration platform is a comprehensive solution for linking business processes, enterprise and legacy application software products, databases, human workflows and web services, both within and across business enterprises and government organizations.

The webMethods integration platform allows customers to achieve quantifiable return on their investment in our software within a brief timeframe, as well as in their other information technology investments, by linking business processes, seamlessly integrating enterprise and legacy applications and databases, and managing human workflows both within and across enterprises. By deploying the webMethods integration platform, customers can reduce costs, create new revenue opportunities, strengthen relationships with customers, vendors and business partners, substantially increase supply chain efficiencies, streamline internal business processes and provide Enterprise Web Services. The webMethods integration platform enables our customers to rapidly and cost-effectively meet the full range of business integration requirements with a single, globally-scalable infrastructure and provides our customers with a comprehensive, real-time view of customers, vendors and business partners, projects, orders, assets, business processes, human workflows, information system resources and data, which we refer to as “Global Business Visibility”.

We had over 800 customers at March 31, 2002, including many major business enterprises, often referred to as the “Global 2000,” and government organizations. Our customers include leaders in manufacturing, process industries (such as chemicals, oil and gas, metals, paper and plastics), financial services, telecommunications, government, consumer goods manufacturing and retail, utilities and transportation and logistics. We license our software primarily through our direct sales force. In the Asia Pacific region and, to a lesser extent, in Europe, we also license our software through resellers. We pursue joint promotional and selling efforts with strategic partners who provide leading enterprise application software products, many of whom embed our software directly into their application products. We also pursue joint promotional and selling efforts through strategic alliances with major systems integrators. Through those joint efforts with our strategic partners, we leverage our direct sales force, reach a broader range of prospective customers and create opportunities to upsell our products to customers already using limited versions of our software embedded in their enterprise application products. In addition, we license our products through a number of major resellers and distributors.

Our goal is to continue establishing webMethods as the leading independent provider of integration software. Our strategy is based on driving the success of our customers and partners, making our software ubiquitous by expanding and maximizing our strategic software vendor partnerships, leveraging our sales force and technical services team by expanding our strategic alliances with leading systems integrators and providing the most comprehensive integration and web services solution by extending our technology and product leadership.

With the widespread proliferation of mainframes, distributed computing environments, application servers, databases, packaged and custom software applications and Web services within each organization or enterprise, as well as these same information resources and technologies throughout its chain of vendors, customers, affiliates and business partners (collectively comprising the “extended enterprise”), the ability to integrate these disparate systems and applications has become a strategic part of an organization’s information systems infrastructure. In addition, the need for integration software is driven by the widespread adoption of enterprise resource planning (ERP), supply chain management (SCM), financial management and customer relationship management (CRM) software application products, whose benefits are largely dependent on integration with other information systems. Organizations that have purchased such software or systems often seek to streamline internal processes and enable communication and collaboration internally and with their customers, vendors and partners to increase productivity, create new revenue opportunities, reduce costs and strengthen relationships with customers, vendors and partners.

In parallel with the increased demand for software integration, there has been a comparable increase in the need for greater sophistication of integration technology. Integration systems today require the ability not only to integrate the numerous disparate resource types (databases, legacy mainframe applications, packaged applications, custom applications, trading partners, people and web services), but also to manage the business processes that govern the interactions between these resources. This business process management (BPM) capability is the foundation that allows an organization or enterprise to truly manage its business with its information systems.

The ability of integration technology to define business processes in a minimal amount of time and without coding has become an expectation of prospective customers. This demand for ease of use has caused a fundamental shift in integration technology away from complex software programming techniques to a more intuitive, highly-graphical modeling approach. It has also driven the demand for comprehensive, fully-integrated integration software and tools that allow users to do a wide variety of integrations without learning multiple software tools or writing software code.

Integration technology is often rated as the top strategic priority for most Global 2000 companies and government organizations due to the benefits available from comprehensive integration of information resources. As a result, integration systems are considered mission-critical, and the need for industry-

standard operations and systems management capabilities has evolved from nicety to necessity. However, to preserve their significant investments, many Global 2000 companies and government organizations require that integration products support their existing systems management software products, such as those from BMC Software, Inc., Computer Associates International, Inc., Hewlett-Packard Company and IBM/ Tivoli.

As the integration market has evolved, Global 2000 companies and government organizations have increasingly used integration technology to link their disparate information system resources under the control of a business process management capability. In many cases, these business process management functions have revealed that most projects involve certain processes that people must perform manually. Consequently, Global 2000 companies and government organizations are putting pressure on integration software vendors to provide integrated workflow capabilities that allow users to define business processes to include manual steps and to manage the complete business process with their integration technology, and not some non-integrated workflow engine or software program. Global 2000 companies and government organizations are also increasingly demanding software toolsets that allow for the rapid creation of user interfaces to support these human steps.

During our fiscal year ended March 31, 2002, there was a rapid increase in the popularity of web services standards among Global 2000 companies. The interest in web services arises from the promise of cross-platform standardization of the low-level integration points for a wide range of computing resources, thereby allowing a user or software product to seamlessly access functionality or business processes provided by other software products operating within the enterprise. The standardization is considered very valuable, as it offers significant benefit with respect to lowering the services costs associated with integration. Although a number of companies outside the integration software industry promote their individual web services offerings as the ideal solution for this problem, many industry analysts agree that web services-based integration solutions will be delivered by integration software companies.

The webMethods integration platform is designed to provide customers with a multi-faceted solution for solving the unique challenges associated with implementing a comprehensive enterprise integration, Enterprise Web Services and business process management “backbone.” A backbone represents a single integration infrastructure that is capable of meeting all of the integration requirements of an enterprise customer. The webMethods integration platform enables our customers to implement a single integration solution that allows them to not only integrate their internal systems (Enterprise Application Integration — EAI) but also those of their trading partners — customers, vendors and business partners — allowing them to seamlessly integrate cross-enterprise information resources and business processes (Business-to-Business Integration — B2Bi).

Historically, companies may have selected multiple products from different vendors to accomplish this level of integration. By combining these best-of-breed capabilities, we are able to lower our customers’ total cost of ownership and streamline the integration process. By enabling this end-to-end integration of all internal and external resources, we allow our customers to gain greater access to the information that is necessary to gain true Global Business Visibility within their enterprise and across connected enterprises, such as their customers, vendors and business partners. This provides our customers with the ability to realize the greatest value from their current investments in information technology resources, including databases, legacy mainframe applications, packaged applications, custom applications and application servers.

Service-Oriented Architecture. The webMethods integration platform’s service-oriented architecture allows us to easily expand our product as new protocols and standards evolve. This also allows our customers to define integrations and business processes that can be deployed as web services without requiring the substantial programming typical of most web services development tools.

Comprehensive Library of Adapters. We provide a comprehensive library of adapters so that the webMethods integration platform can integrate the numerous proprietary interfaces presented by a broad variety of enterprise applications (e.g., supply chain management and customer relationship management software from i2 Technologies, inter-enterprise software solutions from SAP, sales, marketing and customer relationship management software from Siebel Systems, customer relationship management and enterprise management software from PeopleSoft, and enterprise resource planning software from J.D. Edwards). The webMethods integration platform can also be extended by customers and partners through the use of webMethods toolkits that allow them to develop interfaces for custom applications or other software.

Enterprise Application Integration (EAI). One of the most frequent uses of the webMethods integration platform is for the integration of two or more internal resources that a customer may use for their internal operations. These can include databases, packaged and custom applications, application servers, legacy mainframe applications, Enterprise Web Services and a variety of low-level middleware technologies (e.g., IBM’s Websphere MQ or Microsoft’s MSMQ offerings). These configurations can be very large and may be flexibly configured to support a wide variety of optimization configurations.

Support for eCommerce Protocols. Our software also provides support for a wide range of electronic commerce, or eCommerce, protocols that enable our customers to automate and integrate their commercial transactions with their business partners. Examples of these types of transactions include purchasing and procurement, supply chain management, collaborative product design and vendor-managed inventory. Our software supports a broad range of capabilities to support these and other initiatives of an enterprise to integrate its information resources with those of its trading partners. These include XML, traditional and Internet EDI, Commerce One’s xCBL, RosettaNet, Chem eStandards, ebXML and Microsoft BizTalk. In addition, our software also supports the latest web services standards such as Simple Object Access Protocol (SOAP) and Web Services Description Language (WSDL). Networks of trading partners can be administered utilizing a powerful management system that allows our customers to define sophisticated rules for the automatic processing of business transactions submitted via Internet protocols.

Business Process Management. The webMethods integration platform provides an environment that allows our customers to define business processes, which can include multiple enterprise resources, in a single business process definition. This allows our customers to use a highly graphical modeling tool to define complex rules that govern the flow of information between systems and dynamically modify the flow based on any combination of business data that is accessible to the business process instance. When the business process is invoked in an operating environment, our business process management environment provides a powerful user interface for query, selection and viewing of any business process.

webMethods WorkFlow. We also offer a separately licensed, fully-integrated module named webMethods Workflow that allows our customers to incorporate their human resources into their business processes. Our WorkFlow product is designed to allow our customers to seamlessly mix automated and manual business process steps in a single overall business process. This powerful capability also allows them to monitor the human workflow steps as an integrated part of the overall business process using the same monitoring tools that are employed for automated or electronic steps in the business process.

webMethods Mainframe. In order to provide an integration solution for IBM and compatible mainframe environments, we offer another separately licensed, fully-integrated module called webMethods Mainframe. We have received patent protection on this module’s innovative Direct Transaction Mapping capability. Access to legacy mainframe resources using webMethods Mainframe can be incorporated into any overall business process, as with all other resources.

webMethods Manager. We have defined and are developing the first industry standard systems management solution for an integration system, including access to all business process and transaction information. The results of our efforts, co-authored with the Hewlett-Packard Company, is called the Open Management Interface (OMI) Specification. We have also partnered with three of the dominant systems management vendors (BMC Software, Inc., Computer Associates International, Inc. and Hewlett-Packard

We believe our focused business strategy enables us to be the leading independent integration software provider. Our strategy is based on investing our efforts in our customers and partners to ensure their success and developing and delivering the most comprehensive industry-leading integration tools available. By executing on our strategy, we believe we are helping to ensure the success of our customers and partners. The key elements of our strategy include the following:

Customer Success. A core part of our strategy is a tremendous focus on customers to ensure their success and referenceability. We invest in resources and efforts that will improve our customers’ success rates by reducing their time to deploy our software, minimizing their runtime costs and maximizing their return on investment for the integration project. We attempt to accomplish this by working with customers to understand the foreseeable return on investment for their integration projects and then working closely with them to ensure they achieve it. Our satisfied customers often assist with references and site visits for prospective customers.

Expand and Maximize Our Strategic Software Vendor Partnerships. We have strong relationships with leading enterprise application software vendors, including BroadVision, i2 Technologies, J.D. Edwards, Lawson Software, SAP AG, and Siebel Systems, many of whom embed a limited version of webMethods software into their software. For example, i2 Technologies has selected webMethods as their preferred integration platform, and has licensed webMethods software to tightly integrate their applications. i2 Technologies’ sales representatives can sell both the integrated software as well as other webMethods products. As a result, any customer that licenses Release Five.Two of i2 Technologies’ software receives a license-limited version of webMethods software integrated with Release Five.Two, and we believe this customer of i2 Technologies will be a likely candidate to purchase additional webMethods integration software from i2 Technologies or webMethods. We continue to build upon existing strategic relationships and develop new ones. In our fiscal year ended March 31, 2002, we created new partnerships with Siebel Systems and Lawson Software and renewed our strategic relationship with SAP AG.

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

Concentrate on Leading Systems Integrators. In addition, we have expanded and strengthened our alliances with major system integrators to provide services and sales leverage to our software product-based business model. We have established a series of formal alliance relationships with leading system integrators, such as Accenture, American Management Systems (AMS), Cap Gemini Ernst & Young Group, Computer Sciences Corporation (CSC), Deloitte Consulting, Electronic Data Systems Corporation (EDS), KPMG Consulting and Science Applications International Corporation (SAIC). Each of these partners has established a formal webMethods practice, thus increasing dramatically the number of webMethods-trained resources available through our system integrator partners.

As a result of this expanded knowledge base, as well as implementation successes on which the partner and webMethods have worked jointly, these alliances have resulted in a virtual extension of our direct sales force. This results in the third-party introduction and subsequent endorsement of webMethods’ products in opportunities of which we may not be aware or with customers or prospects of the partner with which we may not be otherwise already be engaged.

Extend Technology and Product Leadership to Provide the Most Comprehensive Integration and Web Services Solution. We believe that we have developed the broadest and most comprehensive integration software currently available, supporting more application-to-application, business-to-business, mainframe integration and web services protocols and data format standards than any competing product. In addition,

we have integrated leading-edge workflow technology to allow our customers and their business partners to automate not only the unattended business process but also those critical business functions where a person plays a key role. We also are developing the OMI specification as the first industry standard systems management solution for an integration system so that all business processes and transaction information from the webMethods integration platform can be accessed and managed by webMethods Manager or many of the dominant systems management solutions.

Building on our pioneering role in the application of extensible markup language (XML) and Java technologies for all areas of integration and e-commerce, we believe we are positioned to lead what we believe may be the next technology wave in the integration marketplace: web services based integration. We are a leading provider of standard protocol-based services for integrating information resources both within the enterprise and across the extended enterprise. This expertise, coupled with our service-based architecture, has allowed webMethods to take a leadership role in defining an extremely comprehensive and competitive Enterprise Web Services offering. Our extensive knowledge of integration technology, combined with our long-standing support of web services concepts, enables webMethods to create an unparalleled platform for delivering web services technology. This combination of web services technology with the extensive integration capabilities of the webMethods integration platform results in the creation of Enterprise Web Services — web services capability optimized for the unique challenges of solving integration problems.

As of March 31, 2002, we had licensed our software to over 800 customers. Many of our customers are Global 2000 companies and represent a broad spectrum of vertical markets. We also have a number of government organizations as customers. Our customers include leaders in manufacturing, process industries (such as chemicals, oil and gas, metals, paper and plastics), financial services, telecommunications, government, consumer goods manufacturing and retail, utilities and transportation and logistics.

In each of the fiscal years ended March 31, 2002, 2001 and 2000 no individual customer accounted for more than 10% of our total revenue. From time to time, we may have a customer that accounts for 10% or more of our total quarterly revenue, as we did in the fourth quarter of our fiscal 2002, but we do not expect to have a significant number of customers accounting for 10% or more of our quarterly revenue.

The percentage of total revenue for our fiscal year ended March 31, 2002 from geographical regions outside of the Americas increased to 27% from 11% for the year ended March 31, 2001 and 8% for the year ended March 31, 2000. We believe that revenue from geographical regions outside of the Americas will continue to be a significant percentage of our total revenue for the foreseeable future. Information on revenue we derived from our Americas, Europe and Asia Pacific operations, as well as long lived assets located in those geographic areas, is included in Note 19 of the Notes to Consolidated Financial Statements of webMethods, Inc. included elsewhere in this report.

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

Our direct sales organization consists of sales representatives and pre-sales consultants supported by personnel with experience within the industries we serve. At March 31, 2002, our sales and marketing group consisted of 333 employees. At that date, our sales and marketing personnel serving North America were located in our headquarters in Fairfax, Virginia, and in approximately 20 other offices in the United States and Canada. At that date, our sales and marketing personnel in Europe were located in five

countries, and our sales and marketing personnel in Asia Pacific were located in six countries. Information on revenue we derived from our Americas, Europe and Asia Pacific operations, as well as long lived assets located in those geographic areas, is included in Note 19 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.

During our fiscal year ended March 31, 2002, we created specialized teams to focus on key vertical markets. Those teams focus on customers, prospective customers and business partners in manufacturing industries and in financial services. We also expanded our specialized team focused on sales to the US Government and other public sector organizations.

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

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

We have experienced significant quarterly fluctuations in our operating results and anticipate fluctuations in the future. We experience certain general seasonal factors, such as: revenue in our second fiscal quarter (ending September 30) can be positively impacted by budgeting cycles of the US Government, and can be negatively impacted because businesses — particularly in Europe — often defer purchase decisions during summer months. In addition, revenue in our third fiscal quarter (ending December 31) can be positively impacted by the end-of-year budgeting cycles of many Global 2000 customers, and revenue in our fourth fiscal quarter (ending March 31) can be positively 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.

We believe that our strategic relationships represent one of the most significant advantages we have over our competition. As described above in “webMethods’ Strategy,” we utilize our strategic partnerships with leading software vendors, such as BroadVision, i2 Technologies, J.D. Edwards, Lawson Software, SAP and Siebel Systems, to provide a unique differentiator when selling to a prospective customer that owns or plans to purchase one or more products from these companies in which a license-limited version of our software is embedded or utilized. We believe that this provides us with an incumbency advantage for many of the new business opportunities in which we compete. We also expect to continue to benefit from these relationships through the promotion of our products by their sales and other personnel.

We believe that our multiple strategic alliances with major systems integrators also constitute a significant advantage over some competitors. As described above in “webMethods’ Strategy,” we work very closely with many major systems integrators. We believe that our investment in these relationships is important because they augment our direct sales force by promoting our products as the most appropriate solution for their clients and greatly increase our implementation capabilities.

We also license our software through resellers and distributors, who may also sell our consulting and implementation services. We have relationships with a number of resellers or distributors with expertise in certain industry sectors or countries in which we do not currently have a significant number of direct sales personnel.

We believe our partners influenced, directly or indirectly, a substantial portion of our license revenue during our fiscal year ended March 31, 2002, and we expect this to increase in future periods. During our fiscal 2002, we entered into a number of new or expanded partnership agreements, including agreements

with BroadVision, J.D. Edwards, Lawson Software and Siebel Systems and we renewed our strategic relationship with SAP AG. During our fiscal 2002, i2 Technologies and J.D. Edwards began shipping the latest versions of their application suites, in which our software is embedded to provide real-time integration.

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

We offer our customers a variety of software support and maintenance options designed to meet their varied needs. Our most sophisticated enterprise customers may choose options that include 24-hour coverage, seven days per week. We have established a “follow-the sun” support model with integrated, major support centers in Virginia and California in the United States and in Australia, Japan and the Netherlands. Our resellers and distributors generally provide initial software support to their customers, and we provide support on more complicated support issues. Our customers and business partners can also receive support from our webMethods Advantage support website, which includes extensive discussion groups, technical advisory papers and provides online access to our customer service management system so that they can submit and monitor the status of any technical issues.

Many of our customers purchase consulting services from us to support their full range of integration initiatives. We may provide all of these services directly or we may augment the efforts of a systems integration partner in performing these services. We offer these professional services both during the initial deployment of our products and thereafter to address our customers’ needs through the entire project lifecycle. We provide professional services ranging from initial architectural planning to the complete deployment of our products. We also offer comprehensive training courses and other education products at our facilities, as well as on-site at customer and partner facilities.

While we are able to provide a wide range of consulting services from introductory training to full-scale implementation, we primarily focus on providing consulting in a mentorship capacity. In this role we commonly augment an internal development team or a systems integration partner that performs the bulk of the integration effort.

We pursue a judicious mix of building and acquiring strategic technologies. This has allowed us to assemble a comprehensive integration platform more quickly than our competitors.

We focus our ongoing product development efforts on enhancing, broadening and deepening the functionality of our core products and services to address new software alliances, industries, marketplaces and geographic markets. These products and services are evolving and have been developed using an architecture that is intended to be (i) modular, so components may be substituted, (ii) flexible, to respond to changing business conditions, (iii) open, to support multiple protocols, and (iv) scalable, to handle messaging and transaction loads that are typical in a complex, enterprise environment.

Our development staff has developed our products utilizing project teams focused on independent components of the software under development. We maintain product release planning procedures to ensure integration, testing and version control among the different project development teams. We maintain our primary development centers in Fairfax, Virginia and Sunnyvale, California and have special expertise teams in Berkeley, California, Bellevue, Washington, and Westborough, Massachusetts. At March 31, 2002, we had 251 employees dedicated to research and development. Our research and development expenditures, excluding stock-based compensation, were $49.6 million in our fiscal year ended

The market for our software and services is extremely competitive and subject to rapid change. We offer a comprehensive suite of application integration software that we believe to be the best and most comprehensive integration solution available. We are not aware of another company that can demonstrate the in-depth expertise in trading partner integration and management, our long history of web services experience, the deep knowledge of legacy IBM mainframe integration as well as the broad expertise in Enterprise Application Integration (EAI) as we do. We compete primarily with providers of integration software products, including International Business Machines Corporation (IBM), SeeBeyond Technology Corporation and TIBCO Software, Inc. We also compete with BEA Systems, Inc., Mercator Software, Inc., Microsoft Corporation, Vitria Technology, Inc. and a wide range of companies that are emerging in this category. We expect additional competition primarily from other emerging companies. In addition, we may face pricing pressures from our current competitors and new market entrants in the future. We believe that the competitive factors affecting the market for our software and services are numerous and the specific importance of any one of these factors varies significantly for each specific customer environment. These competitive factors include product functionality and features; performance and price; ease of product implementation; vendor and product reputation; quality of customer support services; 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.

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 certain employees, 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 and resellers 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 and resellers 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” and “B2B Integration Server” marks, a trademark registration in Australia and Japan for the “webMethods” mark, and have pending applications for the registration of the “webMethods” mark in the European Union. We have a patent issued in the United States and several patent applications pending for technology related to our software. We may file additional patent applications in the United States or other countries in the future.

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

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

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

Despite efforts by us to protect our proprietary rights, parties may breach confidentiality agreements or other protective licenses and contracts into which we have entered, and we may not be able to enforce our rights effectively in the event of these breaches. There can be no assurance that we will be able to prevent unauthorized attempts to copy or reverse engineer aspects of our software or to obtain and use information that we regard as proprietary. Further, unauthorized parties may attempt to copy or otherwise obtain and use software or technology that we consider proprietary, and third parties may attempt to develop similar technology independently. It is possible that our competitors will adopt similar product or service names, impeding our ability to protect our intellectual property and possibly leading to customer

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, it is also possible that third parties will claim that we have infringed on their intellectual property rights currently existing or developed in the future. 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 expect that we may 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 are not aware that any of our software, documentation, copyrights, trademarks, patents, or other proprietary rights infringe the proprietary rights of third parties, it is possible that third parties will claim that we have infringed their current or future products, technology or intellectual property rights. Any infringement claims, with or without merit, brought by such third parties could 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.

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 could be costly to defend or settle.”

In addition, we license technology from third parties that is incorporated into our software, and any significant interruption in the supply or support of any technology we license from third parties could adversely affect our business, unless and until we can replace the functionality provided by the licensed technology. Our products could infringe the intellectual property rights of others causing costly litigation and the loss of significant rights. For more information regarding our proprietary rights, see “Factors That May Affect Future Operating Results — Because our products incorporate technology licensed from third parties, the loss of our right to use this licensed technology could harm our business.”

“webMethods”, “B2B Integration Server”, “Global Business Visibility” and the names of our software are our trademarks or our registered trademarks in the United States and/or other countries.

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. References to “webMethods,” “we,” “us” or “our” include webMethods, Inc. and its subsidiaries unless a

As of March 31, 2002, we employed 888 full-time employees. These included 333 in sales and marketing, 195 in professional services and customer care, 251 in research and development and 109 in other administrative areas, including accounting, finance, human resources, facilities and information technology. Our future success will depend in part on our ability to attract, retain and motivate highly qualified technical and management personnel, for whom competition is intense. From time to time, we have employed, and will continue to employ, independent contractors and consultants to support research and development, marketing and sales, and business development. Our employees are not represented by a collective bargaining agreement and we have never experienced a strike or similar work stoppage. We consider relations with our employees to be good.

Our executive officers and their ages and positions as of May 31, 2002 are as follows:

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

David Mitchell joined webMethods in December 1997 as Vice President, Sales, became Chief Operating Officer in January 2000 and became President in August 2000. Mr. Mitchell served as Vice President of Worldwide Sales from September 1999 to December 1999. From 1995 to 1997, Mr. Mitchell served as Director of Worldwide Sales for the help desk and network management group at McAfee Software, now Network Associates, Inc. From 1993 to 1995, Mr. Mitchell was President and Chief Executive Officer of VYCOR Corporation, a vendor of help desk and customer interactivity software, which was acquired in 1995 by McAfee Software. Mr. Mitchell served as Vice President of Sales of VYCOR from 1989 to 1993. Mr. Mitchell holds a B.S. in Marketing from Virginia Commonwealth University.

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

R. James Green became Chief Technology Officer and Executive Vice President of webMethods in August 2000 upon the completion of its acquisition of Active Software, Inc. Mr. Green founded Active Software in September 1995, and served as its President and Chief Executive Officer from October 1997 until August 2000, as a Director from November 1995 until August 2000 and as its Chairman from April 1996 until August 2000. Prior to founding Active Software, Mr. Green established and managed the distributed objects program at Sun Microsystems, Inc., a provider of network computing products, where he was Director of Engineering from 1988 to 1995. Mr. Green holds a B.A. degree from Hanover College, an M.S. degree from North Carolina State University and an M.S. degree in Computer Science from San Jose State University.

Douglas W. McNitt joined webMethods in October 2000 as General Counsel, and became Executive Vice President in January 2002. Mr. McNitt served as Senior Counsel for America Online, Inc. 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.

Thomas N. Erickson joined webMethods in May 2000 as Vice President of Asia Pacific operations. He has served as webMethods’ General Manager, Asia Pacific since October 2000 and has served as a Senior Vice President since January 2002. In April 2002, he became webMethods’ Senior Vice President, International. Prior to joining webMethods, Mr. Erickson was President of Asia Pacific at Baan Company NV, an enterprise software vendor, from 1999 to May 2000 and President of BaanMSO from 1998 to 1999. Mr. Erickson served as a Consultant at Prides Management, Inc., a management consulting business assisting emerging growth companies, from July 1996 to January 1998. From March 1995 to June 1996 he served as Vice President of Sales at Watermark Software, a startup in the document imaging industry which was acquired by FileNET in July 1995. Mr. Erickson served as Group Vice President of Marketing for Thomson Software/ Alsys (now Aonix) from March 1992 to August 1993. Mr. Erickson held various management positions at Project Software and Development from 1980 to 1992. Mr. Erickson holds a B.S. in Electrical Engineering from the University of Wisconsin.

Laurie Mascott joined webMethods in October 2000 as Vice President of Sales for EMEA (Europe, Middle East and Asia). He has served as webMethods’ General Manager, EMEA since January 2001, and as a Senior Vice President since January 2002. He has held a number of senior management positions in the enterprise software marketplace. From 1995 to 2000, he was EMEA Sales Director for Systems Union Group plc, an international ERP vendor, where he was responsible for operations in all the primary European countries. Prior to 1995, Mr. Mascott ran his own business as an independent marketing consultant and held sales management roles within Systems Union, including starting and running the international government unit. Mr. Mascott graduated from the University of Staffordshire with a joint honors degree in economics and French and received a post-graduate diploma in international marketing in a program run and sponsored by the European Community.

Donna Angiulo joined webMethods in February 2001 as Vice President of Finance and has served as a Senior Vice President since January 2002. Ms. Angiulo served as Vice President of Finance and Operations for Collaborex, Inc., a business-to-business e-commerce services provider, from August 2000 to January 2001. Ms. Angiulo served as Chief Financial Officer — Americas for the enterprise software vendor Baan Company NV from August 1998 to August 2000. She also served as Chief Operating Officer — Corporate Office Solutions at Baan from May 1998 to July 1998. Ms. Angiulo served as Chief

Financial Officer at CODA Plc, a provider of financial accounting software from September 1997 to May 1998. From 1986 to 1997, Ms. Angiulo served in a variety of positions including Controller, Director of Finance, Vice President of Product Development, and Vice President of International Business Development at Banyan Systems Incorporated, a provider of enterprise solutions for networking environments. Ms. Angiulo provided financial consulting services to emerging technology businesses from 1984 to 1986, and was an Audit Manager at Coopers and Lybrand from 1976 to 1984. Ms. Angiulo is a Certified Public Accountant and holds a B.S. in Accounting from Utica College of Syracuse University.

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

Unanticipated fluctuations in our quarterly revenue or operating results could affect the price of our stock.

We believe that quarter-to-quarter or year-to-year comparisons of our financial results are not necessarily meaningful indicators of our future revenue or operating results and should not be relied on as an indication of our future performance. If our quarterly or annual revenue or operating results fail to meet the expectations of investors or analysts, the market price of webMethods’ stock could be negatively affected. Our quarterly operating results have varied substantially in the past and may vary substantially in the future depending upon a number of factors, including the changes in demand for our products and services, economic conditions, competitive pressures, amount and timing of operating costs and changes that we may make in our business, operations and infrastructure. In addition, uncertainties and economic after-effects of terrorist acts or other major, unanticipated events may impact our quarterly operating results. In our fiscal 2002, we closed a substantial number of license transactions in the last month of each quarter, which makes it more difficult to gauge the level of license revenue we will have in any quarter until near to, or after, its conclusion. We expect to continue devoting resources to our sales and marketing operations and our research and development activities. Our operating expenses, which include sales and marketing, research and development and general and administrative expenses, are based on our expectations of future revenue and are relatively fixed in the short term. If revenue falls below our expectations in a quarter and we are not able to quickly reduce our spending in response, our operating results for that quarter could be significantly below the expectations of investors or analysts. It is possible that our revenue or operating results in the future may be below the expectations of investors or analysts and, as a result, the market price of webMethods’ stock may fall. In addition, the stock market, particularly the stock prices of infrastructure software companies, has been very volatile. This volatility is often not related to the operating performance of the companies. From our initial public offering in February 2000 until June 1, 2002, the closing price of webMethods’ stock on The Nasdaq National Market has ranged from a high of $308.06 to a low of $6.32.

Growth of our sales may slow from time to time, causing our quarterly operating results to fluctuate.

Due to customer demand, economic conditions, competitive pressures or seasonal factors, we may experience a lower growth rate for, no growth in, or a decline in quarterly or annual revenue from sales of our software and services. For example, the growth rate for revenue from sales of our software and services during summer months may be slower than at other times during year, particularly in European markets. We also may experience declines in expected revenue due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers, changes in demand for our software and services and deferrals of purchases due to uncertainties and economic after-effects of terrorist acts or other major, unanticipated events. These periods of slower or no growth may lead to lower revenue, which could cause fluctuations in our quarterly operating results. In addition, variations in sales cycles may have an impact on the timing of our revenue, which in turn could cause our quarterly operating results to fluctuate. To successfully sell our software and services, we generally must educate our potential customers regarding

We are a young company and have a limited operating history with which to evaluate our respective business and prospects.

We commenced operations in June 1996 and commercially released our first software product in June 1998. Active Software, with which we completed a merger in August 2000, was incorporated in September 1995 and commercially released its first software product in August 1996. We have been operating as a combined company since August 2000. If we do not generate sufficient cash resources from our business to fund operations, our growth could be limited unless we are willing to incur operating losses that may be substantial and are able to fund those operating losses from our available assets or, if necessary, from the sale of additional capital through public or private equity or debt financings. If we are unable to grow as planned, our chances of achieving and maintaining profitability and the anticipated or forecasted results of operations could be reduced, which, in turn, could have a material adverse effect on the market price of webMethods’ stock. Our software is complex and generally involves significant capital expenditures by our customers. We do not have a long history of selling our software, and we often have to devote substantial resources to educate prospective customers about the benefits of our software. Our efforts to educate potential customers may not result in our software being accepted by the potential customer or achieving market acceptance. In addition, many of these prospective customers have made significant investments in internally-developed or custom systems and would incur significant costs in switching to third party software such as ours. Furthermore, even if our software is effective, our potential customers may not choose it for technical, cost, support or other reasons. If the market for our software fails to grow or grows more slowly than we anticipate, our business could suffer.

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

We have established strategic relationships with enterprise application software vendors and system integration partners and similar relationships with resellers, distributors and other technology leaders. If our relationships with any of these organizations were terminated or if we failed to work effectively with our partners or to grow our base of these types of strategic partners, we might lose important opportunities, including sales and marketing opportunities, and our business may suffer. In general, our partners are not required to market or promote our software and generally are not restricted from working with competing integration software companies. Accordingly, our success will depend on their willingness and ability to devote sufficient resources and efforts to marketing our software rather than the products of competitors. If these relationships are not successful, our revenue and operating results could be materially adversely affected, and we will 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 would harm our business.

Our ability to expand our business and increase our revenue may be impaired and we may lose important sales and marketing opportunities if we cannot maintain our relationship with our strategic partners and add similar relationships with other application software vendors, major systems integrators and resellers.

We currently have a number of strategic partners who provide leading enterprise application software products, many of whom embed our software directly into their application products. We also have strategic alliances with major systems integrators. These strategic partners provide us with important sales and marketing opportunities, leverage our direct sales force, create opportunities to upsell our products to customers already using our software embedded in their enterprise application products, and greatly increase our implementation capabilities. If our relationships with any of these organizations were impaired, if a significant number of our strategic partners decide to compete against us in providing

integration solutions or if our competitors developed similar relationships with our strategic partners, we might lose important opportunities, including sales and marketing opportunities, and we may not be able to increase our penetration of the market for integration software, which could have a material adverse effect on our business, financial condition, revenue, operating results and the price of webMethods’ stock. In addition, if we are unable to develop additional strategic relationships with other application software vendors, major systems integrators or other technology leaders, we may not be able to increase our penetration of the market for integration software, increase our revenue or expand our business in accordance with our business strategy, which could have a material adverse effect on our business prospects, financial condition and price of webMethods’ stock.

We are trying to increase our sales to the US Government and to others in the public sector, and we may face difficulties in our attempts to procure new contracts with them.

We are attempting to expand our customer base to include more entities and agencies within the US Government and state and local governments. Developing new business in the public sector often requires companies to develop relationships with different agencies or entities, as well as other government contractors. If we are unable to develop or sustain these relationships, we may be unable to procure new contracts within the timeframe we expect, and our business and financial results may be adversely affected. Contracting with the US Government also requires businesses to participate in a highly competitive bidding process to obtain new contracts. We are a young company, and we lack substantial experience in bidding for public sector contracts. We may be unable to bid competitively if our software and services are improperly priced or if we are incapable of providing our software and services at a competitive price. The bidding process is an expensive and time-consuming endeavor that may result in a loss for webMethods if we fail to win a contract on which we submitted a bid. Furthermore, some agencies within the US Government may also require some or all of our personnel to obtain a security clearance. If our key personnel are unable to obtain or retain this clearance, we may be unsuccessful in our bid for some government contracts. The US Government may choose to change the way it procures new contracts, and it may adopt new rules or regulations governing contracts such as cost accounting standards. If these changes were implemented, they could cause our costs to increase and may make it difficult or impossible for us to obtain new contracts or keep any existing contracts when they expire and are subject to renewal.

Contracting with the US Government or state and local governments is very different from contracting in the private sector, and these differences could have a detrimental effect on our operating results.

Contracts with the US Government or with many state and local governments frequently include provisions not found in the private sector and are often governed by laws and regulations that do not affect private contracts. These differences permit the public sector customer to take action not available to customers in the private sector. This may include termination of current contracts for convenience or due to a default. If a public sector customer cancels a contract for convenience, which can occur if need for a product changes, we may only be able to collect costs for work done prior to the termination of the contract. If the public sector customer cancels because of default, we may only be able to collect revenue for work we have completed, and we may be forced to pay any costs the public sector customer incurs for procuring the promised product from another source. The US Government can also suspend operations if Congress does not allocate sufficient funds, and the US Government may allow our competitors to protest our successful bids. The US Government also may ban webMethods from doing business with any government entity, and could also impose fines, levy sanctions or subject us to a criminal prosecution. The US Government may refuse to invoke an option to extend a contract and it could attempt to claim rights in technologies and systems we invent. Some government agencies we contract with may prohibit us from seeking contracts with certain other government agencies. If any of these events occur, they may negatively affect our business and financial results. In order to maintain contracts with the US Government, webMethods must also comply with many rules and regulations that may affect our relationship with other customers. The US Government can terminate its contract with us if we come under foreign government control or influence, may require that we disclose our pricing data during the course of negotiations, and may require us to prevent access to classified data. If the US Government requires us to meet any of these

demands, it could result in increased costs or an inability to take advantage of certain opportunities that may present themselves in the future. US Government agencies routinely investigate and audit government contractors’ administrative processes. They may audit our performance and our pricing, and review our compliance with rules and regulations. If they find that we have improperly allocated costs, they may require us to refund those costs or may refuse to pay us for outstanding balances related to the improper allocation. An unfavorable audit could result in a reduction of revenue, and may result in civil or criminal liability if the audit uncovers improper or illegal activities. This could harm our business, financial results and reputation.

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

Customers that license our software typically engage our professional services staff or third party consultants to assist with support, training, consulting and implementation. We believe that many of our software sales depend, in part, on our ability to provide our customers with these services and to attract and educate third-party consultants to provide similar services. New professional services personnel and service providers require training and education and take time to reach full productivity, and competition for qualified personnel and service providers is intense. Our business may be harmed if we are unable to provide professional services to our customers and establish and maintain relationships with third-party implementation providers.

Our software must integrate with applications made by third parties, and, if we lose access to the programming interfaces for these applications, or if we are unable to modify our software or develop new adapters in response to changes in these applications, our business could suffer.

Our software uses software components called adapters to communicate with our customers’ enterprise applications. Our ability to develop these adapters is largely dependent on our ability to gain access to the application programming interfaces, or APIs, for the applications, and we may not have access to necessary APIs in the future. APIs are written and controlled by the application provider. Accordingly, if an application provider becomes a competitor by entering the integration market, it could restrict access to its APIs for competitive reasons. Our business could suffer if we are unable to gain access to these APIs. Furthermore, we may need to modify our software or develop new adapters in the future as new applications or newer versions of existing applications are introduced. If we fail to continue to develop adapters or respond to new applications or newer versions of existing applications, our business could suffer. We rely in part on third parties to develop adapters necessary for the integration of applications using our software. We cannot be certain that these companies will continue to develop these adapters, or that, if they do not continue to do so, that we will be able to develop these adapters internally in a timely or efficient manner. In addition, we cannot be certain that adapters developed by third parties will not contain undetected errors or defects, which could harm our reputation, result in product liability or decrease the market acceptance of our products.

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

Our success depends upon the continued service of our executive officers and other key employees, and none of these officers or key employees is bound by an employment agreement for any specific term. If we lose the services of one or more of our executive officers or key employees, or if one or more of them decide to join a competitor or otherwise compete directly or indirectly with us, our business, operating results and financial condition could be harmed. In particular, Phillip Merrick, our Chairman of the Board and Chief Executive Officer, David Mitchell, our President and Chief Operating Officer, R. James Green, our Chief Technology Officer and Executive Vice President, and Mary Dridi, our Chief Financial Officer and Executive Vice President, would be particularly difficult to replace. Our future

If our customers do not renew their product support and maintenance agreements, we may lose a recurring revenue stream, which could harm our operating results.

Many of our customers subscribe for software support and maintenance services, which we recognize over the term of those support and maintenance agreements. If a significant portion of those customers chose not to continue subscribing for product support and maintenance, our recurring revenue from those services would be adversely affected, which could harm our business, operating results and financial condition.

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

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

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

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

The integration software and web services markets are highly competitive, and we may not be able to compete effectively.

The market for integration software solutions and technology to implement enterprise web services is rapidly changing and intensely competitive. There are a variety of methods available to integrate software applications and to implement web services. We expect that competition will remain intense as the number of entrants and new technologies increases. We do not know if our target markets will widely adopt and deploy integration products such as our software. If our software and enterprise web services are not widely adopted by our target markets or if we are not able to compete successfully against current or future competitors, our business, operating results and financial condition may be harmed. Our current and potential competitors include, among others, large software vendors, companies and trading exchanges that develop their own integration and web service solutions, electronic data interchange, or EDI, vendors, vendors of proprietary enterprise application integration (EAI), solutions and application server vendors. We also face competition from various providers of application integration solutions technologies to implement web services and companies offering products and services that address specific aspects of application integration or web services integration. 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, our customers and companies with whom we currently have strategic relationships may become competitors in the future. Some of our competitors or potential competitors may have more experience developing integration software or implementing web services, 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 software and services, that achieve greater customer acceptance or that have significantly improved functionality or performance as compared to our existing software 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. 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 or decreased market share, which in turn could harm our business, operating results and financial condition.

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

We expect that the rapid evolution of integration software and standards and web services 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 to remain competitive. Our software could become obsolete and unmarketable if we are unable to adapt to new technologies or standards. Software as complex as ours often contains known and undetected errors or performance problems. Many serious defects are frequently found during the period immediately following introduction of new software or enhancements to existing software. Internal quality assurance testing and customer testing may reveal product performance issues or desirable feature enhancements that could lead us to postpone the release of new versions of our software. The reallocation of resources associated with any postponement could cause delays in the development and release of future enhancements to our currently available software. Although we attempt to resolve all errors that we believe would be considered serious by our 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 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, we may have to increase our product development costs and divert our product development resources to address the problems. In addition, because our customers depend on our software for their critical systems and business functions, any interruptions could cause our customers to initiate product liability suits against us.

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

Our software is integrated with our customers’ networks and software applications and is often used for mission critical applications. Errors, defects or other performance problems could result in financial or other damages to our customers. 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 to perform to customer expectations could give rise to warranty claims. Although our license agreements typically contain provisions designed to limit our exposure to product liability claims, existing or future laws or unfavorable judicial decisions could negate these limitation of liability provisions. We have not experienced any product liability claims to date. However, 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

Any future acquisitions of companies or technologies may result in disruptions to our business or the distraction of our management.

We may acquire or make investments in other complementary businesses and technologies in the future. We may not be able to identify other 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. If we acquire or invest in other companies, we may not be able to realize the benefits we expected to achieve at the time of entering into the transaction. In any future acquisitions, we will likely face many or all of the risks inherent in integrating two corporate cultures, product lines, operations and businesses. 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 existing stockholders.

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

In the future, we may not have sufficient resources available to us to take advantage of growth, product development or marketing opportunities. We may need to raise additional funds in the future throu


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

3930 Pender Drive, Fairfax, Virginia (Address of Principal Executive Offices)		22030 (Zip Code)


Part I
Item 1.	Business	1
	Overview	1
	Industry Background	2
	webMethods’ Solution	3
	webMethods’ Strategy	5
	Customers	6
	Sales and Marketing	6
	Partners and Strategic Relationships	7
	Customer Care	8
	Product Development	8
	Competition	9
	Intellectual Property and Other Proprietary Rights	9
	Corporate Information	11
	Employees	12
	Executive Officers of webMethods	12
	Factors that May Affect Future Operating Results	14
Item 2.	Properties	22
Item 3.	Legal Proceedings	22
Item 4.	Submission of Matters to a Vote of Security Holders	22
Part II
Item 5.	Market for Registrant’s Common Stock and Related Stockholder Matters	22
Item 6.	Selected Consolidated Financial Data	25
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
	Overview	27
	Results of Operations	30
	Liquidity and Capital Resources	37
	Recently Issued Accounting Pronouncements	38
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	39
Item 8.	Financial Statements and Supplementary Data	40
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Issues	40
Part III
Item 10.	Directors and Executive Officers of the Registrant	41
Item 11.	Executive Compensation	41
Item 12.	Security Ownership of Certain Beneficial Owners and Management	41
Item 13.	Certain Relationships and Related Transactions	41
Part IV
Item 14.	Exhibits, Financial Statement Schedules, and Reports on Form 8-K	42
Signatures		44


Name	Age		Position

Phillip Merrick		39	Chairman of the Board and Chief Executive Officer
David Mitchell		37	President and Chief Operating Officer
Mary Dridi		41	Chief Financial Officer, Executive Vice President and Treasurer
R. James Green		52	Chief Technology Officer and Executive Vice President
Douglas W. McNitt		37	General Counsel, Executive Vice President, Assistant Secretary
Thomas N. Erickson		43	Senior Vice President, International and General Manager, Asia Pacific
Laurie Mascott		37	General Manager, EMEA and Senior Vice President
Donna M. Angiulo		47	Senior Vice President