Verity 10Q 2006 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended August 31, 2005

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

For the transition period from to

Commission File Number: 0-26880

VERITY, INC.

(Exact name of registrant as specified in its charter)

Delaware

77-0182779

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

894 Ross Drive

Sunnyvale, California 94089

(408) 541-1500

(Address, including zip code, and telephone number, including area code of principal executive offices)

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

The number of shares outstanding of the Registrant’s Common Stock, $0.001 par value, was 35,808,954 as of September 30, 2005.

VERITY, INC.

FORM 10-Q

TABLE OF CONTENTS


		Page
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements	3
	Condensed Consolidated Balance Sheets — As of August 31, 2005 and May 31, 2005	3
	Condensed Consolidated Statements of Operations — For the Three Month Periods Ended August 31, 2005 and August 31, 2004	4
	Condensed Consolidated Statements of Cash Flows — For the Three Month Periods Ended August 31, 2005 and August 31, 2004	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	38
Item 4.	Controls and Procedures	39

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	40
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	41
Item 3.	Defaults upon Senior Securities	41
Item 4.	Submission of Matters to a Vote of Security Holders	41
Item 5.	Other Information	41
Item 6.	Exhibits	41
Signature		42

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

VERITY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

( in thousands, except per share data, unaudited)


	August 31, 2005		May 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	106,169	$	110,262
Short-term investments		59,465		40,376
Trade accounts receivable, net of allowance for doubtful accounts of $1,544 and $1,470		31,708		31,002
Deferred tax assets		1,928		1,946
Prepaid and other assets		3,049		3,644

Total current assets		202,319		187,230
Property and equipment, net		7,017		7,169
Long-term investments		26,213		44,503
Deferred tax assets		15,020		15,020
Intangible assets, net		22,112		22,472
Goodwill		59,428		59,428
Other assets		2,315		2,688

Total assets	$	334,424	$	338,510

LIABILITIES
Current liabilities:
Accounts payable	$	2,847	$	5,441
Accrued compensation		10,878		10,903
Income tax payable		3,181		3,394
Deferred purchase payment		720		570
Other accrued liabilities		5,674		5,959
Deferred revenue		25,285		23,196

Total current liabilities		48,585		49,463

Other non-current liabilities:
Deferred rent		937		951
Deferred revenue		800		—

Total liabilities		50,322		50,414

STOCKHOLDERS’ EQUITY
Preferred stock, $0.001 par value:
Authorized: 2,000 shares
Issued and outstanding: none
Common stock, $0.001 par value:
Authorized: 200,000 shares; issued and outstanding: 35,626 shares in 2006 and 36,040 shares in 2005		36		36
Additional paid-in capital		239,045		243,284
Accumulated other comprehensive income		1,954		1,946
Retained earnings		43,067		42,830

Total stockholders’ equity		284,102		288,096

Total liabilities and stockholders’ equity	$	334,424	$	338,510

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

VERITY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data, unaudited)


	Three months ended August 31,
	2005			2004
Revenues:
Software products	$	19,969		$	19,692
Service and other		15,514			14,930

Total revenues		35,483			34,622

Costs of revenues:
Software products		915			733
Service and other		5,017			4,974
Amortization of purchased intangible assets		2,101			1,689

Total costs of revenues		8,033			7,396

Gross profit		27,450			27,226

Operating expenses:
Research and development		6,768			5,689
Marketing and sales		14,606			15,061
General and administrative		6,495			3,242
Restructuring charges		363			98

Total operating expenses		28,232			24,090

Income (loss) from operations		(782	)		3,136

Other income, net		1,161			1,051

Income before provision for income taxes		379			4,187
Provision for income taxes		142			1,675

Net income	$	237		$	2,512

Net income per share — basic	$	0.01		$	0.07

Net income per share — diluted	$	0.01		$	0.07

Number of shares — basic		35,807			37,183

Number of shares — diluted		35,967			38,118

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

VERITY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands; unaudited)


	Three Months Ended August 31,
	2005			2004
Cash flow from operating activities:
Net income	$	237		$	2,512
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,996			2,403
Noncash restructuring charges		138			86
Tax benefit from disqualified dispositions		113			0
Provision for bad debt expense		141			(137	)
Deferred income taxes		18			1,333
Amortization of premium on securities, net		92			132
Stock-based compensation		0			5
Changes in operating assets and liabilities:
Trade accounts receivable		(1,159	)		5,069
Prepaid and other assets		960			162
Accounts payable		(2,570	)		(260	)
Accrued compensation		(27	)		556
Other accrued liabilities		(783	)		(638	)
Deferred revenue		3,046			(2,107	)

Net cash provided by operating activities		3,202			9,116

Cash flows from investing activities:
Acquisition of property and equipment		(725	)		(839	)
Purchases of investments		(3,369	)		(44,910	)
Maturity of investments		2,500			11,450
Proceeds from sale of investments		0			34,566
Purchase of businesses, net of cash acquired		0			(3,066	)
Intangible assets acquired		(1,425	)		0

Net cash used in investing activities		(3,019	)		(2,799	)

Cash flows from financing activities:
Proceeds from the sale of common stock, net of issuance costs		646			3,398
Repurchase of common stock		(4,998	)		(7,405	)

Net cash used in financing activities		(4,352	)		(4,007	)

Effect of exchange rate changes on cash and cash equivalents		76			(93	)

Net increase (decrease) in cash and cash equivalents		(4,093	)		2,217

Cash and cash equivalents, beginning of period		110,262			38,995

Cash and cash equivalents, end of period	$	106,169		$	41,212

Supplemental disclosure of cash flow information:
Cash paid for interest	$	—		$	67
Cash paid for income taxes	$	242		$	85

VERITY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Information as of August 31, 2005 and 2004 and for the three months ended August 31, 2005 and 2004 is unaudited)

1. Interim Financial Data

The unaudited condensed consolidated financial statements for Verity, Inc. (the “Company” or “Verity”) as of August 31, 2005 and May 31, 2005 and for the three month periods ended August 31, 2005 and 2004 have been prepared on the same basis as the Company’s audited financial statements and, in the opinion of management, include all material adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the financial position and results of operations in accordance with generally accepted accounting principles. Although certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”), the Company believes the disclosures made are adequate to make the information presented not misleading. The accompanying financial statements should be read in conjunction with the Company’s annual financial statements contained in the Company’s Annual Report on Form 10-K for the year ended May 31, 2005.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management’s estimates, judgments and assumptions are continually evaluated based on available information and experience; however, actual amounts could differ from those estimates. Certain prior period balances have been reclassified to conform to current period presentation.

The consolidated financial statements include the accounts of Verity, Inc. and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

The Company’s condensed consolidated balance sheet as of May 31, 2005 was derived from the Company’s audited financial statements, but does not include all disclosures necessary for the presentation to be in accordance with generally accepted accounting principles.

The Company’s critical accounting policies and estimates are discussed in its Annual Report on form 10-K for the fiscal year ended May 31, 2005. In addition, the Company is providing more detail on its contract accounting policies, as set forth below, than previously set forth in its periodic reports.

Revenue Recognition

The Company’s revenues are derived from license fees for software products and fees for services complementary to its products, including software maintenance, consulting and training. The Company derives nominal revenue from hardware product sales complementary to its software products.

The Company recognizes revenue in accordance with the American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition.” The SEC has issued Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements,” as amended by SAB No. 104, which provides guidance related to revenue recognition based on interpretations and practices followed by the SEC. Future interpretations of existing accounting standards or changes in the Company’s business practices could result in future changes in its revenue accounting policies that could have a material adverse effect on its financial position and results of operations.

The Company recognizes revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been delivered, the fees are fixed or determinable and collection of the resulting receivable is probable. Delivery generally occurs when the product is delivered to a common

carrier or made available to the customer for electronic download. At the time of the transaction, the Company assesses whether the fee associated with its revenue transactions is fixed or determinable and whether or not collection is probable. The Company assesses whether the fee is fixed or determinable based on the payment terms associated with the transaction. The Company assesses collection based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer.

The Company has arrangements with government agencies but very few contracts have fiscal funding clauses. Where such a clause exists, the Company obtains representation from the government customer that the funds are available and approved. Based on the representation received from the government customer, the Company has concluded that the probability of cancellation is remote and, in accordance with paragraphs 32-33 of SOP 97-2, revenue is recognized. In those cases where representation is not provided, the Company defers revenue until the representation or cash is received. The Company has not experienced instances of order cancellation, failure to collect accounts receivable, or concessions granted due to fiscal funding clauses.

For most sales, the Company uses either a binding purchase order or signed license agreement as evidence of an arrangement. The Company evidences sales through its distributors by a master agreement governing the relationship together with binding purchase orders on a transaction-by-transaction basis. The Company’s arrangements do not generally include acceptance clauses. However, if an arrangement includes an acceptance provision the Company defers revenue until the earlier of receipt of a written customer acceptance or expiration of the acceptance period.

The Company recognizes maintenance revenues from ongoing customer support and products upgrades ratably over the term of the applicable maintenance agreement, which is typically twelve months. Generally, the Company receives payments for maintenance fees in advance and they are nonrefundable. The Company recognizes revenues for consulting and training generally when the services are performed. The Company recognizes revenue for hardware sales generally when the product is delivered.

For agreements with multiple elements, such as license, maintenance, training, hardware and consulting services, the Company allocates revenue to each component of the arrangement based upon its fair value as determined by vendor specific objective evidence (“VSOE”). VSOE of fair value for all elements of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately. The Company defers revenue for any undelivered elements, and recognize revenue when the product is delivered or over the period in which the service is performed, in accordance with its revenue recognition policy for the element. If the Company cannot objectively determine the fair value of any undelivered element included in bundled software, hardware and service arrangements, the Company defers revenue until all elements are delivered and all services have been performed, or until VSOE of fair value can objectively be determined for any remaining undelivered elements. When the VSOE of fair value of a delivered element has not been established, the Company uses the residual method to record revenue if the fair value of all undelivered elements is determinable in accordance with SOP 98-9. Under the residual method, the Company defers the VSOE of fair value of the undelivered elements and allocates the remaining portion of the arrangement fee to the delivered elements and recognizes it as revenue.

Consulting revenue primarily consists of implementation services related to the installation of the Company’s software, which do not typically involve significant customization to or development of the underlying software code. Many of the Company’s software arrangements include consulting services sold separately under consulting service contracts. Consulting revenues from these arrangements are generally accounted for separately from new software product revenues. The factors considered in determining whether the revenue should be accounted for separately include (1) whether VSOE exists to permit allocation of the revenue to the various elements of the arrangement, (2) the nature of services (i.e., consideration of whether the services are essential to the functionality of any other element of the transaction), and (3) whether the total price of the arrangement would be expected to vary as a result of inclusion or exclusion of the services.

If an arrangement does not qualify for separate accounting of the software license and consulting transactions, then the entire arrangement is recognized applying contract accounting in accordance with the provisions of SOP No. 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.” Revenues from these arrangements are recognized under the percentage of completion method using an input method based on the ratio of direct labor hours incurred to date to total projected direct labor hours except in circumstances where completion status cannot be reasonably estimated or inherent hazards exist, in which case the completed contract method is used.

Most of the Company’s consulting service arrangements are billed on a time and materials basis and revenues are recognized as the services are performed unless there is a significant uncertainty about the project completion or receipt of payment. If such uncertainty exists, the Company defers revenue until the uncertainty is resolved.

Revenue is recognized for fixed fee consulting service arrangements by estimating proportional performance on a monthly basis utilizing hours incurred to date as a percentage of total estimated hours to complete the project. If the Company does not have a sufficient basis to measure progress towards completion, the Company defers revenue until it receives acceptance from the customer. If estimates of total cost exceed revenues, the Company accrues for the estimated loss on the arrangement.

2. Accounting for Computation of Net Income Per Share and Stock-Based Compensation

Basic net income per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted average number of common and potential common shares outstanding during the period. Dilutive potential common shares consist of “in-the-money” stock options. “In-the-money” options are those for which the exercise price is lower than the average market price of the Company’s common stock during the period. For the three months ended August 31, 2005 and 2004, 18,841,494 and 15,396,222 anti-dilutive weighted average potential shares, respectively, have been excluded from the diluted net income per share calculation.

The Company accounts for stock-based employee compensation arrangements under compensatory plans using the intrinsic value method, which calculates compensation expense based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the option exercise price.

Generally accepted accounting principles require companies that choose to account for stock option grants using the intrinsic value method also to determine the fair value of option grants using a stock option pricing model such as the Black-Scholes model and to disclose the impact of fair value accounting in a note to the financial statements. The impact of recognizing the fair value of option grants and stock grants under the Company’s employee stock option and stock purchase plans as an operating expense would have reduced the Company’s net income to a net loss, as follows (in thousands, except per share amounts):


	Three Months Ended August 31,
	2005			2004
Net income
Net income — as reported	$	237		$	2,512

Deduct: Total SFAS 123 stock-based employee compensation expense, net of related tax effects		(2,642	)		(5,401	)

Add: Stock compensation expense included in reported net income, net of related tax effects		0			3

Net loss — pro forma	$	(2,405	)	$	(2,886	)

Earnings per share
Net income per share — basic — as reported	$	0.01		$	0.07

Net loss per share — basic — pro forma	$	(0.07	)	$	(0.08	)

Net income per share — diluted — as reported	$	0.01		$	0.07

Net loss per share — diluted — pro forma	$	(0.07	)	$	(0.08	)

Number of shares used in basic — as reported calculation		35,807			37,183

Number of shares used in diluted — as reported calculation		35,967			38,118

Number of shares used in basic and diluted — pro forma calculation		35,807			37,183

The Company calculated the fair value of each option grant on the date of grant using the Black-Scholes option pricing model. The following assumptions were used for each respective period:


	Three Months Ended August 31,
	2005		2004
Stock Option Plans
Expected volatility	38	%	78	%
Risk-free interest rate	3.85	%	3.22	%
Expected life	2.00 years		4.09 years
Expected dividend yield	0.00	%	0.00	%

Stock Purchase Plan
Expected volatility	38	%	62	%
Risk-free interest rate	2.97	%	1.13	%
Expected life	0.82 years		0.90 years
Expected dividend yield	0.00	%	0.00	%

3. Investments

As of August 31, 2005, available-for-sale securities consist of the following (in thousands):


	Amortized Cost		Gross Unrealized Losses			Fair Value
Short-term investments:
Municipal securities	$	4,753	$	(26	)	$	4,727
Corporate notes		4,841		(42	)		4,799
Government securities		50,498		(559	)		49,939

Short-term investments		60,092		(627	)		59,465

Long-term investments:
Corporate notes		4,627		(77	)		4,550
Government securities		21,995		(332	)		21,663

Long-term investments		26,622		(409	)		26,213

Total investments	$	86,714	$	(1,036	)	$	85,678

At August 31, 2005, scheduled maturities of investments classified as available-for-sale are as follows (in thousands):


Within one year	$	59,465
After one year through two years		26,213
After two years through three years		—
After three years		—

	$	85,678

As of May 31, 2005, available-for-sale securities consist of the following (in thousands):


	Amortized Cost		Gross Unrealized Losses			Fair Value
Short-term investments:
Municipal securities	$	1,375	$	(10	)	$	1,365
Corporate notes		6,392		(49	)		6,343
Government securities		33,001		(333	)		32,668

Short-term investments		40,768		(392	)		40,376

Long-term investments:
Municipal securities		1,000		(21	)		979
Corporate notes		4,665		(73	)		4,592
Government securities		39,495		(563	)		38,932

Long-term investments		45,160		(657	)		44,503

Total investments	$	85,928	$	(1,049	)	$	84,879

At May 31, 2005, scheduled maturities of investments classified as available-for-sale are as follows (in thousands):


Within one year	$	40,376
After one year through two years		43,503
After two years through three years		1,000
After three years		—

	$	84,879

4. Deferred Purchase Payment

In June 2005, the Company completed a software asset purchase for $1.7 million from 80-20 Software. ( See Note 9 to Condensed Consolidated Financial Statements in this Form 10-Q.) Of the total purchase price, the Company deferred $150,000 to secure any indemnification obligations under the Software Acquisition Agreement. The Company believes that the likelihood of an event requiring indemnification is remote and that the Company will be obligated to pay the remaining $150,000 in June 2006.

On March 3, 2004, the Company acquired the intellectual property, customer agreements, and certain other assets from NativeMinds, Inc., for $3.9 million. The Company accounted for the NativeMinds transaction as a purchase of a business. Of the total purchase price, the Company deferred $0.8 million to secure NativeMinds’ indemnification obligations under the Purchase Agreement. The Company paid $0.2 million of this deferred payment obligation in the fourth quarter of fiscal 2004. NativeMinds met the remaining indemnification obligations under the agreement and the Company paid the remaining $0.6 million in September 2005.

5. Comprehensive Income

Comprehensive income is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-operational sources, such as foreign currency translation gains and losses and unrealized gains and losses on fixed income securities that are reflected in stockholders’ equity instead of net income.

The following table sets forth the calculation of comprehensive income (in thousands):


	Three Months Ended August 31,
	2005			2004
Net income	$	237		$	2,512
Unrealized gains on available for sale investments, net		30			276
Foreign currency transalation adjustments		(22	)		(70	)

Comprehensive income	$	245		$	2,718

6. Foreign Sales and Segment Reporting

The Company has adopted the provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS No. 131”) which establishes standards for the manner in which public companies report information about operating segments in annual and interim financial statements. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The method for determining the information to report is based on the way management organizes the operating segments within the Company for making operating decisions and assessing financial performance.

The Company’s chief operating decision-maker is considered to be the Chief Executive Officer. The Chief Executive Officer reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. On this basis, the Company is organized and operates in a single segment: developing, marketing and supporting infrastructure products for corporate intranets, extranets, websites, corporate portals, business applications, online publishers and e-commerce providers and original equipment manufacturer toolkits for independent software vendors.

The Company evaluates the performance of its geographic regions based only on revenues. The Company does not assess the performance of its geographic regions on other measures of income or expense, such as depreciation and amortization, operating income or net income. In addition, the Company’s assets are primarily located in the United States and not allocated to any specific region. The Company does not produce reports for, or measure the performance of, its geographic regions using any asset-based metrics. Therefore, geographic information is presented only for revenues.

The following geographic information for total revenues is presented for the three months ended August 31, 2005 and 2004 (in thousands):


	Three Months Ended August 31,
	2005		2004
United States	$	25,326	$	23,828
United Kingdom		2,135		3,364
Other Europe		4,436		5,108
Other foreign		3,586		2,322

	$	35,483	$	34,622

7. Stock Repurchase Program

On June 30, 2005, Verity’s Board of Directors approved a $50.0 million stock repurchase program whereby the Company is authorized to repurchase up to $50.0 million of common stock in fiscal 2006. The program will terminate at the end of the fiscal year ending May 31, 2006 unless amended by the Board of Directors. Verity repurchased and retired 514,577 and 571,892 shares, valued at approximately $5.0 million and $7.4 million, in the three month periods ended August 31, 2005 and 2004, respectively.

8. Restructuring Costs

Restructuring-related costs have been and will be recorded in accordance with SFAS No. 112, “Employers’ Accounting for Postemployment Benefits” or SFAS No. 146, “Accounting for the Costs Associated with Exit or Disposal Activities,” as appropriate.

In May of 2005, the Company recorded a restructuring charge of approximately $1.1 million primarily related to severance costs associated with the reduction in force of approximately 32 employees, which the Company implemented in June 2005.

During the three months ended August 31, 2005, the Company recorded an additional restructuring charge of $0.4 million for severance in relation to the announced reduction in force implemented in June 2005.

During the three month period ended August 31, 2004, we incurred a facility restructuring charge of $0.1 million related to the closing of our UK Cardiff facility in July of 2004.

The following table summarizes the restructuring expenses incurred during the three months ended August 31, 2005 and the remaining obligations related to the restructurings as of May 31, 2005 and August 31, 2005 (in thousands):


	Severance			Facilities and other			Legal and outside services		Total
At May 31, 2005	$	1,068		$	341		$	38	$	1,447

Charges		377			—			—		377
Adjustments		(14	)		—			—		(14	)
Paid		(1,083	)		(90	)		—		(1,173	)

At Aug. 31, 2005	$	348		$	251		$	38	$	637

The remaining $0.3 million balance relating to severance will be paid in the second quarter of fiscal 2006. The remaining $0.3 million facilities and other balance will be paid out ratably through June 2006. The remaining $38,000 legal and outside services balance will be paid out in the second quarter of fiscal 2006. The accrued severance is categorized as accrued compensation, and the accrued facilities and legal and outside services is categorized as other accrued liabilities on the Company’s Condensed Consolidated Balance Sheets.

The following table summarizes the restructuring expenses incurred during the three months ended August 31, 2004 and the remaining obligations related to the restructurings as of May 31, 2004 and August 31, 2004 (in thousands):


	Severance		Facilities and other			Legal and outside services		Total
At May 31, 2004	$	259	$	103		$	—	$	362

Charges		—		98			—		98
Adjustments		—		—			—		—
Paid		—		(11	)		—		(11	)

At Aug. 31, 2004	$	259	$	190		$	—	$	449

9. Acquisitions, Goodwill and other Intangible Assets

80-20 Software Limited, In June 2005, the Company entered into a definitive software acquisition agreement and acquired a desktop search application and other assets from 80-20 Software, a privately held software company, headquartered in Melbourne, Australia. Verity has rebranded “Retriever” as “Verity Enterprise Desktop Search” and believes this product to be complimentary to its current Enterprise Search technologies, namely K2 and Ultraseek.

The total purchase price for the 80-20 assets is as follows (in thousands):


Cash	$	1,380
Deferred payment		150
Acquisition costs		211

Total purchase price	$	1,741

The Company accounted for the 80-20 Software Limited transaction as a asset purchase, and the total purchase consideration of approximately $1.7 million (including cash, deferred payment, and acquisition costs) was allocated to identifiable intangible assets based upon their estimated fair value as of the date of completion of the acquisition. The $1.7 million of total purchase consideration includes $150,000 paid to a third party escrow agent and to be paid to 80-20 shareholders in June of 2006, which was recorded as a deferred purchase payment on the Company’s Condensed Consolidated Balance Sheets. The Company believes the likelihood of an event requiring indemnification is remote and therefore has recorded the entire amount held in the third party escrow account in the purchase price.

The purchase price was allocated as follows (in thousands):


Developed technology	$	1,402
Customer relationships		278
Workforce in place		61

Total purchase price	$	1,741

The useful life for developed technology is four years, and the useful lives for customer relationships and workforce in place are two years.

Dralasoft, Inc.On December 16, 2004, the Company acquired Dralasoft, Inc., a privately held software company, headquartered in Colorado. Dralasoft is a leading innovator of Java-based technology for business process management (“BPM”). The acquired technology portfolio originally named Dralasoft Workflow, re-branded Verity LiquidBPM, is a comprehensive enterprise BPM suite that features a high-performance and scalable orchestration engine with a suite of graphical tools. In addition, LiquidBPM is an embedded application found in many leading software products used in several vertical markets, such as manufacturing, government, retailing, telecommunications, defense, law, education, entertainment and agriculture.

The total purchase price for Dralasoft is as follows (in thousands):


Cash	$	8,214
Acquisition costs		133

Total purchase price	$	8,347

In accordance with SFAS No. 141, “Business Combinations” (“SFAS No. 141”), the Company accounted for the Dralasoft transaction as a purchase of a business, and the total purchase consideration of approximately $8.3 million was allocated to net tangible and identifiable intangible assets based upon their estimated fair value as of the date of completion, and the residual of $3.9 million was recorded as goodwill. The $8.3 million of total purchase consideration includes approximately $1.2 million paid to a third party escrow agent and to be paid to Dralasoft’s shareholders 18 months from the acquisition. The future payments are subject to no breaches of the representations and warranties set forth in the definitive acquisition agreement. The Company believes that the likelihood of a breach is remote, and therefore has recorded the entire $1.2 million as purchase consideration.

The purchase price was allocated as follows (in thousands):


Developed technology	$	4,030
Customer relationships		890

Total amortizable intangible assets	$	4,920
In-process research and development		950
Fair value of net tangible assets acquired		586
Deferred tax liability assumed		(2,022	)
Goodwill		3,913

Total purchase price	$	8,347

The useful lives for developed technology and customer relationships are four years and five years, respectively.

The amount of the purchase price allocated to in-process research and development was based on established valuation techniques used in the high technology and the computer software industry. The fair value assigned to the acquired in-process research and development was determined using the income approach, which discounts expected future cash flows to present value. The key assumptions used in the valuation include, among others, the expected completion date of the in-process projects identified as of the acquisition date, the estimated costs to complete the projects, revenue contributions and expense projections assuming the resulting products have entered the market, and the discount rate based on the risks associated with the development life cycle of the in-process research and development acquired. The discount rate used in the present value calculations are normally obtained from a weighted-average cost of capital analysis, adjusted upward to account for the inherent uncertainties surrounding the successful development of the in-process research and development, the expected profitability levels of such technology, and the uncertainty of technological advances that could potentially impact the estimates. The Company assumes the pricing model for the resulting product of the acquired in-process research and development to be standard within its industry. The Company, however, did not take into consideration any consequential amount of expense reductions from integrating the acquired in-process research and development with other existing in-process or completed technology. Therefore, the valuation assumptions do not include significant anticipated cost savings.

The key assumptions underlying the valuation of acquired in-process research and development from Dralasoft are as follows:

IPR&D Product

Leverage

Factor

Discount

Rate

Expected
Revenue

BPM

Q1 2006

Pro-Forma information has not been provided as the acquisition is not material to the results of operations of the Company.

Goodwill and Other Intangible Assets

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), the Company no longer amortizes goodwill but will test it for impairment annually or whenever events or changes in circumstances suggest that the carrying amount may not be recoverable. The Company prepared an annual impairment analysis during the quarter ended February 28, 2005, and concluded that no impairment had occurred.

The following table sets forth the carrying amount of goodwill (in thousands):


Goodwill:
Balances as of May 31, 2005	$	59,428
Add: acquisitions		—
Less: adjustments		—

Balances as of August 31, 2005	$	59,428

The following tables set forth the carrying amount of other intangible assets that will continue to be amortized (in thousands):


	August 31, 2005
	Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount
Developed technology	$	31,900	$	12,838	$	19,062
Customer relationships		3,656		1,069		2,587
Tradename		644		235		409
Workforce in place		61		7		54

Total other intangible assets	$	36,261	$	14,149	$	22,112


	May 31, 2005
	Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount
Developed technology	$	30,498	$	11,015	$	19,483
Customer relationships		3,378		838		2,540
Tradename		644		195		449
Workforce in place		—		—		—

Total other intangible assets	$	34,520	$	12,048	$	22,472

Total amortization expense of intangible assets related to acquisitions is set forth in the table below (in thousands):


	Three Months ended
	August 31, 2005		August 31, 2004
Developed technology	$	1,823	$	1,493
Customer relationships		231		155
Tradename		40		41
Workforce in place		7		—

Total other intangible assets	$	2,101	$	1,689

The total expected future annual amortization of intangible assets related to acquisition is set forth in the table below (in thousands):


	Future Amortization
2006	$	6,348
2007		8,419
2008		6,165
2009		1,074
2010		106

Total	$	22,112

10. Legal Proceedings

On October 22, 2004, Inxight Software, Inc., a privately held company, filed a complaint in the Superior Court of California for the County of Santa Clara against the Company, alleging, among other things, breach of contract and trade secret misappropriation, and that the Company had otherwise exceeded its rights under its license agreement with Inxight. Inxight is seeking, among other things, monetary damages of at least $1.0 million and injunctive relief commanding the Company to cease distributing Inxight’s product.

On December 3, 2004, the Company filed an answer and cross-complaint against Inxight, in response to Inxight’s complaint that was filed on October 22, 2004. The Company’s answer and cross-complaint seek a declaration that the Company has acted within its rights under the license agreement, and that Inxight’s purported termination of the license subsequent to the filing of its complaint was invalid. In addition, the Company’s cross-claim alleges that Inxight itself has breached the license by purporting to terminate the parties’ license without cause, and that it has wrongfully interfered in the Company’s business operations, and that such breach and wrongful conduct has caused injury to the Company in excess of $1.0 million. The Company also alleges that Inxight wrongfully induced one of the Company’s former employees, who is now employed at Inxight, to breach certain confidentiality obligations related to confidential and proprietary information of the Company.

On December 20, 2004, the Company filed a separate and independent suit against Inxight in federal court for claims arising from Inxight’s July 24, 1998 license to use the Company’s copyrighted KeyView product (the “KeyView License”) (U.S.D.C. N.D. Cal. Case No. 04-CV-05387 CRB). The Company claims that Inxight has infringed and will continue to infringe the Company’s federally registered copyrights in and related to KeyView by virtue of Inxight’s use, marketing, distribution and licensing of KeyView with applications that are not authorized under the KeyView License. Inxight’s state complaint and the Company’s federal complaint have now been consolidated in the United States District Court for the Northern District of California, Case No. 04-CV-05387 CRB (JL).

Inxight has filed three motions for summary judgment on several claims and defenses in the consolidated action, including (1) Inxight’s claims that the Company has exceeded the scope of the parties’ license and misappropriated Inxight’s trade secrets by selling software with embedded Inxight technology to OEMs; (2) the Company’s claims against Inxight and the former Company employee relating to his unauthorized disclosure to Inxight of the Company’s confidential and proprietary information to Inxight; and (3) all of the Company’s claims relating to Inxight’s use of the Company’s KeyView software. These motions are presently scheduled to be heard on October 7, 2005. Trial of the consolidated actions is currently scheduled to begin on October 11, 2005.

On September 20, 2005, Inxight filed papers with the Court requesting permission to supplement its claims against Verity and to add Verity’s replacement technology vendor, an Inxight competitor, to the consolidated action. Inxight alleges that Verity has shared Inxight’s trade secrets with Verity’s replacement vendor.

On September 21, 2005, Inxight filed a motion for a temporary restraining order to enjoin the Company and the Company’s replacement vendor from using, disclosing, licensing or otherwise transferring any technology that Inxight alleges is derived from unauthorized use of Inxight technology after October 28, 2004, or is based upon any confidential information provided by the Company which Inxight alleges the Company was bound to protect subject to a preexisting nondisclosure obligation.

Verity is subject to certain other legal proceedings and claims that arise in the ordinary course of business. Management believes that Verity’s legal positions in the Inxight litigation and these other legal proceedings and claims are meritorious. As of August 31, 2005, no amount is accrued for Inxight or other legal proceedings as a loss is not considered probable and estimable. While the outcome of these proceedings and claims cannot be predicted with certainty, management does not believe that the loss in these matters will have a material adverse effect on Verity’s condensed consolidated financial position, although results of operations or cash flows could be affected in a particular period.

Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the consolidated financial statements and related notes, which appear in our Annual Report on Form 10-K for the fiscal year ended May 31, 2005. The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly under the heading “Risks Relating to Our Operations” below.

Overview

We are a leading provider of software that enables private and public sector organizations to discover, analyze and process the information in their corporate repositories, applications and systems. In great part, this is the convergence of many core markets in which we have participated for years, including search, corporate portals, and e-commerce, as well as markets we have recently entered, including question and answer interfaces, content capture and business process management, among others.

We develop, market and support two product families: enterprise search and business process management. Enterprise search is a broad category that includes search, classification, recommendation, monitoring/alerting, and question and answer infrastructure products for corporate intranets, extranets, websites, corporate portals, business applications, online publishers and e-commerce providers, and original equipment manufacturer (“OEM”) toolkits for independent software vendors. Our comprehensive and integrated enterprise search products enable numerous enterprise-wide functionalities, all from the same underlying Verity information index. These products organize and provide simple, single-point access to information across the entire enterprise. In doing so, our products can be used to create or enhance Web applications and standalone applications that leverage the value of existing investments in intranets and business applications. Business process management (“BPM”) applications enable the information on paper and electronic forms to be captured in electronic form, and for manual processes that utilize that information to be automated over corporate networks. Our BPM products include capabilities for forms design, scanning, optical character recognition, forms recognition, validation, verification, process automation and routing. Our search technology has been integrated into these products in order to provide real-time search of information while it is in process.

Our software has been licensed to over 15,000 corporations, government agencies, software developers, information publishers and e-commerce vendors. We pursue sales opportunities within corporations and government agencies through the efforts of our direct sales force and through a network of value added resellers and system integrators. We also sell OEM toolkits to independent software vendors that embed Verity technology in their products or services.

Recent Acquisitions

80-20 Software Limited,In June 2005, we entered into a definitive software acquisition agreement and acquired a desktop search application and other assets from 80-20 Software, a privately held software company, headquartered in Melbourne, Australia. We have re-branded “Retriever” as “Verity Enterprise Desktop Search” and believe this product to be complimentary to our current Enterprise Search technologies, namely, K2 and Ultraseek.

We accounted for the 80-20 Software Limited transaction as a asset purchase, and the total purchase consideration of approximately $1.7 million (including cash, deferred payment, and acquisition costs) was allocated to identifiable intangible assets based upon their estimated fair value as of the date of completion of the acquisition. The $1.7 million of total purchase consideration includes $150,000 paid to a third party escrow agent to secure any indemnification obligations under the Purchase Agreement and to be paid to 80-20 shareholders in June of 2006 less any amounts required to meet the indemnification obligations, which was recorded as a deferred purchase payment on our Consolidated Balance Sheets. We believe the likelihood of an event requiring indemnifications is remote and therefore have recorded the entire amount held in the third party escrow account in the purchase price.

Dralasoft, Inc. On December 16, 2004, we acquired Dralasoft, Inc., a privately held software company and a leading innovator of Java-based technology for BPM. The acquired technology portfolio originally named Dralasoft Workflow, re-branded Verity LiquidBPM, is a comprehensive enterprise BPM suite that features a high-performance and scalable orchestration engine with a suite of graphical tools. In addition, LiquidBPM is an embedded application found in many leading software products used in several vertical markets, such as manufacturing, government, retailing, telecommunications, defense, law, education, entertainment and agriculture.

In accordance with SFAS No. 141, “Business Combinations” (“SFAS No. 141”), we accounted for the Dralasoft transaction as a purchase of a business, and the total purchase consideration of approximately $8.3 million (including cash and acquisition costs) was allocated to net tangible and identifiable intangible assets based upon their estimated fair value as of the date of completion and the residual of $3.9 million was recorded as goodwill. The $8.3 million of total purchase consideration includes approximately $1.2 million placed into a third party escrow account to be paid to Dralasoft’s shareholders 18 months from the acquisition. The future payments are subject to Dralasoft and certain Dralasoft shareholders meeting certain obligations outlined under the representations and warranties sections of the definitive merger agreement. We believe that Dralasoft and such shareholders will meet these obligations and therefore have recorded the entire $1.2 million as purchase consideration.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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 assets and liabilities. On an on-going basis, we evaluate our critical accounting policies and estimates, including those related to revenue recognition, bad debts, income taxes and intangible assets. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our Annual Report on form 10-K for the fiscal year ended May 31, 2005. In addition, we are providing below more detail on our contract accounting policies than we have previously provided in our periodic reports.

Revenue Recognition

Our revenues are derived from license fees for our software products and fees for services complementary to our products, including software maintenance, consulting and training. We also derive nominal revenue from hardware product sales complementary to our software products.

We recognize revenue in accordance with the American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition.” The Securities and Exchange Commission (“SEC”) has issued Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements,” as amended by SAB No. 104, which provides guidance related to revenue recognition based on interpretations and practices followed by the SEC. Future interpretations of existing accounting standards or changes in our business practices could result in future changes in our revenue accounting policies that could have a material adverse effect on our financial position and results of operations.

We recognize revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been delivered, the fees are fixed or determinable and collection of the resulting receivable is probable. Delivery generally occurs when the product is delivered to a common carrier or made available to the customer for electronic download. At the time of the transaction, we assess whether the fee associated with our revenue transactions is fixed or determinable and whether or not

collection is probable. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction. We assess collection based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer.

We have arrangements with government agencies but very few contracts have fiscal funding clauses. Where such a clause exists, we obtain representation from the government customer that the funds are available and approved. Based on the representation received from the government customer, we have concluded that the probability of cancellation is remote and, in accordance with paragraphs 32-33 of SOP 97-2, revenue is recognized. In those cases where representation is not provided, we defer revenue until representation or cash is received. We have not experienced instances of order cancellation, failure to collect accounts receivable, or concessions granted due to fiscal funding clauses.

For most sales, we use either a binding purchase order or signed license agreement as evidence of an arrangement. We evidence sales through our distributors by a master agreement governing the relationship together with binding purchase orders on a transaction-by-transaction basis. Our arrangements do not generally include acceptance clauses. However, if an arrangement includes an acceptance provision we defer revenue until the earlier of receipt of a written customer acceptance or expiration of the acceptance period.

We recognize maintenance revenues from ongoing customer support and product upgrades ratably over the term of the applicable maintenance agreement, which is typically twelve months. Generally, we receive payments for maintenance fees in advance and they are nonrefundable. We recognize revenues for consulting and training generally when the services are performed. We recognize revenue for hardware sales generally when the product is delivered.

For agreements with multiple elements, such as license, maintenance, training, hardware and consulting services, we allocate revenue to each component of the arrangement based upon its fair value as determined by vendor specific objective evidence (“VSOE”). VSOE of fair value for all elements of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately. We defer revenue for any undelivered elements, and recognize revenue when the product is delivered or over the period in which the service is performed, in accordance with our revenue recognition policy for the element. If we cannot objectively determine the fair value of any undelivered element included in bundled software, hardware and service arrangements, we defer revenue until all elements are delivered and all services have been performed, or until VSOE of fair value can objectively be determined for any remaining undelivered elements. When the VSOE of fair value of a delivered element has not been established, we use the residual method to record revenue if the fair value of all undelivered elements is determinable in accordance with SOP 98-9. Under the residual method, we defer the VSOE of fair value of the undelivered elements and allocate the remaining portion of the arrangement fee to the delivered elements and recognize it as revenue.

Consulting revenue primarily consists of implementation services related to the installation of our software, which do not typically involve significant customization to or development of the underlying software code. Many of our software arrangements include consulting services sold separately under consulting service contracts. Consulting revenues from these arrangements are generally accounted for separately from new software product revenues. The factors considered in determining whether the revenue should be accounted for separately include (1) whether VSOE exists to permit allocation of the revenue to the various elements of the arrangement, (2) the nature of services (i.e., consideration of whether the services are essential to the functionality of any other element of the transaction), and (3) whether the total price of the arrangement would be expected to vary as a result of inclusion or exclusion of the services.

Most of our consulting service arrangements are billed on a time and materials basis and revenues are recognized as the services are performed unless there is a significant uncertainty about the project completion or receipt of payment. If such uncertainty exists, we defer revenue until the uncertainty is resolved.

Revenue is recognized for fixed fee consulting service arrangements by estimating proportional performance on a monthly basis utilizing hours incurred to date as a percentage of total estimated hours to complete the project. If we do not have a sufficient basis to measure progress towards completion, we defer revenue until we receive acceptance from the customer. If estimates of total cost exceed revenues, we accrue for the estimated loss on the arrangement.

Results of Operations

The following table sets forth the percentage of total revenues represented by certain items in our Condensed Consolidated Statements of Operations for the periods indicated:


	Three Months Ended August 31,
	2005		2004
Revenues:
Software products	56.3	%	56.9	%
Service and other	43.7		43.1

Total revenues	100.0		100.0

Costs of revenues:
Software products	2.6		2.1
Service and other	14.1		14.4
Amortization of purchased intangible assets	5.9		4.9

Total costs of revenues	22.6		21.4

Gross profit	77.4		78.6
Operating expenses:
Research and development	19.2		16.4
Marketing and sales	41.1		43.5
General and administrative	18.3		9.4
Restructuring charge	1.0		0.3

Total operating expenses	79.6		69.6

Income (loss) from operations	(2.2	)	9.0
Other income, net	3.3		3.0

Income before provision for income taxes	1.1		12.0
Provision for income taxes	0.4		4.8

Net income	0.7	%	7.2	%

Quarters Ended August 31, 2005 and 2004

Revenues


	Three Months Ended August 31,
Total revenues	2005		2004		Dollar Change		Percent Change
	*(dollars in millions)*
Total revenues	$	35.5	$	34.6	$	0.9	2.6	%

The increase in total revenues for the three month period ended August 31, 2005, compared with the same period a year ago, was due to a $0.3 million increase in our software product revenues and to a $0.6 million increase in our service and other revenues.

In practice, we track most closely and calculate our average selling prices only for those deals which total $40,000 or more in the total deal size (product and services). The increase in total revenues in our first quarter of fiscal 2006 as compared to our first quarter of fiscal 2005 was due both to an increase in the total number of customer transactions for deal sizes greater than $40,000 and to an increase in average selling price. These increase were substantially offset by decreased volumes associated with transactions less than $40,000 primarily related to decreased revenue of our BPM products.

We expect volumes of transactions and total revenues to increase throughout fiscal 2006 as we expect to maintain a growth rate consistent with the overall growth rates of the markets that we serve. These expectations are based on assumptions we believe are reasonable, but actual results may differ from our expectations as a result of the risks set forth in “Risks Relating to Our Operations” at the end of this Item 2. of this form 10-Q.

Revenues derived outside of the U.S. accounted for 28.6% and 31.2% of total revenues for the three month periods ended August 31, 2005 and 2004, respectively. Our export sales consist of products licensed for delivery outside of the United States. In the three month periods ended August 31, 2005 and 2004, export sales accounted for 12.8% and 17.5% of total revenues, respectively.

No single customer accounted for 10% or more of our revenues during the three month periods ended August 31, 2005 and 2004. Revenues derived from sales to the federal government and its agencies were 6.8% and 12.4% of total revenues in the three month periods ended August 31, 2005 and 2004, respectively. We expect total revenues to government agencies will continue to fluctuate as a percentage of revenues in the future.

Historically, our total deferred revenue was principally comprised of maintenance and support revenues. In our first fiscal quarter of 2006, however, we entered into a significant license and service transaction from which we recorded deferred revenue comprising more than 10% of the total deferred revenue. The services within this arrangement are considered to be essential to the functionality of the software. We expect the license and service revenues associated with this transaction to be recognized within the next six fiscal quarters as services are rendered and therefore the deferred revenue associated with this transaction to be significant to our total deferred revenue balance for the next two to four fiscal quarters.


Software product revenues	Three Months Ended August 31,
Software product revenues	2005			2004			Dollar Change		Percent Change
	*(dollars in millions)*
Software product revenues	$	20.0		$	19.7		$	0.3	1.5	%
Percentage of total revenues		56.3	%		56.9	%

Our software product revenues consist primarily of fees for software licenses. Our license revenues for our software products increased by $0.3 million for the fiscal quarter ended August 31, 2005 compared to the same period in the prior year.

We saw an increase in demand for our software products in the first fiscal quarter of 2006, compared with the first fiscal quarter of 2005. The increase in software product revenues during this period was due primarily to the following:

•

increased number of sales transactions for transactions greater than $40,000; and

•

modest increase in average sales prices for transactions greater than $40,000.

However, these increases were substantially offset by,

•

decreased volume of transactions less than $40,000 primarily attributable to lower sales of BPM products.

Software product revenues in the first quarter of fiscal 2004 included the recognition of past royalties in connection with our confidential settlement with BroadVision related to our outstanding litigation. This revenue accounted for less than 5% of total revenues in the period.


Service and other revenues	Three Months Ended August 31,
Service and other revenues	2005			2004			Dollar Change		Percent Change
	*(dollars in millions)*
Service and other revenues	$	15.5		$	14.9		$	0.6	4.0	%
Percentage of total revenues		43.7	%		43.1	%

Our service and other revenues consist primarily of fees for software maintenance, consulting and training.

The increase in service and other revenues for the three month period ended August 31, 2005, compared with the same period a year ago, was due to $0.4 million in decreased sales of consulting services and to $1.0 million in increased maintenance revenues. The $0.4 million decrease in consulting services revenues is primarily due to the decreased number of consulting engagements. The $1.0 million increase in maintenance revenues resulted primarily from increased maintenance contracts entered into on new licensing agreements and renewals on a larger install base.

Costs of Revenues


Costs of software products	Three Months Ended August 31,
Costs of software products	2005			2004			Dollar Change		Percent Change
	*(dollars in millions)*
Costs of software products	$	0.9		$	0.7		$	0.2	28.6	%
Percentage of software product revenues		4.5	%		3.7	%

Costs of software products consist primarily of product media, duplication, manuals, packaging materials, shipping expenses, employee compensation expenses, and in certain instances, the licensing of third-party software incorporated in our products.

The $0.2 million increase in costs of software products for the first quarter of fiscal 2006, compared with the same period in the prior year, was primarily attributable to $0.1 million increased compensation costs resulted from increased headcount, and incremental manufacturing costs from product releases.


Costs of services and other	Three Months Ended August 31,
Costs of services and other	2005			2004			Dollar Change	Percent Change
	*(dollars in millions)*
Costs of services and other	$	5.0		$	5.0		—	0.0	%
Percentage of services and other revenues		32.3	%		33.3	%

Costs of service and other consists of costs incurred in providing consulting services, customer training, telephone support and product upgrades to customers. Significant cost components include personnel-related and third-party contractor costs, facilities costs, travel expenses associated with training and consulting implementation services, depreciation expense and corporate overhead allocations.

The relatively constant costs of service and other in absolute dollars from the first quarter of fiscal 2006 to the first quarter of fiscal 2005, was due to a offsetting $0.4 million decrease in consulting and outside services and a $0.4 million increase in third-party contractors to provide professional service.


Amortization of purchased intangible assets	Three Months Ended August 31,
Amortization of purchased intangible assets	2005			2004			Dollar Change		Percent Change
	*(dollars in millions)*
Amortization of purchased intangible assets	$	2.1		$	1.7		$	0.4	23.5	%
Percentage of total revenues		5.9	%		4.9	%

During the three month period ended August 31, 2005, we amortized $2.1 million of the purchased intangible assets in connection with acquired developed technology, patents, customer relationships, tradenames, and maintenance agreements associated with all previous acquisitions. The increase in amortization of purchased intangible assets in the first quarter of fiscal 2006 as compared to the first quarter of fiscal 2005 was attributable to $0.4 million increased amortization of purchased intangible assets associated with our Dralasoft and 80-20 acquisitions which we closed in December of 2004 and June of 2005, respectively. We expect amortization of purchased intangible assets to be $2.1 million per quarter for the remainder of fiscal 2006. See Note 9 to Notes to Consolidated Financial Statements for scheduled amortization of purchased intangible assets beyond fiscal 2006.

Operating Expenses


Research and development	Three Months Ended August 31,
Research and development	2005			2004			Dollar Change		Percent Change
	*(dollars in millions)*
Research and development	$	6.8		$	5.7		$	1.1	19.3	%
Percentage of total revenues		19.2	%		16.4	%

Research and development expenses consist primarily of employee compensation and benefits, payments to outside contractors, depreciation on equipment used for development and corporate overhead allocations. We believe that research and development is essential to maintaining our competitive position and we will continue to make significant investments in research and development with the goal of continuing to align research and development expenses with anticipated revenues. Beyond our first quarter of fiscal 2006, we anticipate that research and development expenses will increase modestly resulting from annual compensation increases and selective increases in headcount.

The $1.1 million increase in research and development expenses in absolute dollars for fiscal 2006 compared with the same period in the prior year was primarily due to $ 0.5 million in increased compensation and other employee related expenses on increased headcount, resulting primarily from our acquisitions of Dralasoft and 80-20, $0.4 million in increased allocations for both management information systems and facilities resulting from an increased share of these shared services based on the increased headcount, and $0.2 million in increased contracted outside services due to an increase in overall consulting services used by us.


Marketing and sales	Three Months Ended August 31,
Marketing and sales	2005			2004			Dollar Change			Percent Change
	*(dollars in millions)*
Marketing and sales	$	14.6		$	15.1		$	(0.5	)	(3.3	)%
Percentage of total revenues		41.1	%		43.5	%

Marketing and sales expenses consist primarily of employee compensation, including sales commissions and benefits, tradeshows, outbound marketing and other lead generation activities, public relations, travel expenses associated with our sales staff and corporate overhead allocations. Beyond our first quarter of fiscal 2006, we anticipate that marketing and sales expenses will increase modestly as a result of planned annual compensation increases and from planned increased headcount and lead generation activities necessary to support our increased revenue projections in the second half of fiscal 2006.

The decrease in marketing and sales expenses in absolute dollars from the first quarter of fiscal 2005 to the first quarter of fiscal 2006 was primarily due to a $1.0 million decrease in compensation related expenses, including travel and entertainment, on decreased sales and marketing headcount due to a reduction in force that occurred at the beginning of June 2005, and offset in part by increase in additional advertising spending for the quarter.


General and administrative	Three Months Ended August 31,
General and administrative	2005			2004			Dollar Change		Percent Change
	*(dollars in millions)*
General and administrative	$	6.5		$	3.2		$	3.3	103.1	%
Percentage of total revenues		18.3	%		9.4	%

General and administrative expenses consist primarily of personnel costs for finance, legal, human resources and general management, provisions for doubtful accounts, insurance, fees for external professional advisors and corporate overhead allocations.

The increase in general and administrative expenses in absolute dollars in the first fiscal quarter of 2006 as compared to the first quarter of fiscal 2005 was primarily due to a $1.0 million increase in salary related expenses associated with increased headcount to support a growing and more complex infrastructure, a $2.0 million increase in outside services primarily to support the Sarbanes-Oxley compliance requirements associated with our year end close and legal costs related to litigation, and $0.2 million increase in bad debt provision due to specific reserves.


Restructuring charge	Three Months Ended August 31,
Restructuring charge	2005			2004			Dollar Change			Percent Change
	*(dollars in millions)*
Severance costs	$	0.4		$	—		$	0.4		N/A
Legal and other outside services costs		—			—			—		N/A
Adjustments to estimates		—			—			—		N/A
Facilities and other charges		—			0.1			(0.1	)	(100.0	)%

Restructuring charge	$	0.4		$	0.1		$	0.3		300.0	%

Percentage of total revenues		1.0	%		0.3	%

In May of 2005, we recorded a restructuring charge of approximately $1.1 million primarily related to severance costs associated with the reduction in force of approximately 32 employees, which we implemented in June 2005.

During the three month ended August 31, 2005, we recorded an additional restructuring charge of $0.4 million for severance in relation to the announced reduction in force implemented in June 2005. The anticipated cost savings resulting from this restructuring consist of reduced compensation expenses from the affected employees.

During the three month period ended August 31, 2004, we incurred a facility restructuring charge of $0.1 million related to the closing of our UK Cardiff facility in July of 2004.


Other income, net	Three Months Ended August 31,
Other income, net	2005			2004			Dollar Change			Percent Change
	*(dollars in millions)*
Interest income	$	1.4		$	1.0		$	0.4		40.0	%
Interest expense		(0.0	)		(0.0	)		0.0		N/A
Foreign exchange gain (loss)		(0.2	)		0.1			(0.3	)	(300.0	)%

Other income, net	$	1.2		$	1.1		$	0.1		9.1	%

Percentage of total revenues		3.3	%		3.0	%

Other income consists primarily of interest income and transaction gains and losses associated with foreign currency fluctuations in our Benelux and Canadian subsidiaries offset by our foreign currency hedging activity. While we engage in simple hedging activities to minimize the impact of foreign currency fluctuation on our consolidated statements of operations, there is no assurance that a significant change in foreign currency exchange rates may not have a material adverse effect on our consolidated statements of operations in the future.

The increase in other income in absolute dollars from the first quarter of fiscal 2006 compared to 2005 was primarily due to higher overall yields caused by increasing interest rates, despite our average overall portfolio levels of marketable securities having decreased year over year.


Income tax provision	Three Months Ended August 31,
Income tax provision	2005			2004			Dollar Change			Percent Change
	*(dollars in millions)*
Income tax provision	$	0.1		$	1.7		$	(1.6	)	(94.1	)%
Percentage of total revenues		0.4	%		4.8	%
Effective tax rate		37.5	%		40.0	%

Our effective tax rate percentage for the three month period ended August 31, 2005 was 37.5%, and we anticipate the same rate for the entire fiscal year of 2006.

We estimate our annual effective tax rate at the end of each quarterly period. Our estimate takes into account estimates of annual pre-tax income (and losses), and the geographic mix of pre-tax income (and losses). Our levels of future taxable income are subject to the various risks and uncertainties discussed in the Risk Relating to Our Operations set forth in this Form 10-Q.

The decrease in our effective tax rate percentage in 2006 as compared to 2005 was primarily due to the increase in allowable research and experimentation credits.

Liquidity and Capital Resources

At August 31, 2005, our principal sources of liquidity were our cash and cash equivalents and short-term investments totaling $165.6 million as compared to $150.6 million at May 31, 2005, and we had no outstanding long-term debt obligations. We also believe that due to the nature of our long-term investments, we can readily convert these investments into cash, cash equivalents and short-term investments although we have not converted these investments to cash historically. At August 31, 2005, we had $191.8 million in cash, cash equivalents and total investments as compared to $195.1 million at May 31, 2005. Our management looks mainly to our cash, cash equivalents and total investments to assess the strength of our financial position.

For the first three month period of fiscal 2006, cash and cash equivalents, plus total investments decreased $3.3 million. We explain the major drivers in this change as follows:


	Three Months ended August 31,
	2005			2004
	*(dollars in millions)*
Net income adding back non-cash operating activities	$	3.7		$	6.3
Option exercises and proceeds from Employee Stock Purchase Plan		0.6			3.4
Working capital changes		(0.5	)		2.8
Repurchase of common stock		(5.0	)		(7.4	)
Purchase of businesses, net of cash acquired		—			(3.1	)
Intangible assets acquired		(1.4	)		—
Capital expenditures		(0.7	)		(0.8	)
Foreign exchange / others		0.0			1.5

Change in cash, cash equivalent, and total investments	$	(3.3	)	$	2.7

Net income for the three months ended August 31, 2005, after adding back non-cash operating activities including depreciation and amortization of $3.0 million, tax benefit from disqualified dispositions of $0.1 million, non-cash restructuring charges of $0.1 million and other miscellaneous non-cash expenses, net of $0.2 million was $3.7 million. Management uses this amount to assess, and is disclosing this amount to assist others to assess, in the way management assesses, the cashflow generating contribution by our operations to the financial strength of our company.

We repurchased $5.0 million of our common stock through our stock repurchase in our first fiscal quarter of 2006, which was partially offset by $0.6 million in proceeds from the sale of common stock as a result of stock option exercises.

Changes in working capital, driven primarily by the increase in deferred revenue and decreases in prepaid and other assets generating $4.0 million, were more than offset by decreases in accounts payable, increases in trade receivables and reductions in and accrued liabilities totaling $4.5 million for the three-month period ended August 31, 2005.

We used a total of $1.4 million for the 80-20 asset purchase in our first quarter of fiscal 2006.

Cash used to acquire capital equipment for during the first three months of fiscal 2006 was $0.7 million consisting mainly of purchases of computer equipment and leasehold improvements associated with the renovation and expansion in our Ross Drive facilities in Sunnyvale.

Changes in our cash, cash equivalents and total investments in future periods could vary widely due not only to variations in our operations, but also the extent that our employees exercise stock options and make purchases under our employee stock purchase plan, as well as our repurchase activity under our stock repurchase program.

In June, 2005, we announced the continuation of our stock repurchase program. The continuation calls for the additional repurchase of outstanding shares of our common stock up to an aggregate value of $50.0 million. The program will terminate at the end of the fiscal year ending May 31, 2006 unless amended by the Board of Directors.

Our principal commitments as of August 31, 2005 consist of obligations under operating leases, totaling $18.2 million over the life of these leases.

Under our operating leases, we have minimum rental payments and receipts as follows (in thousands):


Fiscal Year Ending May 31,	Rental Payments		Sublease Income
2006	$	3,161	$	180
2007		3,376		140
2008		3,328		0
2009		2,311		0
2010		1,920		0
2011 and thereafter		4,058		0

	$	18,154	$	320

In connection with the NativeMinds strategic asset purchase we had, as of August 31, 2005, a $0.6 million deferred payment obligation which we paid in September 2005, as there were no claims made under the NativeMinds purchase agreement.

In connection with the 80-20 Software asset purchase we have, as of August 31, 2005, a $150,000 deferred payment obligation which we will be obligated to pay in June 2006, assuming that we have no claims for indemnification under the 80-20 Software purchase agreement.

We believe that our current cash and cash equivalents, interest income and cash generated from operations, if any, will provide adequate liquidity to meet our working capital and operating resource expenditure requirements through at least fiscal 2006. If the global economy weakens further, our cash, cash equivalents and investments balances may decline. As a result, or if our spending plans materially change, we may find it necessary to seek to obtain additional sources of financing to support our capital needs, and we cannot assure you that a financing will be available on commercially reasonable terms, or at all.

RISKS RELATING TO OUR OPERATIONS

The risks and uncertainties described below are not the only risks and uncertainties we face. Additional risks and uncertainties not currently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks actually occur, our business, results of operations and financial condition would suffer. In that event, the trading price of our common stock could decline, and our stockholders may lose all or part of their investment in our common stock. The discussion below and elsewhere in this report also includes forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements as a result of the risks discussed below.

Risks Related to Our Business

Our revenues and operating results are dependent on many factors, many of which are outside of our control and, as a result may fluctuate in future periods and be less than we or our investors anticipate

The results of operations for any quarter are not necessarily indicative of results to be expected in future periods. Our operating results have in the past been, and will continue to be, subject to quarterly fluctuations as a result of a number of factors, many of which are outside of our control. These factors include:

•

fluctuations in capital spending by customers;

•

the size and timing of orders;

•

changes in the budget or purchasing patterns of customers or potential customers, changes in foreign country exchange rates, or pricing pressures from competitors;

•

increased competition in the software and Internet industries;

•

the introduction and market acceptance of new technologies and standards in search and retrieval, Internet, document management, database, networking, and communications technology;

•

variations in sales channels, product costs, the mix of products sold, or the success of quality control measures;

•

the integration of people, operations, and products from acquired businesses and technologies;

•

changes in operating expenses and personnel;

•

changes in accounting principles, such as a requirement that stock options be included in compensation, which is widely expected to occur, which if adopted, would increase our compensation expenses and have a negative effect on our earnings;

•

the overall trend toward industry consolidation; and

•

changes in general economic and geo-political conditions and specific economic conditions in the computer and software industries.

Any of the factors, some of which are discussed in more detail below, could materially and adversely impact our operations and financial results, which could hurt our business. Any adverse impact our operations and financial results as a result of these or any other factors could cause our stock price to fall.

Demand for our products may be adversely affected if economic and market conditions deteriorate

Adverse economic conditions worldwide have contributed to slowdowns in the software information technology spending environment and may continue to impact our business, resulting in reduced demand for our products as a result of a decrease in capital spending by our customers, increased price competition for our products and higher overhead costs as a percentage of revenues. Decreased demand for our products would result in decreased revenues, which could harm our operating results.

The size and timing of large orders may materially affect our quarterly operating results

The size and timing of individual orders may cause our operating results to fluctuate significantly. An increasing and significant portion of our revenues in recent quarters has been derived from relatively large sales to certain customers, and we currently anticipate that future quarters will continue to reflect this trend. Sales cycles for these customers can take up to eighteen months and can be difficult to forecast. In addition, customer order deferrals in anticipation of new products may cause our operating results to fluctuate. Like many software companies, we have generally recognized a substantial portion of our revenues in the last month of each quarter, with these revenues concentrated in the last weeks of the quarter. Accordingly, the cancellation or deferral of even a small number of purchases of our products could harm our business in any particular quarter. In addition, to the extent that the significant sales occur earlier than expected, operating results for subsequent quarters may fail to keep pace or even decline.

Our sales cycle is lengthy and unpredictable

Any delay in sales of our products and services could cause our quarterly revenue and operating results to fluctuate. The typical sales cycle of our products is lengthy, generally between three to eighteen months, unpredictable, and involves significant investment decisions by prospective customers, as well as our education of potential customers regarding the use and benefits of our products. Our customers spend a substantial amount of time before purchasing our products in performing internal reviews and obtaining capital expenditure approvals. We believe our sales cycle will continue to be lengthened and unpredictable in the future.

Our expenditures are tied to anticipated revenues, and therefore imprecise revenue forecasts may result in poor operating results

Revenues are difficult to forecast because the market for search and retrieval software is uncertain and evolving. Because we generally ship software products within a short period after receipt of an order, we typically do not have a material backlog of unfilled orders, and as a result revenues in any quarter are substantially dependent on orders booked in that quarter. In addition, a portion of our revenues is derived from royalties based upon sales by third-party vendors of products incorporating our technology. These revenues are dependent upon those third-party vendors’ sales and marketing efforts, which may fluctuate dramatically and are difficult for us to predict. Our expense levels are based, in part, on our expectations as to future revenues and are to a large extent fixed in the short term. Therefore, we may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Any significant shortfall of demand in relation to our expectations or any material delay of customer orders would have an almost immediate adverse affect on our operating results.

Changes in effective tax rates could affect our results

Our future effective tax rates could be adversely affected by changes in the valuation of our deferred tax assets and liabilities, and changes in U.S. or foreign tax laws or interpretations thereof.

Our business may suffer due to risks associated with international sales

Historically, a significant portion of our revenues is derived from international sales. We expect international revenues will continue to account for a significant percentage of our revenues for the foreseeable future. Our international business activities are subject to a number of risks, each of which could impose unexpected costs on us that would have an adverse effect on our operating results. These risks include:

•

difficulties in complying with regulatory requirements and standards;

•

tariffs and other trade barriers;

•

costs and risks of localizing products for foreign countries;

•

reliance on third parties to distribute our products;

•

longer accounts receivable payment cycles;

•

potentially adverse tax consequences;

•

limits on repatriation of earnings; and

•

burdens of complying with a wide variety of foreign laws.

We currently engage in only limited hedging activities to protect against the risk of currency fluctuations. Fluctuations in currency exchange rates could cause sales denominated in U.S. dollars to become relatively more expensive to customers in a particular country, leading to reduced sales or profitability in that country. Also, fluctuations in the opposite direction could cause sales denominated in foreign currencies to decrease U.S. dollar revenues derived from these sales. Furthermore, future international activity may result in increased foreign currency denominated sales and, in this event, gains and losses on the conversion to U.S. dollars of accounts receivable and accounts payable arising from international operations may contribute significantly to fluctuations in our results of operations. The financial stability of foreign markets could also affect our international sales. In addition, income earned in various countries where we do business may be subject to taxation by more than one jurisdiction, thereby adversely affecting our consolidated after-tax earnings. Any of these factors could have an adverse effect on the revenues from our future international sales and, consequently, our results of operations.

A portion of our revenues is derived from sales to governments, which are subject to budget cuts and, consequently, the potential loss of revenues upon which we have historically relied

Historically, a material portion of our revenues is derived from sales to governments. As a result, any reductions in government spending on information technologies could harm our operating results. In recent years, budgets of many governments and/or their agencies have been reduced, causing certain customers and potential customers of our products to re-evaluate their needs. These budget reductions are expected to continue over at least the next several years.

Almost all of our government contracts contain termination clauses, which permit contract termination upon our default or at the option of the other contracting party. We cannot assure you that a cancellation will not occur in the future. Termination of any of these contracts could adversely affect our operating results.

We must successfully introduce new products or our customers will purchase our competitors’ products

During the past few years, our management and other personnel have focused on modifying and enhancing our core technology to support a broader set of enterprise search and business process management solutions for use on enterprise-wide systems, over online services, over the Internet and on CD-ROM. In order for our strategy to succeed and to remain competitive, we must continue to leverage our core technology to develop new product offerings by us and by our OEM customers that address the needs of these new markets or we must acquire new technology, such as we did in our Cardiff Software and NativeMinds transactions in the latter half of fiscal 2004, the Dralasoft acquisition in the third quarter of fiscal 2005 and 80-20 acquisition in the first quarter of fiscal 2006. The development of new products, whether by leveraging our core technology or by acquiring new technology, is expensive. If these products do not generate substantial revenues, our business and results of operations will be adversely affected. We cannot assure you that any of these products will be successfully developed and completed on a timely basis or at all, will achieve market acceptance or will generate significant revenues.

Our future operating results will depend upon our ability to increase the installed base of our BPM products, cross-sell our BMP products to our existing enterprise search install base technology and continue to generate significant product revenues from our enterprise search products. Our future operating results will also depend upon our ability to successfully market our technology to online and Internet publishers who use this technology to index their published information in our format. For example, in June 2005, we initiated a new promotional campaign to broaden the use of our Ultraseek enterprise search software. This promotional campaign may not be successful in attracting paying customers of Ultraseek and may diminish

revenues that would have otherwise been received from customers during the period of the promotional campaign. In addition, the promotional campaign may not generate additional revenues through promotion of our other products and services or otherwise. To the extent that customers do not adopt or broaden their use of our technology for indexing their published information, it will limit the demand for our products.

If we are unable to enhance our existing products to conform to evolving industry standards in our rapidly changing markets, our products may become obsolete

The computer software industry is subject to rapid technological change, changing customer requirements, frequent new product introductions, and evolving industry standards, each of which may render our existing products and services obsolete. As a result, our position in our existing markets or other markets that we may enter could be eroded rapidly by any of these factors. Our future success will also depend upon our ability to maintain compatibility between our products and the text publication formats we believe are or will become popular and widely adopted as well as the OEM application products in which our products are embedded. If we are unable to adapt to these rapid technological developments or customer requirements in a timely manner, our sales would diminish and our financial condition and results of operations would be materially and adversely affected.

Our software products are complex and may contain errors that could damage our reputation and decrease sales

Our complex software products may contain errors that may be detected at any point in the products’ life cycles. We have in the past discovered software errors in some of our products and have experienced delays in shipment of products during the periods required to correct these errors. We cannot assure you that, despite our testing and quality assurance efforts and similar efforts by current and potential customers, errors will not be found. The discovery of an error may result in loss of or delay in market acceptance and sales, diversion of development resources, injury to our reputation, or increased service and warranty costs, any of which could harm our business. Although we generally attempt by contract to limit our exposure to incidental and consequential damages, and to cap our liabilities to our proceeds under the contract, if a court fails to enforce the liability limiting provisions of our contracts for any reason, or if liabilities arise which are not effectively limited, we could incur substantial monetary judgments against us.

We are in litigation with Inxight Software, Inc. in a dispute over our rights under a software license agreement and we may incur significant costs whether or not we prevail in this litigation

In October 2004, Inxight Software, Inc., a privately held company, sued us alleging, among other things, that we had breached a license with them and misappropriated their trade secrets, and that we had otherwise exceeded our rights under our license agreement with Inxight. Inxight is seeking, among other things, monetary damages of at least $1.0 million and injunctive relief commanding Verity to cease distributing Inxight’s product to Verity K2 product-line OEM customers. We have responded by an answer and countersuit seeking a declaration that we have acted within our rights under the license agreement, and that Inxight’s purported termination of the license subsequent to the filing of its complaint was invalid. In addition, we alleged that Inxight itself has breached the license by purporting to terminate the parties’ license without cause, and that it has wrongfully interfered in Verity’s business operations, and that such breach and wrongful conduct has caused injury to Verity in excess of $1.0 million. Inxight recently filed papers with the Court requesting permission to supplement its claims against Verity, seeking to add our replacement technology vendor, an Inxight competitor, to the consolidated action, and seeking to obtain a temporary restraining order to enjoin Verity and our replacement vendor from using, disclosing, licensing or otherwise transferring certain technology. Inxight alleges that Verity has shared Inxight’s trade secrets with our replacement vendor. Our litigation with Inxight is scheduled to go to trial on October 11, 2005.

If we do not prevail in this litigation, we could be required to pay significant damages. Further, and we may be prohibited from continuing to distribute Inxight technology in some or all of our products. In order to mitigate the risk of such a prohibition, we entered into license agreements with two software companies providing technology that is similar to that provided by Inxight, but there may be significant costs associated with entirely switching out the Inxight products, including development costs and additional support costs, which could impact our results of operations. Further, if Inxight is successful in this litigation relating to our replacement vendor, we may be precluded from using some of the replacement technology, which could impact the functionality of our products, which in turns could decrease our sales.

In addition, whether or not we prevail in this litigation, we could incur significant costs in the form of legal fees, and our management’s attention could be diverted from the normal daily operations of our business.

We are dependent on proprietary technologies licensed from third parties, the loss of which could delay shipments of products incorporating these technologies and could be costly

Some of the technology used by our products is licensed from third parties, generally on a nonexclusive basis. We believe that there are alternative sources for each of the material components of technology we license from third parties. However, the termination of any of these licenses, or the failure of the third-party licensors to adequately maintain or update their products, could result in a delay in our ability to ship these products while we seek to implement technology offered by alternative sources. Any required replacement licenses could prove costly. Also, any delay, to the extent it becomes extended or occurs at or near the end of a fiscal quarter, could harm our quarterly results of operations. While it may be necessary or desirable in the future to obtain other licenses relating to one or more of our products or relating to current or future technologies, we cannot assure you that we will be able to do so on commercially reasonable terms or at all.

Our ability to compete successfully will depend, in part, on our ability to protect our intellectual property rights, which we may not be able to protect

We rely on a combination of patent, trade secrets, copyright and trademark laws, nondisclosure agreements and other contractual provisions and technical measures to protect our intellectual property rights. The source code for our proprietary software is generally protected both as a trade secret and as a copyrighted work. Policing unauthorized use of our products, however, is difficult. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Litigation could result in substantial costs and diversion of resources and could harm our business regardless of the outcome of the litigation.

Effective copyright and trade secret protection may be unavailable or limited in some foreign countries. To license our products, we frequently rely on “shrink wrap” licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of several jurisdictions. In addition, employees, consultants and others who participate in the development of our products may breach their agreements with us regarding our intellectual property, and we may not have adequate remedies for any such breach. We also realize that our trade secrets may become known through other means not currently foreseen by us. Notwithstanding our efforts to protect our intellectual property, our competitors may be able to develop products that are equal to or superior to our products without infringing on any of our intellectual property rights.

Our products employ technology that may infringe on the proprietary rights of third parties, which may expose us to litigation

Third parties may assert that our products infringe their proprietary rights, or may assert claims for indemnification resulting from infringement claims against us. Any such claims may cause us to delay or cancel shipment of our products, which could harm our business. In addition, irrespective of the validity or the successful assertion of claims, we could incur significant costs in defending against claims. To date, no third party has asserted such claims.

We have been sued in the past and are at risk of future securities class action litigation, due to our past and expected stock price volatility

In the past, securities class action litigation has often been brought against companies following a decline in the market price of their securities. For example, in December 1999 our stock price dramatically declined and a number of lawsuits were filed against us. Because we expect our stock price to continue to

fluctuate significantly, we may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert management’s attention and resources, and could seriously harm our business.

If we lose key personnel, or are unable to attract additional qualified personnel, our ability to conduct and grow our business will be impaired

We believe that hiring and retaining qualified individuals at all levels is essential to our success, and we cannot assure you that we will be successful in attracting and retaining the necessary personnel. In addition, we are highly dependent on our direct sales force for sales of our products, as we have limited distribution channels. Continuity of technical personnel is an important factor in the successful completion of development projects, and any turnover of our research and development personnel could harm our development and marketing efforts.

Our future success also depends on our continuing ability to identify, hire, train and retain other highly qualified sales, technical and managerial personnel. Competition for this type of personnel is intense, and we cannot assure you that we will be able to attract, assimilate or retain other highly qualified technical and managerial personnel in the future. The inability to attract, hire or retain the necessary sales, technical and managerial personnel could harm our business.

We face intense competition from companies with significantly greater financial, technical, and marketing resources, which could adversely affect our ability to maintain or increase sales of our products

A number of companies offer competitive products addressing certain of our target markets. In the enterprise search market, we compete primarily with Autonomy, Convera, Endeca, FAST, Google, IBM, Oracle, SAP and Stellent, among others. These companies offer either stand-alone enterprise search products or offer these capabilities as part of their overall solution. In addition, our Verity Enterprise Web Search competes with Google, Microsoft and other public Internet search engines.

In the content capture segment of the business process management market, we compete with Adobe, AnyDoc, Captiva, Datacap, Dicom (Kofax), and Readsoft, among others. In the larger business process management market, we compete with IBM, Lombardi, Pegasystems, Savvion and Tibco (Staffware), among others. We also compete indirectly with content management vendors, such as FileNet, that offer content capture and process automation with their core content management products, as well as with platform vendors, such as Microsoft, that offer basic capabilities as part of their overall solution.

In the future, we may encounter competition from a number of companies. Many of our existing competitors, as well as a number of other potential new competitors, have significantly greater financial, technical and marketing resources than we do. Because the success of our strategy is dependent in part on the success of our strategic customers, competition between our strategic customers and the strategic customers of our competitors, or failure of our strategic customers to achieve or maintain market acceptance could harm our competitive position. Although we believe that our products and technologies compete favorably with competitive products, we cannot assure you that we will be able to compete successfully against our current or future competitors or that competition will not harm our business.

Our products contain open source software

Products or technologies acquired or developed by us may include so-called “open source” software. Open source software is typically licensed for use at no initial charge, but imposes on the user of the open source software certain requirements to license to others both the open source software as well as the software that relates to, or interacts with, the open source software. Our ability to commercialize products or technologies incorporating open source software or otherwise fully realize the anticipated benefits of any such acquisition may be restricted because, among other reasons:

•

open source license terms may be ambiguous and may result in unanticipated obligations regarding our products;

•

competitors will have improved access to information that may help them develop competitive products;

•

open source software cannot be protected under trade secret law;

•

it may be difficult for us to accurately determine the developers of the open source code and whether the acquired software infringes third party intellectual property rights; and

•

open source software potentially increases customer support costs because licensees can modify the software and potentially introduce errors.

Further, to the extent we utilize “open source” software we face risks. For example, the scope and requirements of the most common open source software license, the GNU General Public License (“GPL”), have not been interpreted in a court of law. Use of GPL software could subject certain portions of our proprietary software to the GPL requirements. Other forms of “open source” software licensing present license compliance risks, which could result in litigation or loss of the right to use this software.

Our recent acquisitions of Dralasoft, Cardiff Software and assets of NativeMinds and 80-20 Software as well as future potential acquisitions, may have unexpected material adverse consequences

Our business is highly competitive and our growth is dependent upon market growth and our ability to enhance our existing products and introduce new products on a timely basis. One of the ways we may address the need to develop new products is through acquisitions of complementary businesses and technologies, such as our acquisitions of Dralasoft and Cardiff Software and the acquisition of theintellectual property, certain customer agreements and other strategic assets from NativeMinds and the acquisition of the desktop search application and other assets from 80-20 Software. From time to time, we consider and evaluate potential business combinations both involving our acquisition of another company and transactions involving the sale of Verity through, among other things, a possible merger or consolidation of our business into that of another entity. Acquisitions involve numerous risks, including the following:

•

difficulties in integration of the operations, technologies, products and personnel of the acquired companies;

•

the risk of diverting management’s attention from normal daily operations of the business;

•

accounting consequences, including changes in purchased research and development expenses, resulting in variability in our quarterly earnings;

•

potential difficulties in completing projects associated with purchased in-process research and development;

•

risks of entering markets in which we have no or limited direct prior experience and where competitors in these markets have stronger market positions;

•

the potential loss of key employees of the acquired company;

•

the assumption of known and potentially unknown liabilities of the acquired company;

•

we may find that the acquired company or assets do not further our business strategy or that we paid more than what the company or assets are worth;

•

we may have product liability associated with the sale of the acquired company’s products;

•

we may have difficulty maintaining uniform standards, controls, procedures and policies;

•

our relationship with current and new employees and clients could be impaired;

•

the acquisition may result in litigation from terminated employees or third parties who believe a claim against us would be valuable to pursue;

•

our due diligence process may fail to identify significant issues with product quality, product architecture and legal contingencies, among other matters;

•

insufficient revenues to offset increased expenses associated with acquisitions;

•

inability to renew third-party software license agreements; and

•

market acceptance of new releases.

Acquisitions may also cause us to:

•

issue common stock that would dilute our current stockholders’ percentage ownership;

•

record goodwill and non-amortizable intangible assets that will be subject to impairment testing and potential periodic impairment charges;

•

incur amortization expenses related to certain intangible assets; or

•

incur large and immediate write-offs.

We cannot assure you that future acquisitions will be successful and will not adversely affect our business. We must also maintain our ability to manage any growth effectively. Failure to manage growth effectively and successfully integrate acquisitions we make could harm our business.

Our net income and earnings per share could be significantly reduced when we account for employee stock option and employee stock purchase plans using the fair value method

We could report significant accounting charges as a result of the requirement to record an expense for our stock-based compensation plans using the fair value method. For example, in fiscal year 2005, had we accounted for stock-based compensation plans using the fair-value method prescribed in SFAS No. 123 as amended by SFAS No. 148, “Accounting for Stock-Based Compensation” (“SFAS No. 148”), net income would have been reduced by $15.9 million. In December 2004, the FASB issued SFAS No. 123R, which requires public companies to comply as of the first interim or annual reporting period beginning after June 15, 2005. On April 14, 2005, the Securities and Exchange Commission announced that the SFAS No. 123R effective transition date had been extended to annual reporting periods beginning after June 15, 2005. We expect to adopt this new standard in the first quarter of our fiscal year 2007, we will then be required to record a compensation expense for all forms of share-based payment awards using the fair value method.

See Note 2 to Consolidated Financial Statements for a more detailed presentation of accounting for stock-based compensation plans.

Risks Related to Our Industry

We depend on increasing use of the Internet, intranets, extranets, portals and electronic commerce. If the use of the Internet, intranets, extranets, portals and electronic commerce do not continue to grow, our business will be seriously impacted. Additionally, if search becomes a commodity through open source initiatives or our competitors provide free search software or search appliances, our business will be seriously impacted.

Most of our products depend on the increased acceptance and use of the Internet as a medium of commerce and on the development of corporate intranets, extranets and portals. As a result, acceptance and use may not continue to develop at historical rates and a sufficiently broad base of business customers may not adopt or continue to use the Internet as a medium of commerce. The lack of such development would impair demand for our products and would adversely affect our ability to sell our products. Demand and market acceptance for recently introduced services and products over the Internet and the development of corporate intranets, extranets and portals are subject to a high level of uncertainty, and there exist few proven services and products.

The business of many of our customers, and consequently our ability to sell our products, would be seriously harmed if:

•

use of the Internet, the Web and other online services does not continue to increase or increases more slowly than expected;

•

the infrastructure for the Internet, the Web and other online services does not effectively support expansion that may occur; or

•

the Internet, the Web and other online services do not create a viable commercial marketplace, inhibiting the development of electronic commerce and reducing the need for our products and services.

Capacity constraints may restrict the use of the Internet as a commercial marketplace, which would restrict our growth

The Internet may not be accepted as a viable long-term commercial marketplace for a number of reasons. These include:

•

potentially inadequate development of the necessary communication and network infrastructure, particularly if rapid growth of the Internet continues;

•

delayed development of enabling technologies and performance improvements;

•

delayed development or adoption of new standards and protocols; and

•

increased governmental regulation.

Our ability to grow our business is dependent on the growth of the Internet and, consequently, any adverse events relating to the Internet would impair our ability to grow our business.

Security risks and concerns may deter the use of the Internet for conducting electronic commerce, which would adversely affect the demand for our products

A significant barrier to electronic commerce and communications is the secure transmission of confidential information over public networks. Advances in computer capabilities, new discoveries in the field of cryptography or other events or developments could result in compromises or breaches of our security systems or those of other websites to protect proprietary information. If any well-publicized compromises of security were to occur, it could have the effect of substantially reducing the use of the Internet for commerce and communications, resulting in reduced demand for our products, thus adversely affecting our revenues.

Item 3.Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk.The primary objective of our investment activities is to preserve the principal while at the same time maximize yields without significantly increasing our risk. To achieve this objective, we maintain our portfolio of cash equivalents and investments in a variety of securities, including both government and corporate obligations and money market funds. As of August 31, 2005, approximately 69% of our investment portfolio matures in one year or less, with the remainder maturing in less than three years. We do not use derivative financial instruments in our investment portfolio. We place our investments with high credit quality issuers and, by policy, limit the amount of credit exposure to any one issuer. All of our investments are held other than for trading purposes.

The following table presents the amounts of our cash equivalents and investments that are subject to interest rate risk by fiscal year of expected maturity and average interest rates as of August 31, 2005:


	FY2006			FY2007			FY2008	Total			Fair Value
	*(dollars in thousands)*
Cash equivalents	$	84,420			—		—	$	84,420		$	84,420
Average interest rate		3.55	%		—		—		3.55	%		3.55	%
Fixed-rate securities	$	41,234		$	44,443		—	$	85,678		$	85,678
Average interest rate		2.45	%		4.53	%	—		3.53	%		3.53	%
Variable-rate securities		—			—		—		—			—
Average interest rate		—			—		—		—			—


	FY2006			FY2007			FY2008			Total			Fair Value
	*(dollars in thousands)*
Cash equivalents	$	84,225			—			—		$	84,225		$	84,225
Average interest rate		3.01	%		—			—			3.01	%		3.01	%
Fixed-rate securities	$	40,376		$	43,503		$	1,000		$	84,879		$	84,879
Average interest rate		2.37	%		2.65	%		3.00	%		2.52	%		2.52	%
Variable-rate securities		—			—			—			—			—
Average interest rate		—			—			—			—			—

Foreign Currency Transaction Risk. We transact business in various foreign currencies and have established a program that primarily utilizes foreign currency forward contracts to offset the risk associated with the effects of certain foreign currency exposures. Under this program, increases or decreases in our foreign currency exposures are offset by gains or losses on the forward contracts, to mitigate the possibility of foreign currency transaction gains or losses. These foreign currency exposures typically arise from intercompany sublicense fees and other intercompany transactions. Our forward contracts generally have terms of 180 days or less. We do not use forward contracts for trading purposes. All foreign currency transactions and all outstanding forward contracts are marked to market at the end of the period with any changes in market value included in Other Income, net. Our ultimate realized gain or loss with respect to currency fluctuations will depend on the currency exchange rates and other factors in effect as the contracts mature. Net foreign exchange transaction loss included in Other Income, net in the accompanying condensed consolidated statements of operations was $0.2 million in the three month period ended August 31, 2005. The fair value of the foreign currency forward contracts was a $1.9 million liability as of August 31, 2005 as compared to a $3.7 million liability at May 31, 2005.

As of August 31, 2005 and May 31, 2005, our forward contracts consisted solely of contracts for the exchange of Canadian Dollars for United States Dollars. As of these dates, the notional amounts (at contract exchange rates) and weighted average contractual foreign currency exchange rates for the

outstanding forward contracts were $1.9 million and $3.7 million, and $1.21 and $1.21, respectively. Notional weighted average exchange rates are quoted using market conventions where the currency is expressed in currency units per United States dollar. All of our forward contracts mature in ninety days or less as of August 31, 2005.

Item 4.Controls and Procedures

Limitations on the Effectiveness of Controls. Our management, including the Chief Executive Officer and Chief Financial Officer, believes that our disclosure controls and procedures and our internal control over financial reporting will provide reasonable assurance that all errors will be detected, but does not expect that our disclosure controls and procedures or our internal control over financial reporting will provide absolute assurance that all errors will be detected. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Verity have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control.

Evaluation of Disclosure Controls and Procedures. An evaluation was performed under the supervision and with the participation of management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of August 31, 2005. Based on that evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of August 31, 2005, to provide reasonable assurance that the information required to be disclosed by us in reports we file with the Securities and Exchange Commission was recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules, and that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding its required disclosure in reports we file with the Securities and Exchange Commission.

Changes in Internal Control over Financial Reporting. During the three month period ended August 31, 2005, there were no changes in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.Legal Proceedings

On October 22, 2004, Inxight Software, Inc., a privately held company, filed a complaint in the Superior Court of California for the County of Santa Clara against Verity, alleging, among other things, breach of contract and trade secret misappropriation, and that Verity had otherwise exceeded its rights under its license agreement with Inxight. Inxight is seeking, among other things, monetary damages of at least $1.0 million and injunctive relief commanding Verity to cease distributing Inxight’s product.

On December 3, 2004, Verity filed an answer and cross-complaint against Inxight, in response to Inxight’s complaint that was filed on October 22, 2004. Verity’s answer and cross-complaint seek a declaration that Verity has acted within its rights under the license agreement, and that Inxight’s purported termination of the license subsequent to the filing of its complaint was invalid. In addition, Verity’s cross-claim alleges that Inxight itself has breached the license by purporting to terminate the parties’ license without cause, and that it has wrongfully interfered in Verity’s business operations, and that such breach and wrongful conduct has caused injury to Verity in excess of $1.0 million. Verity also alleges that Inxight wrongfully induced one of Verity’s former employees, who is now employed at Inxight, to breach certain confidentiality obligations related to confidential and proprietary information of Verity.

On December 20, 2004, Verity filed a separate and independent suit against Inxight in federal court for claims arising from Inxight’s July 24, 1998 license to use Verity’s copyrighted KeyView product (the “KeyView License”) (U.S.D.C. N.D. Cal. Case No. 04-CV-05387 CRB). Verity claims that Inxight has infringed and will continue to infringe Verity’s federally registered copyrights in and related to KeyView by virtue of Inxight’s use, marketing, distribution and licensing of KeyView with applications that are not authorized under the KeyView License. Inxight’s state complaint and Verity’s federal complaint have now been consolidated in the United States District Court for the Northern District of California, Case No. 04-CV-05387 CRB (JL).

Inxight has filed three motions for summary judgment on several claims and defenses in the consolidated action, including (1) Inxight’s claims that Verity has exceeded the scope of the parties’ license and misappropriated Inxight’s trade secrets by selling software with embedded Inxight technology to OEMs; (2) Verity’s claims against Inxight and the former Company employee relating to his unauthorized disclosure to Inxight of Verity’s confidential and proprietary information to Inxight; and (3) all of Verity’s claims relating to Inxight’s use of Verity’s KeyView software. These motions are presently scheduled to be heard on October 7, 2005. Trial of the consolidated actions is currently scheduled to begin on October 11, 2005.

On September 20, 2005, Inxight filed papers with the Court requesting permission to supplement its claims against Verity and to add our replacement technology vendor, an Inxight competitor, to the consolidated action. Inxight alleges that Verity has shared Inxight’s trade secrets with our replacement vendor.

On September 21, 2005, Inxight filed a motion for a temporary restraining order to enjoin Verity and our replacement vendor from using, disclosing, licensing or otherwise transferring any technology that Inxight alleges is derived from unauthorized use of Inxight technology after October 28, 2004, or is based upon any confidential information provided by Verity which Inxight alleges Verity was bound to protect subject to a preexisting nondisclosure obligation.

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds

Item 2(a). The table below sets forth information regarding repurchases of Verity common stock by Verity during the three months ended August 31, 2005.


Period	Total Number of Shares Purchased	Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Programs	Maximum Dollar Value of Shares that May Yet Be Purchased Under the Programs
June 1, 2005 through June 30, 2005	—		—	—	$	50,000,000
July 1, 2005 through July 31, 2005	514,577	$	9.71	514,577	$	45,001,505
August 1, 2005 through August 31, 2005	—		—	—	$	45,001,505
Total	514,577	$	9.71	514,577	$	45,001,505

On June 30, 2005, Verity’s Board of Directors approved a $50.0 million stock repurchase program whereby we are authorized to repurchase up to $50 million of common stock in fiscal 2006. The program will terminate at the end of the fiscal year ending May 31, 2006 unless amended by the Board of Directors.

Item 3.Defaults upon Senior Securities

Not Applicable.

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

Not Applicable.

Item 5.Other Information

(a) None.

(b) None.

Item 6.Exhibits

Exhibits — See Exhibit Index following the signature page to this report, which is incorporated by reference here.

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


VERITY, INC. (Registrant)

By:		/s/ STEVEN R. SPRINGSTEEL
		Steven R. Springsteel
		President and Chief Financial Officer

Dated: October 7, 2005

INDEX TO EXHIBITS


Exhibit Number		Description of Document
3.1		Restated Certificate of Incorporation of the Company. (1)

3.2		By-Laws. (1)

4.1		Amended and Restated Rights Agreement dated August 1, 1995, as amended. (2)

4.2		Form of Rights Agreement between Verity, Inc. and First National Bank of Boston dated September 18, 1996. (3)

4.3		First Amendment to Rights Agreement dated as of July 23, 1999 among Verity, Inc. and BankBoston, N.A. (4)

10.3		Change in Control and Severance Benefit Plan, as amended.

10.17		Executive Officer Summary Compensation Sheet. (5)

10.45		Change in Cash Compensation for Executive Chairman of the Board and Chief Executive Officer. (6)

10.46		Change in Cash Compensation for President and Chief Executive Officer. (7)

31.1		Certification of Anthony J. Bettencourt.

31.2		Certification of Steven R. Springsteel.

32		Certification of Chief Executive Officer and Chief Financial Officer.

(1)	Incorporated by reference from the exhibits with corresponding numbers from the Company’s Form 10-Q for the quarter ended November 30, 2000 with the Securities and Exchange Commission on January 10, 2001. (Commission No. 000-26880).

(2)	Incorporated by reference from the exhibits with corresponding numbers from the Company’s Registration Statement (No. 33-96228), declared effective on October 5, 1995.

(3)	Incorporated by reference from Exhibit No. 1 to the Company’s Form 8-K as filed with the Securities and Exchange Commission on October 10, 1996 (Commission No. 000-26880).

(4)	Incorporated by reference to Exhibit 99.2 from the Company’s Report on Form 8-K filed with the Securities and Exchange Commission on July 29, 1999 (Commission No. 000-26880).

(5)	Incorporated by reference to Exhibit 10.17 from the Company’s Annual Report on Form 10-K for the fiscal year ended May 31, 2005, filed with the Securities and Exchange Commission on August 12, 2005 (Commission No. 000-26880).

(6)	Incorporated by reference to the disclosure under Item 1.01 from the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 20, 2005 (Commission No. 000-26880).

(7)	Incorporated by reference to the disclosure under Item 1.01 from the Company’s Current Report on Form 8-K filed with the Securities and Exchange Commission on September 22, 2005 (Commission No. 000-26880).

Positive
Negative
Uncertain
Constraining
Legalese
Litigious
Readability	H.S. freshman Avg

Verity (VRTY) Inactive 10-Q2006 Q1 Quarterly report

Content analysis