SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2003

Commission File No. 1-11859

PEGASYSTEMS INC.

(Exact name of Registrant as specified in its charter)

Massachusetts

(State or other jurisdiction of incorporation or organization)

(IRS Employer Identification No. 04-2787865)

(617) 374-9600

(Registrant’s telephone number, including area code)

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

None

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

Common Stock, $.01 par value per share

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the 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.¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

Yes  x    No  ¨

The aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant based on the closing price (as reported by Nasdaq)NASDAQ) of such common stock on the last business day of the Registrant’s most recently completed second fiscal quarter (June 30, 2003)2004) was approximately $75$106 million.

There were 35,325,86936,077,940 shares of the Registrant’s common stock, $.01 par value per share, outstanding on February 4, 2004.7, 2005.

Documents Incorporated by Reference

TABLE OF CONTENTS

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PART I

ITEM 1    BUSINESS

Overview

We develop, market, license, and support software that enables transaction intensive organizations to manage a broad array of business processes.Pegasystems was incorporated in Massachusetts in 1983. Our rules based business process management, or BPM, softwarestock is used by some oftraded on the largest companies inNASDAQ National Market under the world to automate decision making and the processes implementing those decisions.symbol PEGA. Our softwarewebsite address is capable of being used by thousands of concurrent users, runs on a broad range of computer platforms and interfaces with many other applications and databases. Business users, and not just technical programmers, are able to modify the logic of our applications, thus enabling organizations to alter their business processes rapidly in response to changing business conditions. We provide implementation, consulting, training, and technical support services to facilitate the use of our software. We also maintain alliances with systems integrators and independent software vendors to support our customers.

SEC Reports and our code of conduct

We maintain a website with the addresswww.pega.com.www.pega.com. We are not including the information contained on our website as part of, or incorporating it by reference into, this Annual Report on Form 10-K. Unless the context otherwise requires, references in this Annual Report on Form 10-K to “the Company”, “we”, “us” or “our” refer to Pegasystems Inc. and its subsidiaries.

Forward-looking statements

This Annual Report on Form 10-K contains or incorporates forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which we operate and management’s beliefs and assumptions. In addition, other written or oral statements that constitute forward-looking statements may be made by us or on our behalf. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate,” “may,” variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. We have included important factors in the cautionary statements in Item 7 under the heading “Factors that may affect future results” that we believe could cause our actual results to differ materially from the forward-looking statements we make. We do not intend to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

SEC reports and our Code of Conduct

We make available free of charge through our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to these reports, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. We make available on our website reports filed by our executive officers and Directors on Forms 3, 4 and 5 regarding their ownership of our securities. Our codeCode of conductConduct, and any amendments to our Code of Conduct, are also available on our website.

Overview

We develop, market, license, and support software to manage a broad array of business processes. Our software unifies Business Process Management (BPM) software with a sophisticated Business Rules Engine (BRE) to broadly improve business effectiveness. This patented technology enables organizations to “build for change” and thus overcome the execution gap that occurs as changing management objectives outpace the ability of operations and systems to respond. Our rules-based BPM software is available freeused by companies to automate decision making and the processes implementing those decisions. Our software runs on a broad range of charge, by contacting Investor Relations, Pegasystems Inc., 101 Main Street, Cambridge, MA 02142.computer platforms, interfaces with many other applications and databases, and is capable of supporting the needs of the world’s largest and most demanding businesses. By enabling organizations to alter their business processes rapidly in response to changing business conditions, our software provides agility for growth, productivity and compliance. We provide implementation, consulting, training, and technical support services to facilitate the use of our software. We also maintain alliances with systems integrators, technology consulting firms, and independent software vendors to support our customers.

Business strategy

Our goal is to provide leadership inbe the market for rules basedleader of the business process management (BPM) software – what we call “Simply Smart BPM.”market by leveraging our advanced technology. We are pursuing this goal through two complementary sales strategies.

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Direct salessales.: We intend to continue direct sales of our software products, both our BPM applicationswhich include PegaRULES and our BPM platform products,PegaRULES Process Commander, complemented by customer process and exceptions management frameworks, which are software that provide purpose or industry specific functionality to our target markets in financial servicesPegaRULES and healthcare. These products streamline and enhance work performance by applying process automation to key areas of customer service and exceptions processing. Exceptions are transactions that are identified as requiring additional information or follow up activity to be completed.Process Commander products.

Strategic partnershipspartnerships.: We also intend to continue to develop and expand non-exclusive strategic relationships with systems integrators for the marketing and sale of our rules based BPM technology.software products. Through these partnerships, we seek to pursueare pursuing business in other industries including financial services, health care, insurance, telecommunications and government. These partners complement our software with their technology and domain expertise, and may deliver strategic business planning, consulting, project management, and implementation services to our customers. Currently, our systems integration partners include Accenture, BearingPoint, Cognizant Technology Solutions, Computer Sciences Corporation, IBM, and IBM.Satyam Computer Services Ltd.

Pegasystems’ products

We provide rules baseda comprehensive rules-based BPM platforms applicablesuite intended to many industrieshelp our customers plan, build and rules based software applications for customermanage business process management and exceptions management in the financial services and healthcare industries.solutions.

Rules based BPM platformsPegaRULES

We provide twoOur advanced PegaRULES rules based BPM platforms — engine is a key differentiator of our rules-based BPM. Our rules management technology employs an inference engine that automatically analyzes our customer’s data, determines which business rules apply to that data, initiates the appropriate business processes, and prompts users for any additional inputs required. Our rules engine uses change-aware declarative rules that automatically recognize changes in data, such as changes in age or account balance, and initiate the appropriate business processes for that change, such as a notification of eligibility for an account upgrade. This combination of rules and processing provides our customers the agility to better align their business processes with their strategic objectives.

PegaRULES Process Commander

PegaRULES Process Commander provides additional capabilities designed to model, simulate, execute, monitor and PegaWORKS. These platforms helpanalyze results. Built on the PegaRULES engine, PegaRULES Process Commander offers a browser-based development environment, execution engine and management dashboard — built in a graphical, rapid solution development environment. This platform helps solve a wide range of business process management problems and provideprovides our customers an

opportunity to leverage previous technology investments by integrating software applications across a common platform. Our applications products are based on these platforms.

Customer process management applicationsPegasystems SmartBPM Suite

With Pegasystems’ products, organizations link customer service and back office operations and integrate multiple communications channels, such as call center, e-mail, local branch offices, andPegasystems SmartBPM Suite layers process analysis, process simulation, enterprise integration, portal integration, content management and/or case management on the Internet. Our products extend the reach of existing customer relationship applications to achieve automation efficiencies by completing the oftenPegaRULES Process Commander capabilities.

Based on our more than 20 years experience helping companies manage complex and detailed follow up activities associated with customer interactions. Our productschanging processes, Pegasystems also integrate with customers’ legacy applications.

Exceptions management applications

geographies. We offer products predominately for the financial services and healthcare industriesframeworks that address exceptions management — transactions that are not automatically processed by existing systems. These products are designed to increase the numbersystems and represent excellent examples of transactions processed straight through without intervention.where rules-based BPM adds value. By automating not only research and decision making, but also the business processes necessary to execute the decisions, our exceptions management applicationsframeworks can reduce the costs and risks associated with manual processing, while improving quality and efficiency.

Results of Operations — Factors that may affect future results” of this Annual Report on Form 10-K.

Markets and representative customers

The market for BPM software is driven by businesses that seek systemsto close the execution gap that meetmay exist between their need for productivity, quality, agilitybusiness objectives and compliance.their existing business processes. Our target customers are those organizations faced with managing complex customer transactions and who regularly modifychanging processes that seek the rulesagility needed for growth, productivity and processes relating to those transactions.compliance. Our traditional customers arehave been large companies in the financial services and healthcare markets. With our PegaRULES Process Commander, platform, we are also able to offer solutions to othera broader range of companies as well as a broader range of industries.

Financial services

Financial services organizations continue to require software to improve the quality, accuracy and efficiency of customer interactions and transactions processing. Pegasystems’ customer process and exceptions management products provide flexibility and functionality to allow customers maximum responsiveness to meet changing business requirements. Representative financial services customers of ours include: American National Insurance Company, Bank of America N.A.,Corporation, Barclays Bank PLC, Citibank, N.A., Credit Lyonnais,Calyon, Credit Suisse Group, Fleet/Boston Financial Services, N.A., The Hong KongHongkong and Shanghai Banking Corporation Limited, JP MorganJPMorgan Chase & Co., National Australia Bank Limited, Rabobank Group, and Société Générale S.A..Group.

Healthcare

Healthcare organizations also continue to seek out products that integrate their front and back office initiatives and help drive customer service, efficiency and productivity. Representative healthcare customers of ours includeinclude: Aetna Inc., Blue Cross and Blue Shield of Massachusetts, Blue Cross & Blue Shield of Rhode Island, HealthNow New York Inc., and Hospitals Contribution Fund of Australia Limited.

Other industries

PegaRULES Process Commander offers solutions to a broad range of companies and industries. Recent examples of rules-based BPM technology sales outside our traditional markets include sales to customers in insurance, government, manufacturing, and travel services. Customers include: American Insurance Underwriters “AIU”, The Allstate Corporation, Advanced Micro Devices “AMD”, General Electric Company, GMAC, and Starwood Hotels &Resorts Worldwide Inc.

Sales and marketing

We market our industry-specific applications software and services primarily through a direct sales force. force and a partner network. Our partners include systems integrators who design and deploy implementations based on Pegasystems’ rules-based BPM technology, independent software vendors who build specific applications on our technology, and technology partners with whom we work to broaden platform support. Our partners include Accenture, BearingPoint, Cognizant Technology Solutions, Computer Sciences Corporation, IBM, and Satyam Computer Services Ltd.

To support our sales force,efforts, we conduct a fullbroad range of marketing programs, including industry trade shows, industry seminars, meetings with industry analysts, and other direct and indirect marketing efforts. Our consulting staff, business partners, and other third parties also generate sales leads. As of December 31, 2003,2004, our sales and marketing included 102staffing consisted of 108 people worldwide.

We also market our software with partners, including systems integrators who design and deploy implementations based on Pegasystems’ rules based BPM technology; independent software vendors who build specific applications on our technology; and technology partners with whom we work to broaden platform support. Our partners include Accenture, BearingPoint, CSC, IBM, Satyam, and Sun Microsystems.5

In addition, we market our products and technology through third parties. For example:

Sales by geography

In 2004, 2003, 2002, and 2001,2002, sales to customers based outside of the United States represented 20%32%, 22%20%, and 23%22%, respectively, of our total consolidated revenue. During 2004, 2003, 2002, and 2001,2002, we derived our revenue from the following geographic areas:

In 2004, no customer accounted for 10% or more of our total revenue. In 2003, two customers each accounted for approximately 15% and 12% of our total revenue. In 2002 and 2001, one customer accounted for approximately 26% and 14% of our total revenue, respectively. See Note 1 to Consolidated Financial Statements.

Services and support

We offer services and support through three groups: our professional services group which sharesprovides market, business and technical knowledge withto assist our customers throughout the sale and deployment of our applications;products; our global customer support group which provides support and maintenance for our customers; and our education services group which offers training programs for our staff, customers, and partners. As of December 31, 2003, these2004, our services and support groups consisted of 128123 people located in our 1011 offices.

Professional services

Our professional services group helps companies and partners implement and optimize our software. These projects enable us to guide our customers through a disciplined approach to deployment of our applications,software, and allow our workflow architects and business process automation consultants to gain industry specific knowledge that can benefit future product development. Many of our customers choose to engage our professional services group to expand their use of our software to additional business or product lines or add new functionality to their existing solutions. In addition, systems integrators and consulting firms, with which we have alliances, also help our customers deploy our products.

Our implementation procedures, which we call Advanced Implementation Methodology, or AIM, were developed through field experience and facilitate implementation of our software through a disciplined approach to project management that establishes standards for project activities and provides a basis for governance and accountability. By adopting a phased approach to deployment, our customers can engage in smaller, more easily managed projects that are more likely to result in a successful solution.

Global customer support

Our global customer support group is primarily responsible for support of our software deployed at customer sites. Support services can include automated problem tracking, prioritization and escalation procedures, periodic preventativepreventive maintenance, documentation updates, new software releases, and regularly scheduled meetings with our staff.

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Our customers are granted access to our web-based self-service extranet. The password-protected site offers a portal for information important to the implementation and use of our products. Our extranet is available at any time of day or night and users may access the site to interact with us at their convenience and to view product information, sales and marketing support materials, Pegasystems news and event information.

Education services

We offer training for our staff, customers partners, and staff.partners. Training is offered in one of our regional training facilities in Cambridge, Massachusetts and Reading, England, or may be specially arranged at customer sites. Courses are role based and are designed to meet the specific role requirements of process architects, system architects, and system administrators.

Research and development

Our product development priorities arepriority is to continue expanding the capabilities of our rules-based BPM technology. We intend to expand our rules based BPM platformsmaintain and extend the support of our customer process managementexisting frameworks, and exception management products into new areas withinwe may choose to invest in additional frameworks which incorporate the financial services and healthcare markets.latest business innovations. We also intend to maintain and extend the support of our products for popular hardware platforms, operating systems, databases and connectivity options to facilitate easy and rapid deployment in diverse information technology infrastructures. Our goal with all of our products is to enhance product capabilities, ease of implementation, long-term flexibility, and the ability to provide improved customer service.

We believe that the challenge of maintainingenhancing future performance and maintaining visionary technology leadership will depend on our ability to anticipate changes, maintain and enhance our current products, develop new products, and keep pace with the increasingly sophisticated requirements of our current and prospective customers. We must develop products that conform to our customers’ information technology standards, scale to meet the needs of large enterprises, operate globally, and cost less than ana comparable internal development effort. Our development organization is responsible for product architecture, core technology development, product testing, and quality assurance.

As of December 31, 2003,2004, our development group consisted of 10190 people and has been significantly supplemented by the use of outsourced resources. During 2004, 2003, 2002, and 2001,2002, research and development expenses were approximately $19.9 million, $21.6 million, $21.3 million, and $20.8$21.3 million, respectively. We expect that we will need to continue to commit significant resources to our product research and development in the future. We expectfuture to spend somewhat less in 2004 than in 2003, following the deployment of several new products in the first half of 2004.maintain our leadership position.

Competition

The BPM software market is increasingly and intensely competitive, rapidly changing, and highly fragmented, as current competitors expand their product offerings and new companies enter the market. Competitors vary in size and in the scope and breadth of the products and services offered. We encounter competition from:

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We have a strong presence in the overall BPM software market, as well as a strong presence in exceptions management in the financial services and healthcare; however, we have a relatively small share of the overall BPM market.healthcare markets. We have been most successful competing in situations that require a high propensity for change, high process complexity and/or high degree of scale and process compatibility and high propensity for change.scale. We believe that the principal competitive factors within our market include:

Many competitors have far greater resources and may be able to respond more quickly and efficiently to new or emerging technologies, programming languages or standards or to changes in customer requirements or preferences. Competitors may also be able to devote greater managerial and financial resources to develop, promote and distribute products and provide related consulting and training services. There can be no assurance that we will be able to compete successfully against current or future competitors or that the competitive pressures faced by us will not materially adversely affect our business, operating results, and financial condition.

Employees

As of December 31, 2003,2004, we had 422406 employees, of whom 346339 were based in the United States, 4 were1 was based in Canada, 6057 were based in Europe, and 129 were based in Australia. Of the total, 102108 were in sales and marketing, 128123 performed consulting and customer support, 10190 performed research and development, and 9185 were in administration.

Backlog of license, maintenance and consulting revenues

As of December 31, 2003,2004, we had software license and maintenance agreements and fixed fee professional services agreements with our customers expected to result in approximately $29.8$29.5 million of revenue in 2004.2005. Under such agreements, we must fulfill certain conditions prior to recognizing revenue, and there can be no assurance when, if ever, we will be able to satisfy all such conditions in each instance. As of December 31, 2002,2003, we had software license and maintenance agreements and fixed fee professional services agreements with our customers that were expected to result in approximately $38.9$29.8 million of revenue in 2003.2004. We do not believe that backlog, as defineddescribed above, is a meaningful indicator of future financial performance.

ITEM 2    PROPERTIES

Our principal administrative, sales, marketing, support, and research and development operations are located in an 85,228 square foot leased facility in Cambridge, Massachusetts. The lease for this facility expires in 2013, with the option to extend for two additional five-year periods. We also lease space for our other offices in the United States, Canada, Australia, France, and the United Kingdom. These leases expire at various dates through 2007.2010. We believe that additional or alternative space will be available as needed in the future on commercially reasonable terms.

ITEM 3    LEGAL PROCEEDINGS

Not applicable.

ITEM 4    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

During the fourth quarter of fiscal 2003,2004, there were no matters submitted to a vote of security holders.

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EXECUTIVE OFFICERS OF THE REGISTRANT

The names of our executive officers and certain information about them are set forth below as of December 31, 2003:February 1, 2005:

There are no family relationships among any of our executive officers or directors.

Alan Trefler, a founder of Pegasystems, serves as Chief Executive Officer and Chairman and has been a Director since we organized in 1983. Prior thereto,to 1983, he managed an electronic funds transfer product for TMI Systems Corporation, a software and services company. Mr. Trefler holds a B.A. degree in economics and computer science from Dartmouth College.

Henry Ancona joined Pegasystems in 2002 as President and Chief Operating Officer and was elected a Director of Pegasystems in December 2002. He serves as a director of OneSource Information Services, Inc., a provider of business information, and Sentillion, Inc., a provider of healthcare information technology solutions. Prior to joining us, he served as Chairman, President and Chief Executive Officer of Evidian, a supplier of security and telecommunications management software. Prior to Evidian, he served as Executive Vice President at Polaroid Corporation, where he led the Commercial Imaging and Electronic Imaging businesses. He also held a variety of management positions at Digital Equipment Corporation, a computer company, including Vice President of the office software business. Mr. Ancona holds B.S. and M.S. degrees in electrical engineering from the Massachusetts Institute of Technology and an M.B.A. from Harvard University’s Graduate School of Business Administration.

Joseph J. Friscia joined Pegasystems in 1984 and has served as Executive Vice President of Sales and Service from 1987 until January 2004. Prior to joining us, he worked as a money transfer operations manager with Bankers Trust Company and J. Henry Schroder Bank and Trust Company. Mr. Friscia holds a B.A. degree from Long Island University and an M.B.A. degree from Adelphi University. In January 2004, Mr. Friscia resigned from Pegasystems.

Christopher J. Sullivan joined Pegasystems in July 2001. In August 2001, he was elected Senior Vice President, Chief Financial Officer and Treasurer. From August 2000 to July 2001, he served as CFO at Event Zero, an IT consulting company. From December 1998 to August 2000, he was the CFO and Executive Vice President of AMS Holding Group, a software and information services provider to the insurance industry. From 1997 to 1998,Previously, he served as Vice President of Finance at Compaq Computer Corporation, a computer company. His prior experience also includes service as Senior Vice President of Finance at Fisher Scientific International, Inc., a distributor of clinical and scientific laboratory equipment, and as Vice President of Finance at Digital Equipment Corporation. He holds a B.S.B.A. degree and an M.B.A. degree from Babson College.

Michael Pyle joined Pegasystems in 1985 and has served as Senior Vice President of Product Development since August 2000. Including his positions with Pegasystems, Mr. Pyle’s professional background encompasses almost thirty years of software development and managerial experience throughout Europe and the United States. Mr. Pyle completed his B.C.S. specializing in Computer Science and Systems Programming at the C.S.Civil Service College in London.

Michael J. Wallrich joined Pegasystems in November 2004 as Senior Vice President of Global Sales. From 2002 to 2004, Mr. Wallrich served as President of MicroTek, an educational facility provider whose customers include most of the major technology vendors. From 1991 to 2002, Mr. Wallrich held a variety of management positions, including Senior Vice President of Americas at FileNet, a software company. His prior experience includes management positions at Stratus Computer Inc., a computer company, in both direct and indirect sales. Mr. Wallrich holds a B.S. in Economics from the University of Illinois - Chicago.

Douglas I. Kra joined Pegasystems in November 2004 as Vice President of Global Services. From 2002 to 2004, Mr. Kra served as Vice President at eLoyalty Corp., a consulting company specializing in customer relationship management. From 2000 to 2001, Mr. Kra served as President of Zefer Corp., an internet consulting firm. Prior to Zefer, Mr. Kra spent ten years at Cambridge Technology Partners Inc. in a variety of senior roles. He holds a B.A. in Computer Science from Brandeis University and an M.B.A. in finance from New York University Stern School of Business.

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PART II

ITEM 5    MARKET FOR REGISTRANT’S COMMON STOCK, RELATED STOCKHOLDER

   MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The following table sets forth the range of high and low sales prices of our common stock on the National Association of Security Dealers Automatic Quotation (“Nasdaq”)NASDAQ National Market System for 20032004 and 2002.2003. Our common stock is traded under the NasdaqNASDAQ Symbol “PEGA.”“PEGA”. As of January 13, 2004,February 1, 2005, we had approximately 9775 stockholders of record and approximately 4,0004,300 beneficial owners of our common stock. On January 13, 2004,February 1, 2005, the closing sale price of our common stock was $9.64.$6.83. We have never declared or paid any cash dividends on our common stock. We intend to retain our earnings to finance future growth, and therefore have not paid dividends, nor do we presently anticipate paying any dividends in the foreseeable future.

Pegasystems did not sell anyOur Board of its equity securitiesDirectors has authorized the repurchase of up to $10 million of our common stock. The purchases will be made from time to time on the open market or in 2003 thatprivately negotiated transactions. Under the program, shares may be purchased in such amounts as market conditions warrant, subject to regulatory and other considerations. As of February 16, 2005, no shares had been repurchased under the program. The authorization expires on September 30, 2005.

In February 2004, we issued 33,287 shares of our common stock in connection with the exercise of warrants issued as part of the consideration for our acquisition of 1mind Corporation in 2002. These warrants were not registeredexercised by four former stockholders of 1mind. The consideration for these exercises was paid in the form of the surrender of 2,967 shares of our common stock under the warrants as a net exercise, which shares were valued at a total of $31 thousand, based on the average closing price of our common stock over the ten consecutive trading days ending on the third trading day prior to the date of exercise. We issued these 33,287 shares pursuant to the registration exemption under Section 4(2) of the Securities Act of 1933.

As of December 31, 2004, there were outstanding warrants to purchase 73,576 shares of our common stock with a weighted average fair value of $3.38 per share and a weighted average exercise price of $4.08 per share.

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ITEM 6    SELECTED CONSOLIDATED FINANCIAL DATA

The selected consolidated financial data presented below have been derived from our consolidated financial statements. This data may not be indicative of our future condition or results of operations and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes.

ITEM 7    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND11

RESULTS OF OPERATIONS

Results of Operations

20032004 Overview

TotalOur total revenue for 2004 decreased 3% to $96.5 million from $99.3 million in 2003, increased 2% to $99.3 million from $97.4 million in 2002 due to an increasea decrease in servicesour license revenue, which was partially offset by aan increase in our services revenue. Excluding the anticipated $10.6 million reduction in revenue associated with the restructured First Data Resources (“FDR”) 2002 agreement, total revenue increased 9% versus 2003. The decrease in license revenue. We signed more new customer license business in 2003 than in 2002. However, the majority of our license revenue in 20032004 was due primarily to a decline in term license renewals, extensions and additions, and to an anticipated decline in license revenue from existingFDR. These declines were partially offset by an increase in license revenue from new customers, who chose to renew, addmost of which was derived from sales of perpetual licenses of products based on to, or extend their use of our software.PegaRULES technology. The increase in our services revenue in 20032004 was primarily due to implementation projectsservices associated with recent new customer signings and to maintenance services associated with an expanded installed base of software. Historically, our mix of license signings. Some of those implementation projects are not yet complete and therefore the associated licenseservices revenue has fluctuated from year to year, and we believe that the composition of license and services revenue will continue to fluctuate. In 2004, new customers (i.e., organizational units, divisions, or companies from whom we have not yet been recognized. Incomepreviously derived any license revenue) accounted for $27.8 million, or 29%, of our total revenue.

Profit before provision for income taxes increaseddecreased to $11.1 million in 2004 from $21.8 million in 2003, from $17.2 million in 2002 primarily due to a $10.3$16.1 million decrease in license gross margin, and a $7.2 million increase in selling and marketing expense, partially offset by a $14.2 million improvement in service margins. Net income for 2003 increased2004 decreased to $7.6 million from $17.7 million from $15.3 million in 2002 despite an increase2003 due to the decrease in ourprofit before taxes and a higher effective income tax rate.rate in 2004. We generated $21.0$7.6 million in positive cash flow from operations during 2003,2004, and ended the period with $87.9$97.4 million in cash and marketable securities and $82.2$75.7 million in combined short and long-term license installment receivables.

We face several challengessee three significant trends in our business:

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Statement of Income Information

The following shows certain items reflected in our Statements of Income as a percentage of total revenue:

International Revenues

International revenue was 20%32%, 22%,20% and 23%22% of total consolidated revenue in 2004, 2003 2002, and 2001,2002, respectively. Our international revenue may fluctuate in the future because such revenue is generally dependent upon a small number of product acceptances by our customers during a given period. Historically, most of our contracts have been denominated in U.S. dollars. We expect, however, that in the future more of our contracts may be denominated in foreign currencies which may expose us to increased currency exchange risk.

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Year ended December 31, 2004 compared to year ended December 31, 2003

Revenue

Our total revenue for 2004 decreased 3% to $96.5 million from $99.3 million in 2003. This decrease was due to a decline in license revenue, partially offset by an increase in services revenue. The following table summarizes our revenue composition:

Total license revenue for 2004 decreased to $41.6 million from $57.7 million for 2003. This decrease in total license revenue was the result of a $13.9 million decrease in term license renewals, extensions and additions, and an anticipated $10.6 million decline in perpetual license revenue from FDR, partially offset by an $8.4 million increase in other perpetual and subscription license revenue.

The $13.9 million decrease in term license renewals, extensions and additions reflects a lower value of scheduled renewals in 2004 versus 2003, as well as a reduction in license add-ons and extensions associated with those renewals. In addition, fewer customers renewed term licenses in advance of their scheduled renewal date during 2004 as compared to 2003. Term license renewals scheduled for 2005 are modestly higher than renewals in 2004. While historically a majority of customers have renewed their term licenses, there can be no assurance that a majority of customers will continue to do so.

Services revenue for 2004 increased 32% to $54.9 million from $41.6 million for 2003. This increase was due primarily to an increase in new license implementations in 2004, and higher customer maintenance revenue. Implementation, consulting and training services revenue in 2004 increased 30% to $39.0 million from $30.1 million for 2003. This increase was due primarily to implementation projects associated with new customer signings and more projects reaching completion in 2004. Typically, we derive substantial revenue from services provided in connection with the implementation of software licensed by new customers. Going forward, as we continue to complement our direct selling and support efforts with those of our alliance partners, we do not expect to sustain this rate of services revenue growth. Maintenance revenue in 2004 increased 38% to $15.9 million from $11.5 million in 2003. The increase in maintenance revenue was due to a larger installed base of software and improved pricing for maintenance support.

Deferred revenue at December 31, 2004 consisted primarily of billed fees from arrangements for which acceptance of the software license or service milestone had not occurred, and advance payment of maintenance fees. Deferred revenue balances decreased to $9.1 million as of December 31, 2004 from $14.2 million as of December 31, 2003. The decrease was due primarily to a decrease in the unearned portion of services revenue related to new software implementations and a decrease in deferred license revenue, partially offset by an increase in the unearned portion of services revenue related to advance payments of maintenance fees.

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Cost of revenue

Cost of services consists primarily of the cost of providing implementation, consulting, maintenance, and training services. Our cost of services for 2004 decreased 3% to $26.1 million from $27.1 million in 2003, primarily due to the redeployment of some of our services staff to pre-sales support activities. Cost of services as a percentage of services revenue decreased to 48% for 2004 from 65% for 2003. The percentage decrease was primarily due to the increase in our services revenue and the redeployment of some of our services staff to pre-sales support activities. Services gross margin was $28.8 million for 2004 compared to $14.5 million for 2003. The increase in services gross margin reflects recognition of deferred margin on completed services engagements and improved effectiveness of our professional services staff, achieved in part through the increased use of third party contractors when necessary to meet higher demand.

Operating expenses

Research and development expenses for 2004 decreased 8% to $19.9 million from $21.6 million for 2003. As a percentage of our total revenue, research and development expenses decreased to 21% in 2004 from 22% in 2003. The decrease in spending was primarily due to reduced R&D staff and staff related expenses as well as reduced spending on outsourced R&D contractors. R&D headcount at the end of 2004 was 90 compared to 101 at the end of 2003.

Selling and marketing expenses for 2004 increased 29% to $32.1 million from $24.8 million for 2003. This increase was due to an increase in our sales personnel, and an increase in sales commissions associated with increased new license bookings, partially offset by a decrease in marketing program spending. Many of the additional sales personnel were hired late in 2003. As a percentage of total revenue, selling and marketing expenses increased to 33% in 2004 from 25% in 2003, due to the combined effect of increased spending and lower total revenue in 2004. Selling and marketing headcount at the end of 2004 was 108 compared to 102 at the end of 2003.

General and administrative expenses for 2004 increased 14% to $12.3 million from $10.8 million for 2003. As a percentage of our total revenue, general and administrative expenses increased to 13% for 2004 from 11% for 2003. These increases were primarily due to increased spending in 2004 on audit and compliance activities associated with the requirements of the Sarbanes-Oxley Act of 2002 and related regulations as well as increased staff costs. General and administrative headcount was 85 at the end of 2004 compared to 91 at the end of 2003.

Installment receivable interest income

Installment receivable interest income, which consists of the portion of all term license fees under software license agreements attributable to the time value of money, decreased in 2004 to $3.0 million from $5.2 million for 2003. The decrease was due primarily to a lower average discount rate for our portfolio of term software licenses and a lower total value of that portfolio. A portion of the fee from each term license arrangement is initially deferred and recognized as installment receivable interest income over the remaining term of the license. For purposes of the present value calculations, the discount rates used are estimates of customers’ borrowing rates, typically below prime rate, and have varied between 3.25% and 7.0% during the past few years. It is expected that installment receivable interest income will decline further in 2005 due to the lower total value of our portfolio of term software licenses.

Other interest income, net

Other interest income, net, increased to $1.8 million for 2004 from $0.8 million for 2003. The increase was due to increased cash and investment balances and improved yields.

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Other income (expense), net

Other income (expense), net, which consists primarily of currency exchange gains and losses, was $0.5 million for 2004 versus $1.2 million for 2003. The decrease was due to lower currency exchange gains in 2004 versus 2003, and expenses incurred in the second quarter of 2004 associated with restructuring our investment portfolio.

Income before provision for income taxes

Income before provision for income taxes decreased to $11.1 million for 2004 from $21.8 million in 2003. This decrease was due to a $16.1 million decrease in license revenue, a $7.0 million increase in operating expenses primarily due to investments in sales and marketing, a $1.8 million decrease in other income and expense, partially offset by $14.2 million improvement in service gross margin.

Provision for income taxes

The provision for income taxes in 2004 was $3.6 million compared to $4.2 million in 2003. The effective tax rate was 32% in 2004 compared to 19% for 2003. This increase in effective rate was due to lower benefits from the recognition of loss and credit carry forwards in 2004 compared to 2003, partially offset by improved estimates in 2004 of tax benefits related to export sales.

Year ended December 31, 2003 compared to year ended December 31, 2002

Revenue

Total revenue for 2003 increased 2% to $99.3 million from $97.4 million for 2002. The increase was due to an increase in services revenue, which was partially offset by a decrease in software license revenue. Total revenue from new customers (i.e., organizational units, divisions, or companies from which we have not previously derived any license revenue) was 24% of total revenue for 2003, compared with 10% in 2002. The increase in services revenue was due primarily to more new license implementation activity in 2003. The decrease in license revenue was due mainly to the reduction in revenue from the restructured arrangement with FDR. The following table summarizes our revenue composition:

SoftwareTotal license revenue for 2003 decreased 10% to $57.7 million from $63.9 million for 2002. The decrease in license revenue from FDR of $13.3 million was partially offset by an increase in new customer license revenue. License revenue, excluding revenue from FDR, grew 17% in 2003 from 2002. A substantial majority of our software license revenue continues to bein 2003 and 2002 was from existing customers.

The $8.1 million decrease in perpetual and subscription license revenue in 2003 compared to 2002 was primarily due to a $13.3 million reduction in license revenue from FDR, partially offset by an increase in license revenue from new customers. Under the terms of the perpetual license agreement entered into during the first

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quarter of 2002, when we restructured our arrangement with FDR, FDR made monthly payments through December 2003. We recognized revenue under the FDR agreement, through the third quarter of 2003. We dodid not expect to recognize license revenue from this FDR agreement in 2004, however we will continuecontinued to earn maintenance revenue. The following table summarizes the revenue we have recognized in 2003 and 2002 under the FDR perpetual license and the prior agreements with FDR:

Term license revenue in 2003 was primarily from customers renewing and extending their use of Pegasystems’ software. Discount rates used to recognize term license revenue vary directly with market interest rates. The discount rates used to recognize term license revenue are estimates of customer borrowing rates at the time license revenue is recognized and averaged 3.25% in 2003.recognized. A decrease in the average discount rate resulted in an increase in license revenue of approximately $1.4 million for 2003 versus 2002. If interest rates increase and in turn the discount rates we use to recognize term license revenue increase, we would defer as installment receivable interest a greater portion of the revenue from such new arrangements and recognized license revenue would decrease by the same amount.

In the future, we expect to enter into more perpetual license transactions than term licenses with new customers, the effect of which may be to increase our license revenue and cash flow in the short term and to decrease the amount of revenue and cash flow in the future, unless we are able to expand our current volume of business.

License renewal revenue may be less in 2004 than in 2003 because of the expected decline in license revenue from FDR and the lower value of term licenses scheduled to renew in 2004. In recent years a significant portion of our revenue has been attributable to term license renewals. In 2004, the dollar value of licenses scheduled to renew is materially less than in 2003. Consequently, absent an increase in the volume of license renewals in advance of the scheduled renewal dates or an increase in the scope (and hence the value) of the licenses renewed on schedule, license renewal revenue will be less in 2004 than in 2003. Any increase in early license renewals in 2004 may adversely impact license revenue in subsequent periods.

Services revenue for 2003 increased 24% to $41.6 million from $33.5 million for 2002. The increase was due to more new license implementation activity in 2003 and new customer maintenance revenue. Implementation, consulting and training services in 2003 increased 25% to $30.1 million from $24.2 million for 2002. Typically, we derive substantial revenue from services provided in connection with the implementation of software licensed by new customers. Going forward, as we continue to complement our direct selling and support efforts with those of our alliance partners, we do not expect to sustain these rates of services revenue growth. Maintenance revenue in 2003 increased 23% to $11.5 million from $9.3 million in 2002 due primarily to the larger installed base of our software.

Deferred revenue at December 31, 2003 consisted primarily of billed fees from arrangements for which acceptance of the software license or service milestone had not occurred, plus the unearned portion of services revenue and advance payment of maintenance fees. Deferred revenue balances increased to $14.2 million as of December 31, 2003 from $13.3 million as of December 31, 2002. The increase was due primarily to an increase in the unearned portion of services revenue related to new software implementations and advance payments of maintenance fees, partially offset by a decrease in deferred license revenue.

Cost of revenue

Cost of software license of $0.4 million in 2003 related to the amortization of technology we purchased in connection with a business acquisition in 2002. Cost of software license of $2.7 million in 2002 reflected the amortization associated with purchased software under an agreement with FDR as well as the technology purchased in connection with the 2002 business acquisition. The $2.3 million decrease in cost of software license in 2003 was primarily attributable to the completion of the amortization related to the FDR asset in the fourth quarter of 2002.

Cost of services consists primarily of the cost of providing implementation, consulting, maintenance, and training services. Cost of services for 2003 decreased 7% to $27.1 million from $29.2 million in 2002, primarily due to reduced staff costs. Cost of services as a percentage of services revenue decreased to 65% for 2003 from 87% for 2002. The percentage decrease was primarily due to the increase in services revenue and reduced staff costs, which significantly improved employee utilization. Services gross margin was $14.5 million for 2003 compared to $4.3 million in 2002. The increase in services gross margin reflected improved utilization of our professional staff achieved in part through the increased use of third party contractors when necessary to meet higher demand.

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Operating expenses

Research and development expenses for 2003 increased 1% to $21.6 million from $21.3 million for 2002. As a percentage of total revenue, research and development expenses remained flat at 22%. The increase in spending was primarily due to increased investment in our PegaRULES technology and applications built upon that technology. Increases in spending on outsourced R&D contractors were partially offset by decreases in staff related costs.

Selling and marketing expenses for 2003 increased 7% to $24.8 million from $23.3 million for 2002. This increase was due to more spending on marketing and sales programs, increased service activities for pre-sales support, such as software demonstrations, and growth in sales and marketing staff from 84 inat the end of 2002 to 102 inat the end of 2003, partially offset by decreases in sales staff average compensation. As a percentage of total revenue, selling and marketing expense increased to 25% in 2003 from 24% in 2002.

General and administrative expenses for 2003 increased 14% to $10.8 million from $9.5 million for 2002. As a percentage of total revenue, general and administrative expenses increased to 11% for 2003 from 10% for 2002. The increases were due to employee compensation related expenses and corporate governance programs and initiatives. Headcount in administrative services increased from 85 inat the end of 2002 to 91 inat the end of 2003.

Installment receivable interest income

Installment receivable interest income for 2003, which consists of the portion of all license fees under long-term software license agreements that is attributable to the time value of money, decreased 11% to $5.2 million from $5.8 million for 2002. The decrease was due to a lower average discount rate for our portfolio of term software licenses, partially offset by net growth in the portfolio. A portion of the fee from each license lease arrangement is initially deferred and recognized as installment receivable interest income over the term of the license. For purposes of the present value calculations, the discount rates used are estimates of customer borrowing rates at the time license revenue is recognized, typically below prime rate, and have varied between 3.25% and 8% during the past few years. It is expected that installment receivable interest income will decline further in 2004 because the average discount rate in our license lease portfolio is now lower than it was during 2003. The average rate declined when new license installment receivables were added to the portfolio at lower current market interest rates and replaced older contracts that had higher historical interest rates.

Other interest income, net

Other interest income, net, remained flat at $0.8 million for 2003 as larger invested cash balances and investments in securities were offset by lower interest rates.

Other income (expense), net

Other income (expense), net, which consists primarily of currency exchange gain and losses, was income of $1.2 million for 2003 versus expense of $0.8 million for 2002. The change was due to currency exchange gains in 2003 versus losses in 2002.

Income before provision for income taxes

Income before provision for income taxes increased to $21.8 million for 2003 from $17.2 million in 2002. The $4.6 million increase was primarily due to a $10.3 million improvement in service gross margin, and a $2.0 million increase in other income, offset by a $3.9 million reduction in software license margin, a $3.2 million increase in operating expenses, and a $0.6 million reduction in installment receivable interest income.

Provision for income taxes

Our effective income tax rate has increased from 11% in 2002 to 19% in 2003. We expect that our effective income tax rate in 2004 will be in the range of 35% to 40%, although the final rate will be impacted by the level of taxable income, the application of tax laws, and other variables. The provision for income taxes in 2003 was $4.2 million, compared to $1.9 million in 2002. The provision increased due to higher levels of income before income taxes and lower benefits from the recognition of loss and credit carry forwards in 2003.

Year ended December 31, 2002 compared to year ended December 31, 2001

Revenue

Total revenue for 2002 increased 2% to $97.4 million from $95.1 million for 2001. The increase was due primarily to increases in software license revenue, which were partially offset by decreases in services revenue. License and services revenue from new customers was 10% of total revenue for 2002, compared with 15% for 2001. The decrease in license contracts with new customers adversely impacted our services business for 2002 because we derive a substantial portion of our services revenue from implementation of software licensed by these customers. The following table summarizes our revenue composition:

Software license revenue for 2002 increased 45% to $63.9 million from $44.1 million for 2001 due primarily to software license renewals by existing customers. The increase in perpetual and subscription license revenue for 2002 was primarily due to a perpetual license agreement entered into with FDR in the first quarter of 2002. That perpetual license agreement replaced a prior term license agreement with FDR under which revenue was being recognized on a subscription basis and which was due to expire in December 2002. Of the $21.9 million increase in perpetual and subscription license revenue for 2002, $17.6 million was due to the FDR perpetual license agreement. The following table summarizes the revenue we have recognized under the FDR perpetual license and the prior agreements with FDR:

Under the terms of the FDR perpetual license agreement, FDR was required to make monthly payments through December 2003. These payments totaled $3.54 million in each of the four quarters of 2003. We

recognized revenue as earned, which was three months in advance of receipt of payments, because while FDR had the contractual right to terminate the agreement, FDR was required to provide us with at least three months advance notice.

Revenues from term software licenses, renewals, extensions, and additions decreased by $2.1 million to $28.3 million for 2002 from $30.4 million for 2001. Included in term software license revenues in the fourth quarter of 2002 was $2.4 million received from Qwest in settlement of a dispute. Discount rates used to recognize term license revenue vary directly with market interest rates. Decreases in the average discount rate resulted in an increase in license revenue of approximately $1.2 million for 2002 versus 2001.

Services revenue for 2002 decreased 34% to $33.5 million from $51.0 million for 2001. The decrease was due primarily to delayed customer spending and a decrease in new customer license transactions. Typically, we derive substantial revenue from services provided in connection with the implementation of software licensed to new customers. New customer implementations in 2002 were significantly below 2001.

Deferred revenue at December 31, 2002 consisted primarily of billed fees from arrangements for which acceptance of the software license or service milestone had not occurred, the unearned portion of services revenue and advance payment of maintenance fees. Deferred revenue balances increased to $13.3 million as of December 31, 2002 from $6.2 million as of December 31, 2001, due to payments for software licenses in advance of customer acceptance and advance payment of maintenance fees.

Cost of revenue

Costs of software license includes the amortization associated with purchased software under an agreement with FDR and the amortization of technology we purchased in connection with a business acquisition in 2002. The amortization related to the FDR asset was completed in the fourth quarter of 2002. Cost of software license for 2002 decreased 13% to $2.7 million from $3.0 million for 2001. As a percentage of software license revenue, cost of software license revenue decreased to 4% for 2002 from 7% for 2001. The decreases were due to a $0.6 million charge taken in the second quarter of 2001, and the increased volume in software license revenue. The charge was for software we acquired in the fourth quarter of 2000, which, after initially being amortized, was expensed in full in the second quarter of 2001 because the productive use of this software was no longer anticipated.

Cost of services consists primarily of the cost of providing implementation, consulting, maintenance, and training services. Cost of services for 2002 decreased 22% to $29.2 million from $37.3 million for 2001, primarily due to reduced staff costs and reduced spending on consultants. Cost of services as a percentage of services revenue increased to 87% for 2002 from 73% for 2001. The percentage increase was primarily due to the reduction in services revenue, which was only partially offset by lower salary costs resulting from staff reductions in the latter part of the year.

Operating expenses

Research and development expenses for 2002 increased 2% to $21.3 million from $20.8 million for 2001. As a percentage of total revenue, research and development expenses remained flat at 22%. The increase in spending was primarily due to increased compensation and staff-related expenses, and continued investment in our PegaRULES business.

Selling and marketing expenses for 2002 increased 33% to $23.3 million from $17.5 million for 2001. As a percentage of total revenue, selling and marketing expenses increased to 24% for 2002 from 18% for 2001. These increases were due to increased staff and marketing program spending in our applications business and investment in our PegaRULES business.

General and administrative expenses for 2002 decreased 3% to $9.5 million from $9.8 million for 2001 due to reduced employee compensation expense and a reduction in the allowance for doubtful accounts of $0.4

million to reflect better collections experience. As a percentage of total revenue, general and administrative expenses remained essentially flat at approximately 10% for 2002.

Installment receivable interest income

Installment receivable interest income for 2002, which consists of the portion of all license fees under long-term software license agreements that is attributable to the time value of money, decreased 6% to $5.8 million from $6.2 million for 2001. The decrease was due to a lower average discount rate for our portfolio of term software licenses. A portion of the fee from each license lease arrangement is initially deferred and recognized as installment receivable interest income over the term of the license. For purposes of the present value calculations, the discount rates used are estimates of customer borrowing rates at the time license revenue is recognized, typically below prime rate, and have varied between 3.25% and 8.0% for the three years ended December 31, 2002.

Other interest income, net

Other interest income, net, remained flat at $0.8 million for 2002 as larger invested cash balances and investments in securities were offset by lower interest rates.

Other income (expense), net

Other income (expense), net, which consists primarily of currency exchange losses and reseller development funds received from third-party vendors of computer hardware products, decreased to a $0.8 million expense for 2002 compared to $15 thousand income for 2001. The decrease was due to greater currency exchange losses and lower reseller development funds.

Income before provision for income taxes

Income before provision for income taxes increased to $17.2 million in 2002 from $13.5 million in 2001. The $3.7 million improvement was due primarily to a $20.3 million improvement in software license gross margin from increased revenues, partially offset by a $9.4 million reduction in services gross margin due to lower services revenues, increased operating expenses of $5.9 million, greater currency exchange losses and reduced interest income.

Provision for income taxes

The provision for income taxes in 2002 was $1.9 million, an effective rate of 11%, compared to $1.0 million in 2001, which was an effective rate of 7%. The provision increased primarily due to compensation deductions triggered by stock option exercises in 2002, which were reflected as increases in equity instead of reductions in the provision for income taxes. During 2002 and 2001, our provisions for U.S. federal income tax were generally nominal, due to the recognition of tax benefits associated with our tax loss carry forwards, for which valuation allowances had been provided due to uncertainty regarding their realization.

Liquidity and capital resources

We have funded our operations primarily from cash flow from operations and the proceeds of our public stock offerings.operations. At December 31, 2003,2004, we had cash and cash equivalents of $68.0 million,and short-term investments of $19.9$97.4 million, a $9.4 million increase from $87.9 million at

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December 31, 2003. Working capital was $118.9 million at December 31, 2004, a $22.9 million increase from $96.0 million at December 31, 2003. Working capital increased primarily due to increases in cash and working capitalinvestments, accounts receivable, the short-term portion of $96.0 million.license installments and a reduction in deferred revenue.

Net cash provided by operations for 20032004 was $21.0$7.6 million compared with $27.1$21.0 million for 2002.2003. The decrease was primarily due to increasesa decrease of $10.1 million in accounts receivable duenet income for 2004 compared to increases in services revenue which increased our average collection period. It has been our experience that customers pay license and maintenance invoices more promptly than consulting services invoices. Although we have been successful in achieving days

billed outstanding of 30 days as of December 31, 2003, growth in the consulting services portion of our business or adverse economic conditions may lengthen our collection period further.2003.

Net cash used in investing activities for 20032004 was $(14.3)$(58.3) million, primarily due to net purchases of marketable debt securities during 2003.2004. This compared with $(7.5)$(14.3) million used in 2002investing activities in 2003, also primarily for similar purchases of marketable debt securities.

On February 6, 2002, we acquired substantially all of the assets of 1mind Corporation for initial consideration valued at $3.9 million, consisting of 569,949 shares of our common stock (155,760 shares of which were deposited into escrow to secure the indemnity obligations of 1mind’s equity holders relating to the transaction) and warrants to purchase for nominal consideration 83,092 shares of our common stock. During the first quarter of 2003, we made a claim against all of the shares in escrow. In April 2003, these shares were returned, retired and cancelled. This resulted in a $0.9 million reduction of goodwill and additional paid in capital in 2003.

Net cash provided by financing activities for 20032004 was $3.0$3.5 million compared with $4.4$3.0 million in 2002.2003. The decreaseincrease was primarily due to lowerhigher proceeds from employee stock option exercises.

Our Board of Directors has authorized the repurchase of up to $10 million of our outstanding common stock. The purchases will be made from time to time on the open market or in privately negotiated transactions. Under the program, shares may be purchased in such amounts as market conditions warrant, subject to regulatory and other considerations. As of February 16, 2005, no shares had been repurchased under the program. The authorization expires on September 30, 2005.

We believe that current cash, cash equivalents, and cash flow from operations will be sufficient to fund our business for at least the next twelve months. Material risks to cash flow from operations include delayed or reduced cash payments accompanying sales of new licenses or a decline in our services business. There can be no assurance that changes in our plans or other events affecting our operations will not result in materially accelerated or unexpected expenditures. In addition, there can be no assurance that additional capital if needed will be available on reasonable terms, if at all, at such time as we require.

As of December 31, 2003,2004, we did not have material commitments for capital or operating expenditures other than capital and operating leases. Our principal administrative, sales, marketing, support, and research and development operations are located in an 85,228 square foot leased facility in Cambridge, Massachusetts. The lease for this facility expires in 2013, with the option to extend for two additional five-year periods. We also lease certain equipmentspace for our other offices in the United States, Canada, Australia, France, and office spacethe United Kingdom. These leases expire at various dates through 2010. Rent expense under non-cancelable operating leases. Future minimum rental payments required under the operating leases with non-cancelable termsis recognized on a straight-line basis, under which scheduled rent increases are expensed in advance of payment. The excess of one year atexpense over current payments is recorded as deferred rent and included in other long-term liabilities. Our known contractual obligations as of December 31, 2003 are2004 were as follows:

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Our liquidity is affected by the manner in which we collect cash for certain types of license transactions. Historically, our term licenses have provided for monthly license payments, generally over five years. The following amounts of cash are due for receipt in connection with our existing term license agreements:

Critical accounting policies and estimates

Management’s discussion and analysis of the financial condition and results of operations is based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates and judgments on historical experience, knowledge of current conditions and beliefs of what could occur in the future given available information. We consider the following accounting policies to be both those most important to the portrayal of our financial condition and those that require the most subjective judgment. If actual results differ significantly from management’s estimates and projections, there could be a material effect on our financial statements.

Revenue recognition

Our revenue is derived from two primary sources: software license fees and service fees. We offer both perpetual and term software licenses. Perpetual license fees are generally payable at the time the software is delivered, and are generally recognized as revenue when the software is delivered, any acceptance required by contract is obtained, and no significant obligations or contingencies exist related to the software, other than maintenance support. Payments subject to refund are recognized as revenue when refund provisions lapse.

Term software license fees are generally payable on a monthly basis under term license agreements that generally have a five-year term and may be renewed for additional years at the customer’s option. The present value of future license payments is generally recognized as revenue upon customer acceptance, provided that no significant obligations or contingencies exist related to the software, other than maintenance support. A portion of the license fees payable under each term license agreement (equal to the difference between the total license payments and the discounted present value of those payments) is initially deferred and recognized as installment receivable interest income (and is not part of total revenue) over the license term. Many of our license agreements provide for license fee increases based on inflation. When such an increase occurs, as determined by the terms of the license agreement, we recognize the present value of such increases as revenue; the remainder of the increase is recognized as installment receivable interest income over the remaining license term. For purposes of the present value calculations, the discount rates used are estimates of customers’ borrowing rates at the time of recognition, typically below prime rate, and have varied between 3.25% and 8.0%7.0% for the past few years. As a result, revenue that we recognize relative to these types of license arrangements would be impacted by changes in market interest rates. For term license agreement renewals, license revenue is recognized with the same present value approach, when the customer becomes committed to the new license terms and no significant obligations or contingencies exist related to the software, other than maintenance support.

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In certain circumstances, such as when license fees are not fixed or determinable, some term licenses are accounted for on a subscription basis, where revenue is recognized as payments become due over the term of the license.

Our services revenue is comprised of fees for software implementation, consulting, maintenance, and training services. Our software implementation and consulting agreements typically require us to provide services for a fixed fee or at an hourly rate. Revenues for time and material projects are recognized as services are delivered and fees are billed. Until the fair value of the elements of a contract can be determined, the recognition of services revenue for fixed-price projects is limited to amounts equal to direct costs incurred, resulting in no gross profit. We do not have a reliable track record for accurately estimating the time and resources needed to complete fixed price service projects. As a result, determination of the fair value of the elements of the contract has generally occurred late in the implementation process, typically when implementation is complete and remaining services are no longer significant to the project. If the fair values of the elements of a contract are then apparent, the remaining revenue and profit associated with the fixed price services elements will be recognized when the project is completed. To the extent that a software license is included in the contract, any residual amounts remaining after revenue is allocated to the services elements are recorded as license revenues. All costs of services are expensed as incurred.

Software license customers are offered the option to enter into a maintenance contract, which usually requires the customer to pay a monthly maintenance fee over the term of the maintenance agreement, typically renewable annually. Prepaid maintenance fees are deferred and are recognized evenly over the term of the maintenance agreement. We generally recognize training fees revenue as the services are provided.

We reduce revenue for estimates of the fair values of potential concessions, such as disputed services, when revenue is initially recorded. These estimated amounts are deferred or reserved until the related elements of the agreement are completed and provided to the customer or the dispute is resolved.

Our agreements with customers generally require us to indemnify the customer against claims that our software infringes third party patent, copyright, trademark or other proprietary rights. Such indemnification obligations are generally limited in a variety of industry-standard respects, including our right to replace an infringing product. As of December 31, 2003,2004, we had not experienced any material losses related to these indemnification obligations and no material claims with respect thereto were outstanding. We do not expect significant claims related to these indemnification obligations, and consequently, we have concluded that the fair value of these obligations is negligible and we have not established any related reserves.

Deferred revenue

Deferred revenue consists primarily of billed fees from arrangements for which acceptance of the software license or service milestone has not occurred, the unearned portion of services revenue and advance payment of maintenance fees. We estimate the value of committed and undelivered services to be delivered after license implementation, and defer that amount until the related elements of the agreement are completed and provided to the customer. We base these estimates on our historical experience. The timing of revenue recognized under our arrangements with customers is impacted by these estimates, but the total value of revenue recognized during the arrangements is not.

Allowance for doubtful accounts

We maintain an allowance for doubtful accounts using estimates that we make based on factors we believe appropriate such as the composition of the accounts receivable aging, historical bad debts, changes in payment patterns, customer creditworthiness and current economic trends. If we used different assumptions, or if the financial condition of customers were to deteriorate, resulting in an impairment of their ability to make payments, additional provisions for doubtful accounts would be required and would increase bad debt expense.

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Stock-based compensation

We periodically grant stock options for a fixed number of shares to employees, non-employee directors and non-employee contractors with an exercise price equal to the fair market value of the shares at the date of the grant. We account for stock option grants to employees and directors using the intrinsic value method. Under the intrinsic value method, compensation associated with stock awards to employees and directors is determined as the difference, if any, between the current fair value of the underlying common stock on the date compensation is measured and the price the employee or director must pay to exercise the award. The measurement date for employee awards is generally the date of grant. Stock options granted to non-employee contractors are accounted for using the fair value method. Under the fair value method, compensation associated with stock awards to non-employee contractors is determined based on the estimated fair value of the award itself, measured using either current market data or an established option pricing model.

At December 31, 2004, we had four stock-based compensation plans, which are described more fully in Note 4 of the notes to the financial statements. No stock-based employee compensation expense is reflected in net income in 2004, 2003 and 2002, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant and were granted to employees and directors.

The fair value method requires use of an option pricing model, and assumptions required by the selected model. Assumptions required in using these models include average life of options from the vesting date, volatility of our stock price and risk free rate of return. We have used the Black-Scholes multiple option pricing model during the past few years for our pro-forma disclosures in notes to the financial statements regarding what the impact would have been of adopting the fair value method. We have based our assumptions for average life of options on analyses of the history of activity by holders of “in the money” options for our common stock. We have based our assumptions for volatility of our stock price on analyses of the history of the price of our common stock as reported by NASDAQ, looking back over a time period approximating the assumed average life of options. We have assumed a risk free rate of return based on yields of US Treasury notes. We disclose the pro-forma effect on our financial results in Note 1 (m) of the notes to the financial statements.

The effects on pro-forma net income and earnings per share of the estimated fair value of stock options and estimated dilutive shares are not necessarily representative of the effects on the results of operations in the future. In addition, the estimates made utilize a pricing model developed for traded options with relatively short lives; our option grants typically have a life of up to ten years and are not transferable. Therefore, the actual fair value of a stock option grant may be different from our estimates. We believe that our estimates incorporate all relevant information and represent a reasonable approximation in light of the difficulties involved in valuing non-traded stock options.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123R,Share-Based Payment (“SFAS No. 123R”). This Statement is a revision of SFAS No. 123,Accounting for Stock-Based Compensation, and supersedes Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS No. 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. The Statement requires entities to recognize stock compensation expense for awards of equity instruments to employees based on the grant-date fair value of those awards (with limited exceptions). SFAS No. 123R is effective for the first interim or annual reporting period that begins after June 15, 2005.

We are evaluating the two methods of adoption allowed by SFAS No. 123R; the modified-prospective transition method and the modified-retrospective transition method.

Adoption of SFAS No. 123R will significantly increase compensation expense. In addition, SFAS No. 123R requires that excess tax benefits related to stock compensation expense be reported as a financing cash inflow rather than as a reduction of taxes paid in cash flow from operations.

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Accounting for income taxes

We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, or SFAS 109, “AccountingAccounting for Income Taxes”, which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. We evaluate the reliabilityrecoverability of our deferred tax assets quarterly by assessing our valuation allowance and by adjusting the amount of such allowance, if necessary. At December 31, 2003,2004, we had net deferred tax assets primarily resulting from temporary differences between the book and tax bases of assets and liabilities, and loss and credit carry forwards. We continue to provide a valuation allowance on certain deferred tax assets based on an assessment of the likelihood of their realization. In reaching our conclusion, we evaluated certain relevant criteria including deferred tax liabilities that can be used to offset deferred tax assets, estimates of future taxable income of appropriate character within the carry forward period available under the tax law, and tax planning strategies. Our judgments regarding future taxable income may change due to market conditions, changes in U.S. or international tax laws, and other factors. These changes, if any, may require material adjustments to these deferred tax assets, resulting in either a tax benefit, if it is estimated that future taxable income is likely, or a

reduction in the value of the deferred tax assets, if it is determined that their value is impaired, resulting in a reduction in net income or an increase in net loss in the period when such determinations are made.

Principal differences between our book and tax accounts are related to the treatment of our license transactions. We use the installmentoperating lease method of recognition of licensesrecognizing license revenue for tax purposes, so that to the extent we continue to enter into term license contracts, we establish deferred tax liabilities for such future taxable income. In addition, because we defer recognition of this income into future periods for tax purposes, we have generated substantial tax loss carry forwards which partially offset the related liabilities. We also earn tax credits in various jurisdictions for our ongoing investment in research and development activities.

As our business has grown and generated substantial book and tax profits, we have reduced valuation allowances previously provided for our loss and credit carry forwards. As of December 31, 2003,2004, our remaining valuation allowance related to credits, which we expect will expire before we will be able to utilize them, and to loss carry forwards acquired in the 1mind acquisition, the recognition of which will generally reduce goodwill.

We expect our provision for income taxes in future periods to reflect an effective tax rate significantly higher than past periods.

In addition, we have provided for potential tax liabilities due in foreign jurisdictions. Judgment is required in determining our worldwide income tax expense provision. In the ordinary course of conducting a global business enterprise, there are many transactions and calculations undertaken whose ultimate tax outcome cannot be certain. Some of these uncertainties arise as a consequence of transactions and arrangements made among related parties.parties, transfer pricing for transactions with our subsidiaries, and potential challenges to nexus and credit estimates. We estimate our exposure to unfavorable outcomes related to these uncertainties and estimate the probability for such outcomes. Although we believe our estimates are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from what is reflected in our historical income tax provisions, returns and accruals. Such differences could have a material impact on our income tax provision and operating results in the period in which such a determination is made. Provisions have been made for such uncertainties, with reserves totaling approximately $2 million as of December 31, 2004.

In December 2004, the FASB issued FASB Staff Position No. 109-1,Application of FASB Statement No.109 (SFAS 109), Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (FSP 109-1). FSP 109-1 clarifies that the manufacturer’s deduction provided for under the American Jobs Creation Act of 2004 (AJCA) should be accounted for as a special deduction in accordance with SFAS 109 and not as a tax rate reduction. Until the Treasury Department or Congress provides additional clarifying language on key elements of this deduction, the impact of the adoption of FSP 109-1 on our results of operations or financial position for 2005 and subsequent years cannot be determined.

The FASB also issued FASB Staff Position No. 109-2,Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (FSP 109-2). The AJCA introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. The FSP 109-2 provides accounting

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and disclosure guidance for the repatriation provision. Until the Treasury Department or Congress provides additional clarifying language on key elements of the repatriation provision, the tax impact of foreign earnings that might be repatriated by us, if any, cannot be determined.

The FSP 109-2 grants an enterprise additional time beyond the year ended December 31, 2004, in which the AJCA was enacted, to evaluate the effects of the AJCA on its plan for reinvestment or repatriation of unremitted earnings. The FSP 109-2 calls for enhanced disclosures of, among other items, the status of a Company’s evaluations, the effects of completed evaluations, and the potential range of income tax effects of repatriations. Such disclosures are included in Note 7 of the notes to the financial statements.

Contingencies

From time to time, we are threatened with or become party to litigation. We periodically assess each matter in order to determine if a contingent liability in accordance with Statement of Financial Accounting Standards No. 5, or SFAS 5, “AccountingAccounting for Contingencies”, should be recorded. In making this determination, we may, depending on the nature of the matter, consult with internal and external legal counsel and technical experts. Based on the information we obtain, combined with our judgment regarding all the facts and circumstances of each matter, we determine whether it is probable that a contingent loss may be incurred and whether the amount of such loss can be estimated. Should a loss be probable and estimable, we record a contingent loss in accordance with SFAS 5. In determining the amount of a contingent loss, we consider advice received from experts in the specific matter, current status of legal proceedings, settlement negotiations that may be ongoing, prior case history and other factors. Should the judgments and estimates made by us be incorrect, we may need to record additional contingent losses that could materially adversely impact our results of operations.

Inflation

Inflation has not had a significant impact on our operating results to date, and we do not expect it to have a significant impact in the future. Our unbilled license and maintenance fees are typically subject to annual increases based on recognized inflation indices.

Significant customers

No customer accounted for 10% or more of our total revenue in 2004. First Data Resources accounted for 12%, and 26% and 14% of our total consolidated revenue in 2003 2002 and 2001,2002, respectively. In 2003, another customer accounted for approximately 15% of our total revenue.

Forward-looking statements

This Report on Form 10-K contains or incorporates forward-looking statements within the meaning of section 27A of the Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which we operate and management’s beliefs and assumptions. In addition, other written or oral statements that constitute forward-looking statements may be made by or on our behalf. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate,” “may,” variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. We have included important factors in the cautionary statements below under the heading “Factors That May Affect Future Results” that we believe could cause our actual results to differ materially from the forward-looking statements we make. We do not intend to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

Factors that may affect future results

The following important factors, among others, could cause our actual business and financial results to differ materially from those contained in forward-looking statements made in this Annual Report on Form 10-K or presented elsewhere by management from time to time.

Factors relating to our revenues

We need to close morehaveincreasingly been entering into perpetual license transactions with new customers rather than term licenses, which, with respect to increase or maintain our current revenue level.In recent years,such transactions, has the majorityeffect of increasing our license revenue has been derived from existing customers. Weand cash flow in the short term and of decreasing the amount of license revenue and cash flow in the future. In prior years, we typically licensed our software under term licenses requiring the customer to make monthly payments over the license term. More recently, we have been particularly dependent on First Data Resources, or FDR, forselling perpetual licenses to our software with a single license fee typically being payable at the commencement of the license. We expect that our use of perpetual licenses will continue to increase in the foreseeable future, although we expect to enter into new term licenses in certain instances at the request of our customers. Our increased use of perpetual licenses has the effect, with respect to such transactions,

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of increasing our license revenue and cash flow in the short term, but of decreasing the amount of license revenue and cash flow in the future. If we are unable to increase the volume of new license transactions, given the anticipated decline in the recurring revenue from term license arrangements, our license revenue and cash flow will likely decline in future periods.

If existing customers do not renew their term licenses, our financial results may suffer. Term license renewal negotiations have required more effort due to economic pressures and consolidation among our customers. A significant portion of our total revenue duringhas been attributable to term license renewals, although this portion has been declining in recent periods due to the past few years. With theincrease in perpetual license entered into with FDR in 2002, FDR is not likelylicenses. While historically a majority of customers have renewed their term licenses, there can be no assurance that a majority of customers will continue to represent a large portion of our revenue after 2003. Therefore, it will be necessary forrenew expiring term licenses. In addition, customers may choose to renew their expiring term licenses, but on business terms that require us to close moreaccount for such renewals on a subscription basis, thereby reducing the amount of revenue we can recognize at the time of renewal under our existing revenue recognition practices. A decrease in term license renewal revenue absent offsetting revenue from other sources would have a material adverse effect on future financial performance.

Our professional services revenue is dependent to a significant extent on closing license transactions with new customers or expand our relationships with existing customers to replace the FDR revenue. In addition, because we. We derive a substantial portion of our professional services revenue from implementation of software licensed by new customers and the development of applications by our customers using our software. Increasingly, we will needare relying on business partners to provide the implementation services for our customers, thus reducing the amount of professional services revenue we derive relative to a given level of license revenue. Accordingly, it is imperative that we close more license transactions with new customers if we are to maintain or grow our services revenue. While we increased

Factors relating to fluctuations in our license bookings in 2003 as compared to 2002, we will need to continue to grow bookings in the future for us to increase or maintain our 2003 revenue level in 2004 and there can be no assurance that we will be successful in doing so.financial results

The timing of our license revenuesrevenue is often relateddifficult to predict accurately, due to the uncertain timing of the completion of implementation services and product acceptance by the customer the timing of which has been difficult to predict accurately. Quarterly results have fluctuated and are likely to continue to. Our quarterly revenue may fluctuate significantly. There can be no assurance that we will be profitable on an annual or quarterly basis or that earnings or revenues will meet analysts’ expectations. Fluctuations may be particularly pronouncedsignificantly, in part because a significantlarge portion of revenuesour revenue in any quarter is attributable to product acceptance or license renewal by a relatively small number of customers. Fluctuations also reflect our policy of recognizing revenue upon product acceptance or, in the case of term licenses, license renewal in an amount equal to the present value of the total committed payments due during the term.renewal. Customers generally dooften will not accept products until the end of a lengthy sales cycle and an implementation period, typically ranging from six to twelve months but in some cases significantly longer. We are currently in the processrecently introduced a new set of introducingproducts based on our new PegaRULES technology. ThisIn some cases, these new products have a shorter sales cycle and implementation period than our traditional product line. However, our experience with these new products is limited in time, and we may result in even lengthierexperience longer sales and implementation cycles whichin some cases. Any increases in these cycles may adversely affect our financial performance, includingdue in part to the recognition of sales staff and commission costs in advance of revenue recognition. This may increase the volatility in our quarterly operating results. RisksIn addition, risks over which we have little or no control, including customers’ budgets, staffing allocation, and internal authorization reviews, can significantly affect the sales and acceptance cycles. Changes requested by customers may further delay product implementation and revenue recognition.

License renewal revenue may be less in 2004 than in 2003 because of the lower value of term licenses scheduled to renew in 2004. In recent years a significant portion of our revenue has been attributable to term license renewals. In 2004, the dollar value of licenses scheduled to renew is materially less than in 2003. Consequently, absent an increase in the volume of license renewals in advance of the scheduled renewal dates or an increase in the scope (and hence the value) of the licenses renewed on schedule, license renewal revenue will be less in 2004 than in 2003. Any increase in early license renewals in 2004 may adversely impact license revenue in subsequent periods.

In the future, we expect to enter into more perpetual license transactions than term licenses with new customers, the net effect of which may be to increase our license revenue and cash flow in the short term and to decrease the amount of revenue and cash flow in the future, unless we are able to expand our current volume of business. Historically, we have generally licensed our software under term licenses requiring the customer to make monthly payments over the license term. More recently, we have begun selling perpetual licenses to our software with a single license fee being payable at the commencement of the license term. The effect of this change in strategy may be to increase our license revenue and cash flow in the short term but to decrease the amount of revenue and cash flow in the future, unless we are able to expand our overall volume of business.

Our stock price has been volatile.Quarterly results have fluctuated and are likely to continue to fluctuate significantly. The market price of our common stock has been and may continue to be highly volatile. Factors that are difficult to predict, such as quarterly revenues and operating results, statements and ratings by financial analysts, and overall market performance, will have a significant effect on the price for shares of our common stock. Revenues and operating results have varied considerably in the past from period to period and are likely to vary considerably in the future. Historically, most of our revenue in a quarter has been attributable to a small number of transactions. This has caused our quarterly revenue to fluctuate, sometimes significantly. These fluctuations could cause us to be unprofitable on an annual or quarterly basis and to fail to meet analysts’ expectations regarding our earnings or revenue. Our current strategy to rely more heavily on third party services in support of license sales may increase these fluctuations because we will have less control over the timing of customer acceptance of our software. While future fluctuations in our quarterly operating results may be buffered to some extent by the increasing percentages of our total revenue from maintenance services and by an increase in the number of license transactions, we expect those fluctuations will continue to be significant at least in the near term. We plan selling and marketing expenses, product development and other expenses based on anticipated future revenue. If revenue falls below expectations, financial performance is likely to be adversely affected because only small portions of expenses vary with revenue. As a result, period-to-period comparisons of operating results are not necessarily meaningful and should not be relied upon to predict future performance.

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If existing customers do not renew their term licenses, our financial results may suffer. Term license renewal negotiations have required more effort due to economic pressures and consolidation among our customers. A significant portion of total revenueOur stock price has been attributable to term license renewals. While historically a majorityvolatile. The market price of customers have renewed their term licenses, there can be no assurance that a majority of customers willour common stock has been and may continue to renew expiring term licenses. A decrease in term license renewals absent offsetting revenue from other sources wouldbe highly volatile. Factors that are difficult to predict, such as quarterly revenues and operating results, statements and ratings by financial analysts, and overall market performance, will have a material adversesignificant effect on future financial performance.the price for shares of our common stock.

Factors relating to our products and markets

We will need to develop new products, evolve existing ones, and adapt to technology change. Technical developments, customer requirements, programming languages and industry standards change frequently in our markets. As a result, success in current markets and new markets will depend upon our ability to enhance current products, to develop and introduce new products that meet customer needs, keep pace with technology changes, respond to competitive products, and achieve market acceptance. Product development requires substantial investments for research, refinement and testing. There can be no assurance that we will have sufficient resources to make necessary product development investments. We may experience difficulties that will delay or prevent the successful development, introduction or implementation of new or enhanced products. Inability to introduce or implement new or enhanced products in a timely manner would adversely affect future financial performance. Our products are complex and may contain errors. Errors in products will require us to ship corrected products to customers. Errors in products could cause the loss of or delay in market acceptance or sales and revenue, the diversion of development resources, injury to our reputation, or increased service and warranty costs which would have an adverse effect on financial performance.

The market for our offerings is increasingly and intensely competitive, rapidly changing, and highly fragmented. The market for business process management software and related implementation, consulting and training services is intensely competitive and highly fragmented. We currently encounter significant competition from internal information systems departments of potential or existing customers that develop custom software. We also compete with companies that target the customer interaction and workflow markets and professional service organizations that develop custom software in conjunction with rendering consulting services. Competition for market share and pressure to reduce prices and make sales concessions are likely to increase. Many competitors have far greater resources and may be able to respond more quickly and efficiently to new or emerging technologies, programming languages or standards or to changes in customer requirements or preferences. Competitors may also be able to devote greater managerial and financial resources to develop, promote and distribute products and provide related consulting and training services. There can be no assurance that we will be able to compete successfully against current or future competitors or that the competitive pressures faced by us will not materially adversely affect our business, operating results, and financial condition.

We have historically sold to the financial services market.and healthcare markets. This market isThese markets are continuing to consolidate, and facesface uncertainty due to many other factors. We have historically derived a significant portion of our revenue from customers in the financial services market, and healthcare markets, and increased sales to these markets are important for our future growth, depends, in part, upon increasedalthough we have been increasing our sales to this market.other markets. Competitive pressures, industry consolidation, decreasing operating margins within this industry,these markets, currency fluctuations, geographic expansion and deregulation affect the financial condition of our customers and their willingness to pay. In addition, customers’ purchasing patterns are somewhat discretionary. As a result, some or all of the factors listed above may adversely affect the demand by customers. The financial services market is undergoing intense domestic and international consolidation. Consolidation may interrupt normal buying behaviors and increase the volatility of our operating results. In recent years, several customers have been merged or consolidated. Future mergers or consolidations may cause a decline in revenues and adversely affect our future financial performance.

We depend on certain key personnel, and must be able to attract and retain qualified personnel in the future.The business is dependent on a number of key, highly skilled technical, managerial, consulting, sales, and marketing personnel, including Mr. Trefler, our Chief Executive Officer. The loss of key personnel could adversely affect financial performance. We do not have any significant key-man life insurance on any officers or employees and do not plan to obtain any. Our success will depend in large part on the ability to hire and retain qualified personnel. The number of potential employees who have the extensive knowledge of computer hardware and operating systems needed to develop, sell and maintain our products is limited, and competition for their services is intense, and there can be no assurance that we will be able to attract and retain such personnel. If we are unable to do so, our business, operating results, and financial condition could be materially adversely affected.

We rely on certain third-party relationships. We have a number of relationships with third parties that are significant to sales, marketing and support activities, and product development efforts. We rely on relational database management system applications and development tool vendors, software and hardware vendors, large system integrators and consultantstechnology consulting firms to provide marketing and sales opportunities for the direct

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sales force and to strengthen our products through the use of industry-standard tools and utilities. We also have relationships with third parties that distribute our products. In particular, we benefit from our non-exclusive relationship with First Data Resources for the distribution of products to the credit card market and with PFPC Inc. for distribution of products to the mutual fund market. FDR can sell applications based on our software to their credit card customers who have less than an agreed number of active credit card accounts as identified in the perpetual license agreements, without paying an additional fee to us. There can be no assurance that these companies, most of which have significantly greater financial and marketing resources, will not develop or market products that compete with ours in the future or will not otherwise end their relationships with or support of us.

We may face product liability and warranty claims. Our license agreements typically contain provisions intended to limit the nature and extent of our risk of product liability and warranty claims. There is a risk that a court might interpret these terms in a limited way or could hold part or all of these terms to be unenforceable. Also, there is a risk that these contract terms might not bind a party other than the direct customer. Furthermore, some of our licenses with our customers are governed by non-U.S. law, and there is a risk that foreign law might give us less or different protection. Although we have not experienced any material product liability claims to date, a product liability suit or action claiming a breach of warranty, whether or not meritorious, could result in substantial costs and a diversion of management’s attention and our resources.

We face risks from operations and customers based outside of the U.S. Sales to customers headquartered outside of the United States represented approximately 20%, 22% and 23%32% of our total revenue in 2004, 20% in 2003, 2002 and 2001, respectively.22% in 2002. We, in part through our wholly-owned subsidiaries based in the United Kingdom, Singapore, Canada, and Australia, market products and render consulting and training services to customers based in Canada, the United Kingdom, France, Germany, the Netherlands, Belgium, Switzerland, Austria, Ireland, Sweden, South Africa, Mexico, Australia, Hong Kong, and Singapore. We have established offices in continental Europe and Australia. We believe that growth will necessitate expanded international operations requiring a diversion of managerial attention and financial resources. We anticipate hiring additional personnel to

accommodate international growth, and we may also enter into agreements with local distributors, representatives, or resellers. If we are unable to do one or more of these things in a timely manner, our growth, if any, in our foreign operations will be restricted, and our business, operating results, and financial condition could be materially and adversely affected.

In addition, there can be no assurance that we will be able to maintain or increase international market demand for our products. Most of our international sales are denominated in U.S. dollars. Accordingly, any appreciation of the value of the U.S. dollar relative to the currencies of those countries in which we distribute our products may place us at a competitive disadvantage by effectively making our products more expensive as compared to those of our competitors. Additional risks inherent in our international business activities generally include unexpected changes in regulatory requirements, increased tariffs and other trade barriers, the costs of localizing products for local markets and complying with local business customs, longer accounts receivable patterns and difficulties in collecting foreign accounts receivable, difficulties in enforcing contractual and intellectual property rights, heightened risks of political and economic instability, the possibility of nationalization or expropriation of industries or properties, difficulties in managing international operations, potentially adverse tax consequences (including restrictions on repatriating earnings and the threat of “double taxation”), enhancedincreased accounting and internal control expenses, and the burden of complying with a wide variety of foreign laws. There can be no assurance that one or more of these factors will not have a material adverse effect on our foreign operations, and, consequentially, our business, operating results, and financial condition.

Factors relating to our internal operations and potential liabilities

We depend on certain key personnel, and must be able to attract and retain qualified personnel in the future. The business is dependent on a number of key, highly skilled technical, managerial, consulting, sales, and marketing personnel, including Mr. Alan Trefler, our Chief Executive Officer. The loss of key personnel could adversely affect financial performance. We do not have any significant key-man life insurance on any officers or employees and do not plan to obtain any. Our success will depend in large part on the ability to hire and retain qualified personnel. The number of potential employees who have the extensive knowledge of computer hardware and operating systems needed to develop, sell and maintain our products is limited, and competition for their services is intense, and there can be no assurance that we will be able to attract and retain such personnel. If we are unable to do so, our business, operating results, and financial condition could be materially adversely affected.

We may face product liability and warranty claims. Our license agreements typically contain provisions intended to limit the nature and extent of our risk of product liability and warranty claims. There is a risk that a court might interpret these terms in a limited way or could hold part or all of these terms to be unenforceable. Also, there is a risk that these contract terms might not bind a party other than the direct customer. Furthermore,

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some of our licenses with our customers are governed by non-U.S. law, and there is a risk that foreign law might give us less or different protection. Although we have not experienced any material product liability claims to date, a product liability suit or action claiming a breach of warranty, whether or not meritorious, could result in substantial costs and a diversion of management’s attention and our resources.

We face risks related to intellectual property claims or appropriation of our intellectual property rights. We rely primarily on a combination of copyright, trademark and trade secrets laws, as well as confidentiality agreements to protect our proprietary rights. In October 1998, we were granted a patent by the United States Patent and Trademark Office relating to the architecture of our systems. We cannot assure that such patent will not be invalidated or circumvented or that rights granted there underthereunder or the description contained therein will provide competitive advantages to our competitors or others. Moreover, despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain the use of information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. There can be no assurance that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology.

We are not aware that any of our products infringe the proprietary rights of third parties. There can be no assurance, however, that third parties will not claim infringement by us with respect to current or future products. Although we attempt to limit the amount and type of our contractual liability for infringement of the proprietary rights of third parties, these limitations often contain certain exclusions, and we cannot be assured that these limitations will be applicable and enforceable in all cases. Even if these limitations are found to be applicable and enforceable, our liability to our customers for these types of claims could be material in amount given the size of certain of our transactions. We expect that software product developers will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays, or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could have a material adverse effect upon our business, operating results, and financial condition.

Investor confidence and share value may be adversely impacted if our management is unable to provide an unqualified assessment regarding the adequacy of our internal control over financial reporting, or if our independent auditors are unable to provide us with their attestation regarding our management’s assessment, for our 2005 fiscal year or beyond, as required by Section 404 of the Sarbanes-Oxley Act of 2002. The Securities and Exchange Commission, as directed by Section 404 of the Sarbanes-Oxley Act of 2002, adopted rules requiring public companies to include a report of management on the company’s internal control over financial reporting in its annual reports on Form 10-K that contain an assessment by management of the effectiveness of the company’s internal control over financial reporting. In addition, the company’s independent auditors must attest to and report on management’s assessment of the effectiveness of the company’s internal control over financial reporting. For the year ended December 31, 2004, management’s assessment is included on page 31 of this Annual Report on Form 10-K and our independent auditors’ attestation is included on page 33 of this Annual Report on Form 10-K. These reports, however, speak only as of a single point in time. For future periods, although we intend to diligently and regularly review and update our internal control over financial reporting in order to ensure compliance with the Section 404 requirements, our management may not be able to provide an unqualified assessment for our 2005 fiscal year or beyond, and our independent auditors may be unwilling to provide an attestation for any of these years. Any such event could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our financial statements, which ultimately could negatively impact the market price of our shares.

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ITEM 7A    QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Market risk represents the risk of loss that may affect us due to adverse changes in financial market prices and rates. Our market risk exposure is primarily fluctuations in foreign exchange rates and interest rates. We have not entered into derivative or hedging transactions to manage risk in connection with such fluctuations.

Foreign currency exposure

We derived approximately 20%32% of our total revenue in 20032004 from sales to customers based outside of the United States. Some of our international sales are denominated in foreign currencies, such as the British pound and Euro. The price in United States dollars of products and services sold outside the United States in foreign

currencies will vary as the value of the United States dollar fluctuates against those foreign currencies. There can be no assurance that sales denominated in foreign currencies will not be material in the future and that there will not be increases in the value of the United States dollar against such currencies that will reduce the dollar return to us on the sale of our products and services in such foreign currencies. The foreign currency exposure related to revenue is currentlylargely offset by the expenses we incur in foreign currencies.

We had net assets valued in foreign currencies, consisting primarily of cash, investments, license installments, and receivables, partially offset by accounts payable and accruals, with a carrying value of $21$17 million as of December 31, 2003.2004. A ten percent change in currency exchange rates would change by approximately $2 million the carrying value of those net assets as reported on our balance sheet as of December 31, 2003,2004, with most of that change recognized in the statement of income as other income (expense).

Interest rate exposure

Our balance sheet contains interest bearing assets which have fixed rates of interest. These assets are license installments receivable generated in the normal course of business through transactions with customers and investments of excess cash in marketable debt securities.

License installments receivable bear interest at the rate in effect when the license revenue was recognized, which does not vary throughout the life of the contractual cash flow stream. We believe that at current market interest rates, the fair value of license installments receivable approximates the carrying value as reported on our balance sheets. However, there can be no assurance that the fair market value will approximate the carrying value in the future. Changes in market rates do not affect net earnings, as the license installments receivable are carried at cost and, since they are not financial instruments and are held until maturity, are not marked to market to reflect changes in the fair value of the portfolio. Factors such as increasing interest rates can reduce the fair market value of the license installments receivable. The carrying value of $82$76 million as of December 31, 20032004 reflects athe weighted average of historic discount rates.rates used to record each term license arrangement. The average rate changes with market rates as new license installments receivable are added to the portfolio, which mitigates exposure to market interest rate risk. A 200 basis point increase in market interest rates would have decreased the fair value of our license installments receivable by approximately $2.8$2 million as of December 31, 2003.2004.

We have invested in fixed rate marketable debt securities. A 200 basis point increase in market interest rates would have reduced the fair value of our marketable debt securities by less than $1approximately $2 million as of December 31, 2003, due to the relatively short maturities of those investments.2004. Changes in market rates and the related impact on fair value of the investments do not generally affect net earnings as our investments are fixed rate securities and are classified as available-for-sale. Investments classified as available-for-sale are carried at fair value with unrealized gains and losses recorded as a component of accumulated other comprehensive income.

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ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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MANAGEMENT REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework inInternal Control — Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission. Work in support of the independent auditor attestation as required under Section 404 of the Sarbanes-Oxley Act of 2002 has indicated that we have some deficiencies in internal control over financial reporting, and management is working to remediate those deficiencies. Our management has concluded that those deficiencies, individually and in the aggregate, do not constitute a material weakness in internal control over financial reporting. Based on our evaluation under the framework inInternal Control — Integrated Framework,our management concluded that our internal control over financial reporting was effective as of December 31, 2004.

Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of our management and directors; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which is included in this Item 8 of our Annual Report on Form 10-K on page 33.

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REPORT OF INDEPENDENT AUDITORS’ REPORTREGISTERED PUBLIC ACCOUNTING FIRM

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

We have audited the accompanying consolidated balance sheets of Pegasystems Inc. and subsidiaries (the “Company”) as of December 31, 20032004 and 20022003, and the related consolidated statements of income, stockholders’ equity and other comprehensive income, and cash flows for each of the three years in the period ended December 31, 2003.2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditingthe standards generally accepted inof the United States of America.Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, thesuch consolidated financial statements referred to above present fairly, in all material respects, the financial position of Pegasystems Inc. as of December 31, 20032004 and 20022003, and the results of itstheir operations and itstheir cash flows for each of the three years in the period ended December 31, 20032004, in conformity with accounting principles generally accepted in the United States of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on the criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 24, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Boston, MassachusettsTo the Board of Directors and Stockholders of Pegasystems Inc.:

We have audited management’s assessment, included in the accompanyingManagement Report on Internal Control Over Financial Reporting, that Pegasystems Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established inInternal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel 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. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established inInternal Control — Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the criteria established inInternal Control — Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2004 of the Company and our report dated February 16, 200424, 2005 expressed an unqualified opinion on those financial statements.

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PEGASYSTEMS INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share-related data)

See notes to consolidated financial statements.

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PEGASYSTEMS INC.

CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share amounts)