SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934

(Mark One) |X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 1999
OR

|_| 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 000-22647

Peritus Software Services, Inc.
(Exact Name of Registrant as Specified in Its Charter)

Massachusetts 04-3126919
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

112 Turnpike Road, Suite 111 01581-2860
Westborough, Massachusetts (Zip Code)
(Address of Principal Executive Offices)

Registrant's telephone number, including area code: (508) 870-0963

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

Title of Each Class Name of Each Exchange on Which Registered
- ------------------- -----------------------------------------
Not Applicable Not Applicable

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

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

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

As of March 28, 2000, the aggregate market value of common stock
held by non-affiliates of the registrant was approximately $12,973,681. As of
that date, there were 27,276,569 shares outstanding of the registrant's common
stock, $0.01 par value.

DOCUMENTS INCORPORATED BY REFERENCE

None.

PERITUS SOFTWARE SERVICES INC.

FORM 10-K

ANNUAL REPORT

TABLE OF CONTENTS

PART I

Page
----

Item 1. Business..................................................................................... 3
Item 2. Properties................................................................................... 13
Item 3. Legal Proceedings............................................................................ 13
Item 4. Submission of Matters to a Vote of Security Holders.......................................... 14

PART II

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters........................ 15
Item 6. Selected Financial Data...................................................................... 16
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations........ 17
Item 7A. Quantitative and Qualitative Disclosures about Market Risk................................... 49
Item 8. Financial Statements and Supplementary Data.................................................. 50
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure......... 82

PART III

Item 10. Directors and Executive Officers of the Registrant........................................... 83
Item 11. Executive Compensation....................................................................... 84
Item 12. Security Ownership of Certain Beneficial Owners and Management............................... 89
Item 13. Certain Relationships and Related Transactions............................................... 91

PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.............................. 93

SIGNATURES

Peritus is a registered trademark, Automate:2000 is a registered service
mark, AutoEnhancer, SAM Relay and SAM Workbench are trademarks and Renovation
Quality Evaluation and Software Asset Maintenance are service marks of Peritus
Software Services, Inc., MDI is a registered trademark, Vantage YR 2000 is a
trademark and the MDI logo is a registered service mark of Millennium Dynamics,
Inc.

From time to time, information provided by the Registrant or statements
made by its employees may contain "forward-looking" statements, as that term is
defined in the Private Securities Litigation Reform Act of 1995. For this
purpose, any statements contained herein that are not statements of historical
fact may be deemed to be forward-looking statements. Without limiting the
foregoing, the words "believes," "anticipates," "plans," "expects" and similar
expressions are intended to identify forward-looking statements.

This Annual Report may contain forward looking statements which involve
risks and uncertainties. The Registrant's actual results may differ materially
from the results discussed in such statements. Certain factors that could cause
such a difference include, without limitation, the factors listed below in
"Factors That May Affect Future Results".

PART I.

Item 1. Business

Company Current Condition and Current Strategy

In the second half of 1998 and in 1999, the overall market for the year
2000 tools and services of Peritus Software Services, Inc. ("Peritus" or the
"Company") contracted dramatically, resulting in substantial financial losses.
In response, the Company substantially reduced its workforce in September and
December of 1998 and again in April of 1999. During the second and third
quarters of 1999, the Company also settled its leases for its facilities in
Cincinnati, Ohio, Lisle, Illinois and Billerica, Massachusetts and took other
efforts to reduce its fixed costs. As a result of the Company's degraded
financial condition, the Company began encountering major obstacles in obtaining
new outsourcing business. Since most outsourcing engagements are multi-year and
involve critical applications, prospective new clients, although interested in
the capabilities and technology of the Company, were reluctant or unwilling to
commit to contracts. Despite the significant reduction in the overall cost
structure as a result of the foregoing actions, the Company was unable to
achieve a cash flow break-even position in the year ended December 31, 1999.

The Company's current strategy is to continue to service its existing
outsourcing customers and to renew expiring contracts. At the same time, the
Company is pursuing new business through the licensing of, and associated
consulting and training for, its outsourcing methodology (technology transfer
services) and SAM Relay and SAM Workbench tools. The Company anticipates using
the proceeds from the Rocket investment to fund additional investments in sales
and marketing, and research and development (particularly the enhancement of the
Company's SAM Workbench tool), and for other general corporate purposes. The
Company also plans to develop other service offerings and to renew its efforts
to generate new outsourcing business.

Company Overview

Peritus provides solutions consisting of software products and services
that enable organizations to improve the productivity, quality and effectiveness
of their information technology ("IT"), systems maintenance or software
evolution functions. The Company employs software tools, methodologies and
processes, designed to automate the typically labor-intensive processes involved
in conducting mass change and other software maintenance tasks. In 1996, the
Company released its first commercially available product, its AutoEnhancer/2000
software, which was aimed at the industry's most pervasive mass change
challenge, the year 2000 problem, to value added integrators and directly to end
users. In 1996, the Company expanded its research and development efforts
through the acquisition of Vista Technologies Incorporated ("Vista"), a
developer of computer-aided engineering software. In 1997, the Company expanded
its product offerings and research and development efforts by releasing an
enhanced version of the AutoEnhancer/2000 software, which enables a client to
perform logic correction only changes with regard to year 2000 renovations, and
by acquiring substantially all of the assets and the assumption of certain of
the liabilities of Millennium Dynamics, Inc. ("MDI"), a software tools company
with year 2000 products for the IBM mainframe and AS/400 platforms from American
Premium Underwriters, Inc. ("APU").

In response to changes in the markets for the Company's products and
services, the Company emphasized the

direct delivery of year 2000 renovation services and renovation quality
evaluation ("RQE") services in the beginning of 1998 and also began to refocus
the Company's business on software maintenance outsourcing services. In 1998,
the Company also began licensing its RQE tool, a product used to facilitate an
in-house evaluation of a completed year 2000 renovation. As the market continued
to shift from the Company's year 2000 products and services during the third
quarter of 1998, the Company revised its overall strategy to emphasize the
growth of its software maintenance outsourcing business over the long term and
to meet its clients needs for year 2000 renovation services and RQE services. In
July 1998, the Company announced its software maintenance outsourcing offerings,
"Software Asset Maintenance for Software Providers" ("SAMsp")and "Software Asset
Maintenance for Information Systems" ("SAMis"), which are outsourcing solutions
designed specifically for the manufacturers of system software and software
products and for information technology departments that maintain application
software, respectively.

In the second half of 1998, the overall market for the year 2000 products
and services of the Company contracted dramatically, resulting in substantial
financial losses, and, in response, the Company substantially reduced its
workforce in September and December of 1998. As a result of the Company's
degraded financial condition, the Company began encountering major obstacles in
obtaining new outsourcing business. Since most outsourcing engagements are
multi-year and involve critical applications, prospective new clients, although
interested in the capabilities and technology of the Company, were reluctant or
unwilling to commit to contracts. Based upon its continued difficulties, the
Company substantially reduced its workforce again in April 1999 and has
experienced significant voluntary attrition in its workforce.

On February 3, 1999, the Company's common stock was delisted from trading
on the Nasdaq National Market. The Company's common stock is now currently
traded on the Over The Counter ("OTC") Bulletin Board which has several
requirements for listing.

In March 1999, the Company announced that it had retained Covington
Associates to render financial advisory and investment banking services in
connection with exploring strategic alternatives including the potential sale of
the Company. The engagement agreement was entered into in December 1998 and was
terminated in December 1999.

In June 1999, the Company reached a settlement with American Financial
Group, Inc. ("AFG") and its subsidiaries and affiliates for release from its
real estate lease in Cincinnati, Ohio and certain other obligations. Under the
settlement, the Company agreed to pay $200,000 in cash and issue 300,000 shares
of Common Stock in exchange for release of its real estate lease for 20,500
square feet that required average monthly payments excluding operating expenses
of $36,000 through November 2002. The Company had not made any payments since
October 1998. The settlement also released the Company from net claims for other
services and disputes of $334,500.

In August 1999, the Company executed a lease termination agreement for its
Lisle, Illinois facility. Under that agreement, the Company agreed to pay
$100,000 in cash and relinquish its $16,000 security deposit. The real estate
lease for 9,000 square feet required average lease and operating expense
payments of $18,000 per month through February 2003. The Company had not made
any payments since March 1999.

Effective September 27, 1999, the Company relocated its corporate
headquarters from Billerica, Massachusetts to its existing facility located at
112 Turnpike Road, Westborough, Massachusetts. In September of 1999, the Company
also reached a settlement agreement with BCIA New England Holdings LLC for
release from its real estate lease at 2 Federal Street, Billerica,
Massachusetts. Under the settlement, the Company agreed to pay $200,000 in cash,
relinquish its $300,000 security deposit, issue 500,000 shares of Common Stock
and transfer miscellaneous furnishings and equipment. In exchange, the Company
was released from its real estate lease for 100,000 square feet which required
average lease and operating expense payments of $145,000 per month through
February 2006. The Company had not made any payment since July 1999.

The Company experienced net losses of $2,583,000, $26,673,000 and
$67,490,000 in the years ended December 31, 1999, 1998 and 1997, respectively.
The Company's long-term future is dependent upon its ability to achieve a
break-even cash flow or raise additional financing. There can be no assurances
that the Company will be able to do so.

The Company currently derives its revenue from software maintenance
outsourcing services, software and methodology licensing and other services.
Historically, the Company's products and services have been marketed through its
direct sales force, both domestically and in Europe, and through value added
integrators operating worldwide. As a result of its downsizings in 1998 and
1999, the Company currently has only one direct sales force representative.
However, the Company plans to increase its sales resources in the future.

Industry Background

With the globalization of markets and increased competitive pressures to
reduce operating costs, shorten time to market, improve product quality and
increase customer responsiveness, large organizations throughout the world have
become increasingly dependent on IT to organize and manage their businesses and
serve their customers. Many of these organizations utilize large mainframe
computer systems, client/server systems or a combination thereof for the
information processing requirements of their enterprises. These IT systems
contain the core knowledge and processes that support mission-critical
operations, and maintaining the investment in these IT systems is a requirement
for organizations worldwide. In some circumstances, it has formed the basis for
organizations to enter into new business or develop new business strategies.

A key challenge facing organizations has been to understand, modify,
update and adapt their IT systems and evolve their software to respond to a
changing, more complex and more competitive business environment. This challenge
has increased with the broadening complexity of IT and the continued evolution
of mainframe systems, as well as the advent of distributed, client/server
computing and the proliferation of third-party enterprise software applications.
At the same time, the pace of change in business environments has accelerated,
requiring organizations to continually evolve their IT systems and environments
to adapt to changing business conditions and processes. This software evolution
process is typically time-consuming, labor-intensive and expensive, and consists
not only of fixing "bugs" and maintaining the current level of software
performance and functionality, but also making enhancements, implementing mass
changes to the code and migrating applications to new computing platforms.

Peritus Solutions

Peritus offers products and services that enable organizations to improve
the productivity, effectiveness and quality of the software evolution process.
The Company's solutions employ a combination of tools, processes, skilled
professionals and methodologies. The Company's underlying technology consists of
its Peritus Intermediate Language ("PIL") and proprietary tools that can be
implemented to address mass change or other software maintenance or development
challenges.

Application Understanding Solution

Technology for Application Understanding. The Company's SAM Workbench tool
enables a user to understand a mainframe based application or application set.
It employs a combination of methodologies and automated software features that
enable a user to extract mainframe applications and move the code to a PC
workstation for analysis and understanding. It provides detailed information on
the application inventory and relationships between software assets; partitions
the assets into applications, business transactions, and elementary
transactions; generates application size metrics, such as function point counts;
and supports the modeling of enhancements including function point counts. It
can also provide low-level impact analysis on individual code members.

Mass Change Solutions

Technology for Mass Change. The Company's Mass Change Engine, which is
based on PIL and other proprietary technologies, converts source code from a
variety of programming languages into PIL in order to perform analysis,
correction and testing on the code during mass change maintenance initiatives.
The Mass Change Engine is designed to automate the labor-intensive code
maintenance function, thereby increasing productivity, and can be customized to
provide function-specific mass change capabilities. The Mass Change Engine
operates across multiple platforms, languages and operating systems. The Company
has received a United States Patent, Patent Number: 5,838,979 covering certain
technology applicable to the Mass Change Engine.

Year 2000 Renovation Tools. The Company's year 2000 products and services
provide a comprehensive renovation solution for organizations seeking to address
the year 2000 problem. The Company's AutoEnhancer/2000 software, which is based
on its Mass Change Engine, is also designed to provide flexibility in addressing
the critical identification, correction and verification components of a year
2000 renovation. The AutoEnhancer/2000 software is designed to be interoperable
with third-party assessment, extraction and testing tools. The Vantage YR2000
software toolset is designed to assist and automate the code conversion process
required to make software code residing on the IBM mainframe and AS/400
platforms year 2000 compliant. The toolset employs a combination of
methodologies and automated software tools that are designed to enhance the
productivity of the code conversion process. The underlying technology is based
on an automated parsing and conversion technology that identifies date sensitive
variables and provides correction either through date expansion or logic
conversion.

Year 2000 Renovation Quality Evaluation Tool. The Company's RQE Tool is
used to facilitate an in-house evaluation of a Year 2000 renovation of C and
COBOL code by identifying and evaluating date sensitive variables in the
renovated code.

Service Offering Components

Comprehensive Software Evolution Services. The Company's service offerings
are designed to address software evolution needs through tools and processes
that provide productivity gains by automating and improving the software
evolution process. These services are generally offered on a fixed-fee basis,
and the client can realize the resulting productivity gains in the form of
reductions in internal IT costs, increases in throughput, improved turn-around
time and/or improved software quality. The Company's current service offerings
include SAMsp and SAMis designed respectively for the manufacturers of systems
software and products and companies' information technology organizations. In
each of these services, Peritus assumes responsibility for the evolution of a
client's software, and technology transfer services, and provides its
methodologies and tools to clients in-house, enabling them to implement
enhanced, repeatable processes for software evolution.

Team-Based Process Methodologies. The Company employs team-based
methodologies in its service offerings, on a stand alone basis or in conjunction
with its SAM Relay tool. Teams typically consist of both Company and client
employees, with a Company project manager supervising the process. In the
delivery of its services, the Company combines concepts from disciplines such as
scientific inquiry, operations research and psychology with engineering "best
practices" (such as formal inspections, cross functional teams and quality
initiatives) to create a workflow paradigm that optimizes a team's ability to
leverage its combined talent, knowledge and experience.

Advanced Technology Platform. The Company has developed its core
technologies through the use of advanced mathematical algorithms and techniques.
To achieve productivity gains, the Company utilizes proprietary tools that
better enable maintenance teams to rapidly locate and fix bugs and provide
software enhancements. These tools include a software maintenance assistance
tool designed to automate the process of logical code analysis, an application
understanding tool and a groupware tool designed to facilitate workflow
coordination.

Technology

The Company's core technologies consist of its Peritus Intermediate
Language, SAM Workbench tool, Mass Change Engine, other computer-based
tools and formal mathematical techniques.

The Peritus Intermediate Language. The Company has developed its Peritus
Intermediate Language to support accurate analysis of why a program functions
incorrectly. PIL is based on the mathematical theory that all computations can
be expressed in a small number of abstract instructions into which existing
computer languages can be translated. PIL consists of 13 abstract instructions,
and currently the COBOL, RPG, C and PL/1 programming languages have been
translated by the Company into PIL. When data enter a computer program, their
paths can be traced by the values assigned to them by the instructions in that
program. In contrast, PIL can be used to trace the paths of all data that fall
into mathematically describable classes. As a result, if the data are in a
certain state when a program completes or aborts, it is possible, using PIL, to
determine the initial conditions of these data before the program was executed.
In addition, the use of PIL allows tools to be built that can verify that a
program is logically correct by specifying pre and post conditions of classes of
data rather than relying on the traditional method of testing, which is based on
trial and error using selected data points. The Company has received a United
States Patent, Patent Number: 6,029,002 relating to the use of PIL.

SAM Workbench. The Company's SAM Workbench tool enables a user to
understand a mainframe based application or application set. It employs a
combination of methodologies and automated software features that enable a user
to extract mainframe applications and move the code to a PC workstation for
analysis and understanding. It provides detailed information on the application
inventory and relationships between software assets; partitions the assets into
applications, business transactions, and elementary transactions; generates
application size metrics, such as function point counts; and supports the
modeling of enhancements including function point counts. It can also provide
low-level impact analysis on individual code members. SAM Workbench also aids in
the understanding of legacy applications to help facilitate determining the best
strategy for enabling these applications for Internet use.

Mass Change Engine. The Company's Mass Change Engine is designed to
address mass changes to IT systems (such as expansion of data fields or changes
in product or part identifiers) by accepting as input the identified data
structure and desired rules of transformation. The Mass Change Engine then
examines the entire set of computer programs to trace all related data and
instructions, computes the necessary changes that are the result of that simple
change requirement and makes corresponding adjustments in all programs and data
so that only the desired change occurs without impacting the underlying logic.
These tasks are accomplished through the use of an adaptive seed generator based
on neural network technology, the creation of a repository of relationships
between the data and instructions using PIL and the use of propagations that
determine the relationship between variables and seeds using a set of
identification rules and information embedded in the repository. The Company's
Mass Change Engine can be adapted to address specific mass change needs. The
Company's AutoEnhancer/2000 software is an example of an extension of the Mass
Change Engine. The Company has received a United Stated Patent, Patent Number:
5,838,979 covering certain technology applicable to the Mass Change Engine.

Other Computer-Based Tools. The Company's software tools have been
specifically designed to address the needs of the software maintenance
practitioner or developer and are used by the Company's outsourcing teams. Sam
Relay and SAM Workbench are also licensed externally. Currently, the Company's
other computer-based tools include:

Peritus Code Analyzer ("PCA"). PCA is a software maintenance assistance
tool designed to automate the process of logical code analysis. The tool is used
to discover and correct defects, implement enhancements, verify properties of
software (such as database integrity or security properties), migrate from one
language to another and update systems or programs and data for specific
enhancements (such as those required by the year 2000 problem). The Company has
received a United States Patent, Number: 6,029,002 covering certain technology
applicable to PCA.

SAM Relay. SAM Relay is a workflow and productivity-enhancing groupware
tool designed to support the Peritus model for workflow coordination and
accumulation of maintenance-related knowledge and experience.

Formal Mathematical Techniques. Peritus has developed a discipline that
makes the analysis of software a more reliable activity based on the technique
of logical code analysis. Logical code analysis facilitates the understanding of
unfamiliar code and the isolation of the code specifically related to the
maintenance task and executes the required changes without impacting the
underlying logic. The Company's formal mathematical techniques are an integral
component of its core technologies and serve as the basis for the automation
capabilities of those technologies.

Products and Services

Currently, the Company's product offerings include its SAM Workbench and
SAM Relay tools, and its service offerings include software maintenance
outsourcing (SAMis and SAMsp), technology transfer and insourcing services.

SAM Workbench

The Company's SAM Workbench tool enables a user to understand a mainframe
based application or application set. It employs a combination of methodologies
and automated software features that enable a user to extract mainframe
applications and move the code to a PC workstation for analysis and
understanding. It provides detailed information on the application inventory and
relationships between software assets; partitions the assets into applications,
business transactions, and elementary transactions; generates application size
metrics, such as function point counts; and supports the modeling of
enhancements including function point counts. It can also provide low-level
impact analysis on individual code members. SAM Workbench also aids in the
understanding of legacy applications to help facilitate determining the best
strategy for enabling these applications for Internet use.

SAM Relay

SAM Relay is a web-based, groupware tool used for managing and tracking
workflow. It was developed specifically to support task management as applied to
Peritus Software Maintenance Teams and facilitates twenty-four hours, seven days
per week service through its web-based interface, enabling geographically
dispersed individuals and teams to share information in real time.

Outsourcing Services

The Company offers customized software maintenance outsourcing services to
clients. In an outsourcing project, the Company assumes responsibility for the
evolution of a client's software, including bug fixing, enhancements,
applications migration, modernization and porting. The Company's outsourcing
services address the maintenance needs of application software, system software,
embedded software and software products and are designed to provide productivity
gains regardless of platform, operating system, language or software function.
In the delivery of its outsourcing services, the Company uses a number of
proprietary technologies. Compared to traditional software maintenance methods,
the Company's technologies allow faster de-bugging by identifying and excluding
irrelevant variables and by tracing the cause of errors from the known output
resulting from such errors and the Company's processes enable workflow
management techniques to improve a maintenance team's throughput.

The Company offers two distinct types of software maintenance outsourcing
services, SAMsp and SAMis. SAMsp is a fixed price software maintenance
outsourcing solution designed specifically for the manufacturers of both systems
software and software products. SAMsp combines people, process, formal
mathematical techniques,

computer-based tools, and continuous improvement to improve productivity and
responsiveness. SAMis is a fixed price software maintenance solution designed
specifically to assist a company's information technology organization in
managing their application portfolio.

Outsourcing services are performed at both Company and client locations
with a team of Company employees, or a team comprising Company and client
employees. The Company also selectively employs subcontractors. Formal training,
support and continuous improvement are part of every outsourcing service
offering. The Company's self-directed outsourcing teams understand and exploit
organizational dynamics, workflow management and proprietary technology to
enhance the productivity, responsiveness and quality of the software evolution
process. Individual team members develop a deep and broad understanding of many
programming languages and applications, as well as maintenance technologies and
bugging methodologies. The Company also uses its SAM Relay Tool in its
outsourcing arrangements where appropriate.

In connection with the delivery of its outsourcing services, the Company
assesses the IT costs of a client together with other factors such as quality,
productivity, and software and hardware environment and in general agrees to
provide IT services on a fixed price, fixed timeframe basis after a detailed
assessment.

A typical outsourcing engagement represents a multi-million dollar,
multi-year, fixed-price contract that specifies service rather than staffing
levels.

Technology Transfer Services

The Company offers technology transfer services to assist organizations
that seek to increase the productivity of their software evolution activities
while keeping their software maintenance activities in-house. This technology
transfer program transfers the organizational model and workflow methodology of
the Company's software maintenance outsourcing solutions to enable clients to
implement enhanced, repeatable processes for software evolution.

The Company also provides insourcing services, which combine the Company's
technology transfer services with on-site management of the Peritus-trained
client teams. In an insourcing engagement, the Company participates with the
client management to provide that the teams accurately implement the Company's
approach and perform at expected productivity levels. Typical insourcing
engagements have two revenue components: a fee for services and a royalty tied
to the client's productivity gains.

Sales and Marketing

Historically, the Company offered its products and services to clients
through both direct and indirect channels, including relationships with value
added integrators using the Company's technology as an integral part of their
overall solutions, as well as domestic and international distributors.

Direct Sales

In April 1999, the Company reduced its direct sales force to one sales
representative. Future sales will be dependent upon this single sales
representative, the addition of new sales resources, the sales efforts of senior
management and the potential establishment of sales agency relationships. Prior
to April 1999, the Company sold and supported its products and services directly
in the United States. The Company plans to increase its sales resources in the
future.

Indirect Sales

The Company has agreements with value added integrators for its Year 2000
products. During 1999 and to date, the Company had limited sales from these
value added integrators. Currently, the Company's integrators are

located in the United States, Canada, Europe and Japan and are authorized by
Peritus to sublicense the Company's products and/or services to end users or
system integrators in their respective territories.

Marketing

In April 1999, the Company eliminated its marketing organization to
minimize its expenses. Prior to April 1999, the Company's marketing organization
worked closely with product management and the sales organization in the
development of Company marketing literature, market research to assist in
strategic planning and tactical decision making, trade show programs and exhibit
planning, advertising and public relations support. The Company plans to
increase its marketing efforts in the future.

Clients

The Company offers its products and services to end users in a variety of
industries including financial services, telecommunications, transportation,
insurance, utilities and manufacturing.

To date, the Company's revenue has been dependent on a few major clients,
including American Telephone & Telegraph Company ("AT&T"), Bull HN Information
Systems, Inc. ("Bull"), Computer Sciences Incorporated ("CSC"), Compaq Computer
Corporation ("Compaq"), EMC Corporation ("EMC"), International Business Machines
Corporation ("IBM"), Merrill Lynch, Pierce Fenner & Smith Incorporated ("Merrill
Lynch"), Metropolitan Life Insurance Company ("Met Life"), MicroAge Computer
Center, Inc. ("Microage"), and Telesector Resources Group Inc. ("NYNEX"). During
1999, Bull and Compaq represented approximately 21.7% and 11.8% of the Company's
total revenue, respectively. During 1998, AT&T and Bull represented
approximately 12.2% and 10.0% of the Company's total revenue, respectively.
During 1997, Bull, Merrill Lynch and Met Life represented approximately 8.4%,
6.7% and 6.7% of the Company's total revenues, respectively. In addition, the
Company's ten largest clients represented approximately 70.1%, 52.4% and 63.8%
of the Company's total revenue in the years ended December 31, 1999, 1998 and
1997, respectively.

The Company has entered into agreements to provide software consulting
services and software maintenance services with Computervision and Bull. The
Computervision agreement expires, subject to extension, on December 31, 2000.
The Bull contract expires on December 31, 2006 but is earlier cancelable upon
twelve-months notice.

The Company has also entered into a license agreement with Bull that
expires on December 31, 2001. This agreement grants to Bull certain use rights,
sublicensing rights and the right to make certain derivative works with regard
to proprietary software programs of the Company. In the event that the Company
fails to fulfill any of its obligations under the Bull license agreement for a
period of 90 days, Bull has the option, upon notice to the Company, to elect in
lieu of termination to assume performance of the Company's obligations and to
have access to source code of the Company's licensed software to perform such
assumed obligations.

The Company and Merrill Lynch have entered into a master license agreement
granting to Merrill Lynch the right to use certain proprietary software of the
Company on a non-exclusive, perpetual use basis to address year 2000 issues. The
Company has also entered into a license agreement with Met Life that provides
for the purchase by Met Life of several non-exclusive, worldwide licenses of
certain of the Company's proprietary software.

Client Technical Support

In connection with the licensing of its products, the Company provides its
clients with technical support and advice, including problem resolution,
installation assistance, error corrections and product enhancements released
during maintenance. The Company provides toll-free telephone support, as well as
access to electronic bulletin boards and other forms of electronic communication
to provide clients with the latest information regarding the Company's products
and services. Client technical support fees related to the Company's year 2000
products were typically 15% of license fees and were typically capped at
$400,000 annually per direct licensee. The Company

notified customers of its Vantage YR2000 software toolset that it was
terminating client technical support for that product in the first quarter of
the year 2000.

Research and Product Development

Historically, the Company has invested significantly in enhancing existing
technology and developing new products and services. As a result of the
Company's restructurings in 1998 and 1999, the majority of the Company's
research and development resources have been eliminated. The Company plans to
continue maintenance of and enhancements to its existing products and may
selectively develop new products. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations" for a description of research and
development expenses incurred from 1997 through 1999.

The Company has its remaining development facility at the Company's
Westborough, Massachusetts headquarters. The Company closed its development and
support center in Bangalore, India in 1999.

The Company has generally relied on internal efforts and resources to
develop its software and methodologies. However, in some limited cases, the
Company has contracted with various firms, certain of which were located in
India and Canada, to develop materials, processes, software or portions of
software for and on behalf of the Company.

Competition

The market for the Company's software products and services is intensely
competitive and characterized by rapid changes in technology and user needs and
the frequent introduction of new products. The Company's competitors include
outsourcing service providers and software maintenance tools vendors. The
Company faces competition with its SAM Workbench tool from vendors whose
products include some of the functionality of SAM Workbench, such as Merant PLC,
SEEC Inc., Viasoft Inc., and Relativity Technologies, Inc. The Company faces
competition with its SAM Relay tool from vendors whose products include some of
the functionality of SAM Relay, such as Instinctive Inc., Starbase Inc, Rational
Inc. and Interliant Inc.

The Company also faces competition in the provision of its software
maintenance outsourcing services. The Company believes that the principal
competitive factors in the market for outsourcing services include price, the
ability to provide productivity guarantees, strong client relationships,
comprehensive delivery methodologies, responsiveness to client needs, depth of
technical skills and reputation. The Company's principal competitors in this
market include not only in-house IT departments and systems integrators such as
the major accounting firms but also outsourcing service providers such as
Computer Sciences Corp., Electronic Data Systems Corporation, IBM Global
Services, Keane, Inc. and PKS Information Services, Inc.

A number of the Company's competitors are more established, benefit from
greater name recognition and have substantially greater financial, technical and
marketing resources than the Company and certain of the Company's value added
integrators. Moreover, other than the need for technical expertise, there are no
significant proprietary or other barriers to entry in the Company's market.

Intellectual Property

The Company relies on a combination of copyright, trade secret, patent,
service mark, and trademark laws and license agreements to protect its
proprietary rights in technology. In addition, the Company currently requires
its employees and consultants to enter into nondisclosure and assignment of
invention agreements to limit use of, access to and distribution of its
proprietary information.

The Company's business includes the maintenance, evolution, repair and
development of software applications, system software and other deliverables,
including written specifications and documentation in connection with

specific client engagements. Ownership of software and associated deliverables
created for clients is generally retained by or assigned to the client, and the
Company does not retain an interest in such software or deliverables. The source
code for the Company's proprietary software is generally protected as a trade
secret and an unpublished copyrighted work. However, the Company has entered
into source code escrow agreements with certain of its licensees requiring
release of source code in certain circumstances. Such source code escrow
agreements usually limit the use and disclosure of such source code in the event
that it is released.

In addition, the Company has entered into license agreements with a
limited number of clients that allow these clients access to and use of the
Company's AutoEnhancer/2000 and Vantage YR2000 software toolset and SAM Relay
and RQE tools source code for certain purposes. Access to the source code may
increase the likelihood of misappropriation or misuse by third parties.

The Company's business also includes licensing of the Company's
proprietary software, methodologies and related services to end users, as well
as to value added integrators authorized to provide services to third parties.
In general, such licensing of the Company's proprietary software, methodologies
and related services to a licensee is a limited term, limited use, non-exclusive
license that contains restrictions on copying, disclosure, usage, decompiling
and transferability. In particular cases, however, a license agreement may have
certain provisions that are exclusive in some manner. Within these licensing
agreements, the Company seeks to avoid disclosure of its trade secrets,
including, but not limited to, generally requiring those persons with access to
the Company's proprietary information to execute confidentiality agreements
restricting use of and access to the Company's confidential information.

The Company generally relies on internal efforts in order to develop its
software and methodologies. However, in some limited cases, the Company has
contracted with various firms, certain of which were located in India and
Canada, to develop software or portions of software for and on behalf of the
Company. Software development by a contractor for the Company is done pursuant
to agreements that generally assign all rights to the Company and contain
nondisclosure provisions. Such software developed by a contractor may be merged
with software that the Company has developed using its internal employees. In
January 1996, the Company acquired Vista and was assigned all of Vista's
intellectual property rights, consisting mainly of unregistered copyrights. In
December 1997, the Company acquired additional year 2000 technology in
connection with the MDI acquisition.

The Company has filed six patent applications with the United States
Patent and Trademark Office (the "PTO") pertaining to technologies, processes
and methodologies used by the Company's software. A patent has been granted on
three of these applications: (i) United States Patent Number: 5,838,979, that
covers certain technology applicable to the Mass Change Engine, (ii) United
States Patent Number: 5,911,142, that covers a system and method that
automatically converts field lengths of data fields in a data file that are
accessed by a computer program and correspond to date-related data, and (iii)
United States Patent Number: 6,029,002 that covers an analyzer for maintaining
and analyzing source code that includes a software translator for converting
source code into an intermediate language, slicing capability based upon weakest
precondition determination, dual direction flow analysis and incorporation of a
computational model to facilitate iterative code. There can be no assurance that
a patent will be issued pursuant to any other of the pending patent applications
or that, if granted, such patents would survive a legal challenge to their
validity or provide meaningful or significant protection to the Company. In
addition, the Company may decide to abandon a patent application if, among other
things, it determines that continued prosecution of an application would be too
costly, the technologies, processes or methodologies are not critical to the
Company's business in the foreseeable future or it is unlikely that a patent
will issue with regard to a particular application. Some competitors of the
Company have announced the filing with the United States Patent and Trademark
Office of patent applications relating to fixing and assessing the year 2000
problem. The Company expects that the risk of infringement claims against the
Company might increase because its competitors might successfully obtain patents
for software products and processes. The Company has become aware of a patent
relating to fixing the year 2000 problem based on a "windowing" method. Certain
of the Company's technology incorporated in some of its products may infringe on
such patent. The Company is in the process of reviewing the matter.

There can be no assurance that the Company's means of protecting its
proprietary rights in the United States or abroad will be adequate. The laws of
some foreign countries may not protect the Company's proprietary rights as fully
or in the same manner as do the laws of the United States. Also, despite the
steps taken by the Company to protect its proprietary rights, it may be possible
for unauthorized third parties to copy aspects of the Company's products,
reverse engineer, develop similar technology independently, or obtain and use
information that the Company regards as proprietary. Furthermore, there can be
no assurance that others will not develop technologies similar or superior to
the Company's technology or design around the proprietary rights owned by the
Company. However, the Company believes that, because of the rapid pace of
technological change in the software industry, patent, trade secret and
copyright protection is less significant to the Company's competitive position
than factors such as the knowledge, ability and experience of its personnel, new
product development, frequent product enhancements, name recognition and ongoing
product maintenance support with regard to developing, establishing and
maintaining a technology leadership position.

Employees

As of March 28, 2000, the Company employed 37 employees, five of whom
were part-time. It is important for the Company to retain and attract highly
skilled and qualified personnel. Competition for such personnel is intense in
the computer software industry, particularly for software developers, service
consultants, and sales and marketing personnel. There can be no assurance that
the Company will be able to attract and retain qualified personnel in the
future.

The Company's employees are not represented by any labor unions. The
Company considers its relations with its employees to be good.

Item 2. Properties

The Company is headquartered in Westborough, Massachusetts, where it
leases approximately 12,000 square feet under a lease expiring in December 2001.
The Company has the right to extend the lease for an additional term of three
years subject to certain terms and conditions.

Item 3. Legal Proceedings

The Company and certain of its officers and directors were named as
defendants in purported class action lawsuits filed in the United States
District Court for the District of Massachusetts by Robert Downey on April 1,
1998, by Scott Cohen on April 7, 1998, by Timothy Bonnett on April 9, 1998, by
Peter Lindsay on April 17, 1998, by Harry Teague on April 21, 1998, by Jesse
Wijntjes on April 29, 1998, by H. Vance Johnson and H. Vance Johnson as Trustee
for the I.O.R.D. Profit-Sharing Plan on May 6, 1998, by John B. Howard, M.D. on
May 21, 1998 and by Helen Lee on May 28, 1998 (collectively, the "complaints").
The complaints principally alleged that the defendants violated federal
securities laws by making false and misleading statements and by failing to
disclose material information concerning the Company's December 1997 acquisition
of substantially all of the assets and assumption of certain liabilities of the
Millennium Dynamics, Inc. business from American Premier Underwriters, Inc.,
thereby allegedly causing the value of the Company's common stock to be
artificially inflated during the purported class periods. In addition, the
Howard complaint alleged violation of federal securities laws as a result of the
Company's purported failure to disclose material information in connection with
the Company's initial public offering on July 2, 1997, and also named Montgomery
Securities, Inc., Wessels, Arnold & Henderson, and H.C. Wainwright & Co., Inc.
as defendants. The complaints further alleged that certain officers and/or
directors of the Company sold stock in the open market during the class periods
and sought unspecified damages.

On or about June 1, 1998, all of the named plaintiffs and additional
purported class members filed a motion for the appointment of several of those
individuals as lead plaintiffs, for approval of lead and liaison plaintiffs'
counsel

and for consolidation of the actions. The Court granted the motion on June 18,
1998.

On January 8, 1999, the plaintiffs filed a Consolidated Amended Complaint
applicable to all previously filed actions. The Consolidated Amended Complaint
alleged a class period of October 22, 1997 through October 26, 1998 and
principally claimed that the Company and three of its former officers violated
federal securities law by purportedly making false and misleading statements (or
omitting material information) concerning the MDI acquisition and the Company's
revenue during the proposed class period, thereby allegedly causing the value of
the Company's common stock to be artificially inflated. Previously stated claims
against the Company and its underwriters alleging violations of the federal
securities laws as a result of purportedly inadequate or incorrect disclosure in
connection with the Company's initial public offering were not included in the
Consolidated Amended Complaint. The Company and the individual defendants filed
motions to dismiss the Consolidated Amended Complaint on March 5, 1999. Oral
arguments on the motions were held on April 21, 1999 and the Court granted the
Company's and the individual defendants' motions to dismiss the Consolidated
Amended Complaint pursuant to an order dated June 1, 1999. The plaintiffs
appealed the Court's order of dismissal. The Company contested the appeal and
supported the Court's order of dismissal. In December, 1999, the parties agreed
to settle the lawsuit. The Company received final approval on February 28, 2000
from the Court of the settlement of the action. The $2.8 million settlement
became effective and the appeal period expired on March 29, 2000. The settlement
was funded entirely by the Company's directors and officers liability insurer
and the Company and the individual defendants received a full release and
dismissal of all claims brought by the class during the class period.

On or about April 28, 1999, the Company filed a lawsuit in the United
States District Court for the District of Massachusetts against Micah Technology
Services, Inc. and Affiliated Computer Services, Inc. (collectively, "Micah").
The lawsuit principally alleges that Micah breached its contract with the
Company by failing to pay for services performed by the Company under such
contract. The lawsuit further alleges that since Micah was unjustly enriched by
the services performed by the Company, the Company is entitled to recovery based
on quantum meruit, and that Micah engaged in unfair and/or deceptive trade
practices or acts in violation of Massachusetts General Laws ("M.G.L.") Chapter
93A by allowing the Company to perform services when Micah did not pay for such
services. The lawsuit seeks unspecified damages on the breach of contract and
quantum meruit claims and double or triple damages on the Chapter 93A claim.
Micah has denied the Company's allegations and has filed a counterclaim against
the Company principally alleging fraud, negligent misrepresentations, breach of
contract and that the Company engaged in unfair and/or deceptive trade practices
or acts in violation of M.G.L. Chapter 93A by its misrepresentations and breach
of contract. The Company denied the allegations contained in Micah's
counterclaim and intends to contest the counterclaim vigorously. The parties are
in the initial discovery phase of the litigation. A non-binding mediation
hearing was held on March 17, 2000 and no settlement was reached.

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

None.

PART II.

Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters

The following table sets forth, for the periods indicated, the range of
high and low sales prices for the Company's common stock, as reported by the
Nasdaq Stock Market, Inc. The Company's securities were traded on the Nasdaq
National Market through February 3, 1999. Thereafter, they have been traded on
the OTC Bulletin Board. The Company's common stock has been traded under the
symbol "PTUS" since the Company's initial public offering on July 2, 1997. These
prices reflect interdealer prices, without retail mark-ups, mark-downs or
commissions, and do not necessarily represent actual transactions.

1998 1999
--------------------- -----------------------
High Low High Low
-------- --------- ---------- ---------
First Quarter ........... $ 23.75 $ 5.4375 $ 1.1875 $ 0.1875
Second Quarter .......... $ 7.00 $ 3.7500 $ 0.3281 $ 0.1250
Third Quarter ........... $ 7.50 $ 1.1562 $ 0.3125 $ 0.1250
Fourth Quarter .......... $ 1.50 $ 0.3438 $ 0.1406 $ 0.0781

Historically, the Company has not declared or paid cash dividends on its
common stock and does not plan to pay cash dividends to its stockholders in the
foreseeable future. The Company presently intends to retain any earnings to
finance its business. As of March 17, 2000, there were 362 stockholders of
record of the Company's common stock.

The Company is furnishing the following information with respect to the
use of proceeds from its initial public offering of common stock, $.01 par value
per share on July 2, 1997:

(1) The effective date of the registration statement for the
offering and the commission file number were July 1, 1997 and
333-27087, respectively.

(4)(vii) From October 1, 1997 to December 31, 1999, $500,000 of the
offering proceeds were used to repay certain indebtedness under a
secured subordinated note, $30 million were paid to APU in
connection with the MDI acquisition and $10,164,000 were used to
fund the Company's operations or for working purposes capital. No
offering proceeds remained as of December 31, 1999.

Except for the $30 million paid to APU which, as a result of the MDI
acquisition, owns 10% or more of the Company's common stock, payment of the
offering proceeds were to persons other than directors, officers, general
partners of the Company or their associates, persons owning 10% or more of the
equity securities of the Company or affiliates of the Company.

Item 6. Selected Financial Data

The selected financial data set forth below as of December 31, 1999 and
1998, and for the three years ended December 31, 1999, are derived from the
Company's Consolidated Financial Statements, which appear elsewhere in this
Annual Report. The selected financial data set forth below as of December 31,
1997, 1996 and 1995 and for the years ended December 31, 1996 and 1995 are
derived from the Company's audited financial statements, which are not included
in this Annual Report. The data set forth below should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the Company's Consolidated Financial Statements, including the
Notes thereto, included elsewhere in this Annual Report.

Year Ended December 31,
--------------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
(In Thousands, Except Per Share Data)

Statement of operations data:
Revenue:
Outsourcing services .............................................. $ 5,923 $ 9,925 $ 11,447 $ 10,190 $ 16,400
License ........................................................... 2,087 9,444 21,255 6,526 --
Other services .................................................... 3,188 12,163 7,007 2,519 2,105
-------- -------- -------- -------- --------
Total revenue(1) .............................................. $ 11,198 $ 31,532 $ 39,709 $ 19,235 $ 18,505
-------- -------- -------- -------- --------
Cost of revenue:
Cost of outsourcing services ...................................... 4,778 7,577 9,536 8,488 9,602
Cost of license ................................................... 238 1,631 690 162 --
Cost of other services ............................................ 2,013 9,110 5,357 2,931 2,421
-------- -------- -------- -------- --------
Total cost of revenue ......................................... 7,029 18,318 15,583 11,581 12,023
-------- -------- -------- -------- --------
Gross profit ......................................................... 4,169 13,214 24,126 7,654 6,482
-------- -------- -------- -------- --------
Operating expenses:
Sales and marketing .................................................. 1,450 13,244 8,864 3,116 2,129
Research and development ............................................. 1,316 8,528 8,324 6,033 1,703
General and administrative ........................................... 3,570 7,466 4,312 3,249 2,357
Write-off of acquired in-process research and development ............ -- -- 70,800 -- --
Impairment of long-lived assets ...................................... 961 5,218 -- -- --
Restructuring charges (credit) ....................................... (455) 5,906 -- -- --
-------- -------- -------- -------- --------
Total operating expenses ...................................... 6,842 40,362 92,300 12,398 6,189
-------- -------- -------- -------- --------
Income (loss) from operations ........................................ (2,673) (27,148) (68,174) (4,744) 293
Interest income (expense), net ....................................... 92 485 948 (296) (203)
-------- -------- -------- -------- --------
Income (loss) before gain on sale of majority-owned subsidiary,
income taxes, minority interest and equity in loss of less
than majority-owned company ....................................... (2,581) (26,663) (67,226) (5,040) 90
Gain on sale of majority-owned subsidiary ............................ -- (11) -- -- --
Provision (benefit) for income taxes ................................. 2 25 260 (143) (8)
-------- -------- -------- -------- --------
Income (loss) before minority interest and equity in loss of less
than majority-owned company ....................................... (2,583) (26,677) (67,486) (4,897) 98
Minority interest in majority-owned subsidiary ....................... -- (4) 4 24 43
-------- -------- -------- -------- --------
Net income (loss) .................................................... $ ( 2,583) $(26,673) $(67,490) $ (4,921) $ 55
======== ======== ======== ======== ========
Net income (loss) per share:(2)
Basic ............................................................. $ ( 0.15) $ (1.65) $ (7.03) $ (1.02) $ 0.01
======== ======== ======== ======== ========
Diluted ........................................................... $ ( 0.15) $ (1.65) $ (7.03) $ (1.02) $ 0.01
======== ======== ======== ======== ========
Weighted average shares outstanding
Basic ............................................................. 16,684 16,177 9,708 5,876 5,078
======== ======== ======== ======== ========
Diluted ........................................................... 16,684 16,177 9,708 5,876 6,456
======== ======== ======== ======== ========

December 31,
-----------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
(In Thousands)

Balance sheet data:
Cash and cash equivalents, including restricted cash ... $ 2,475 $ 3,378 $ 11,340 $ 7,388 $ 264
Short-term investments ................................. -- 500 3,000 -- --
Working capital ........................................ 1,640 1,805 20,931 8,218 2,218
Total assets ........................................... 4,293 13,723 39,870 17,725 7,179
Long-term debt, net of current portion ................. -- -- 413 1,538 1,792
Redeemable stock ....................................... -- -- -- 12,287 --
Stockholders' equity (deficit) ......................... 2,372 4,810 30,005 (3,302) 1,802

- ----------
(1) Revenue (in thousands) from related parties in the years ended December
31, 1999, 1998, 1997, 1996 and 1995 was $0, $1,331, $4,478, $6,443, and
$10,114, respectively. See the Company's Consolidated Financial
Statements.

(2) See Note 2 of Notes to the Company's Consolidated Financial Statements for
an explanation of the determination of historical net income (loss) per
share.

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

Company Current Condition and Current Strategy

In the second half of 1998 and in 1999, the overall market for the
year 2000 tools and services of Peritus Software Services, Inc. ("Peritus" or
the "Company") contracted dramatically, resulting in substantial financial
losses. In response, the Company substantially reduced its workforce in
September and December of 1998 and again in April of 1999. During the second and
third quarters of 1999, the Company also settled its leases for its facilities
in Cincinnati, Ohio, Lisle, Illinois and Billerica, Massachusetts and took other
efforts to reduce its fixed costs. As a result of the Company's degraded
financial condition, the Company began encountering major obstacles in obtaining
new outsourcing business. Since most outsourcing engagements are multi-year and
involve critical applications, prospective new clients, although interested in
the capabilities and technology of the Company, were reluctant or unwilling to
commit to contracts. Despite the significant reduction in the overall cost
structure as a result of the foregoing actions, the Company was unable to
achieve a cash flow break-even position in the year ended December 31, 1999.

On March 27, 2000, Rocket Software, Inc. ("Rocket"), a privately held
company, invested $4,000,000 in the Company in exchange for 10,000,000 shares
($.40 per share) of restricted common stock (37% of outstanding stock after the
investment). The Company granted Rocket certain registration rights with respect
to the shares. The Company will record a one-time charge related to the
investment of approximately $4,000,000 in the quarter ending March 31, 2000. The
charge represents the difference between the quoted market price on the
commitment date and the price paid by Rocket. Under certain sections of the
Internal Revenue Code, a change in ownership of greater than 50% within a
three-year period places an annual limitation on the Company's ability to
utilize its existing net operating loss and research and development tax credit
carry-forwards. The investment by Rocket triggered the limitation. Based on the
Company's current forecasted cash expenditures, its cash on hand prior to the
Rocket investment and the $4,000,000 invested by Rocket, the Company expects to
have sufficient cash to finance its operations through the year 2000. The
Company's future beyond the year 2000 is dependent upon its ability to achieve a
break-even cash flow or raise additional financing. There can be no assurances
that the Company will be able to do so.

investments in sales and marketing, and research and development (particularly
the enhancement of the Company's SAM Workbench tool), and for other general
corporate purposes. The Company also plans to develop other service offerings
and to renew its efforts to generate new outsourcing business.

Company Overview

Peritus provides solutions consisting of software products and services
that enable organizations to improve the productivity, quality and effectiveness
of their information technology ("IT"), systems maintenance or software
evolution functions. The Company employs software tools, methodologies and
processes, designed to automate the typically labor-intensive processes involved
in conducting mass change and other software maintenance tasks. In 1996, the
Company released its first commercially available product, its AutoEnhancer/2000
software, which was aimed at the industry's most pervasive mass change
challenge, the year 2000 problem, to value added integrators and directly to end
users. In 1996, the Company expanded its research and development efforts
through the acquisition of Vista Technologies Incorporated ("Vista"), a
developer of computer-aided engineering software. In 1997, the Company expanded
its product offerings and research and development efforts by releasing an
enhanced version of the AutoEnhancer/2000 software, which enables a client to
perform logic correction only changes with regard to year 2000 renovations, and
acquiring substantially all of the assets and the assumption of certain of the
liabilities of Millennium Dynamics, Inc. ("MDI"), a software tools company with
year 2000 products for the IBM mainframe and AS/400 platforms from American
Premium Underwriters, Inc. ("APU").

In response to changes in the markets for the Company's products and
services, the Company emphasized the direct delivery of year 2000 renovation
services and renovation quality evaluation ("RQE") services in the beginning of
1998 and also began to refocus the Company's business on software maintenance
outsourcing services. In 1998, the Company also began licensing its RQE tool, a
product used to facilitate an in-house evaluation of a completed year 2000
renovation. As the market continued to shift from the Company's year 2000
products and services during the third quarter of 1998, the Company revised its
overall strategy to emphasize the growth of its software maintenance outsourcing
business over the long term and to meet its clients needs for year 2000
renovation services and RQE services. In July 1998, the Company announced its
software maintenance outsourcing offerings, "Software Asset Maintenance for
Software Providers" ("SAMsp")and "Software Asset Maintenance for Information
Systems" ("SAMis"), which are outsourcing solutions designed specifically for
the manufacturers of system software and software products and for information
technology departments that maintain application software, respectively.

Revenue Recognition Policies

Revenue under contracts to provide outsourced software maintenance,
reengineering and development services is recognized using the
percentage-of-completion method and is based on the ratio that labor-hours
incurred to date bear to estimated total labor-hours at completion, provided
that a contract or purchase order has been executed, fees are fixed or
determinable and collection of the related receivable is probable. Adjustments
to contract cost estimates are made in the periods in which the facts which
require such revisions become known. When the revised estimates indicate a loss,
such loss is provided for currently in its entirety. Costs and estimated
earnings in excess of billings on uncompleted contracts represent revenue
recognized in excess of amounts billed. Billings in excess of costs and
estimated earnings on uncompleted contracts represent billings in excess of
revenue recognized.

arrangements where customer acceptance provisions exist, the Company defers
revenue recognition until customer acceptance occurs or the acceptance
provisions have lapsed. The Company generally does not provide its customers
with the right to return software licenses and, once due, license fees are
non-refundable. Revenue from software licenses to value added integrators is
recognized when the licensed software and methodologies have been delivered to
the value added integrator, the fee is fixed or determinable and collection of
the related receivable is probable. Under arrangements combining software and
services, all revenue is recorded using the percent of completion method as
described for other services below. Under such combined arrangements, vendor
specific objective evidence ("VSOE") for software license is used for income
statement classification purposes only and is determined based upon the prices
that exist or are charged for the same software when licensed separately and
distinctly. The VSOE for the service component under combined arrangements is
based upon hourly rates.

Other services provided by the Company include direct delivery contracts
as well as technology transfer arrangements, product training, value added
integrator sales training, consulting services and software product maintenance.
Under direct delivery contracts, the Company provides full and pilot year 2000
renovations and renovation quality evaluation services for clients using the
Company's AutoEnhancer/2000, RQE tool, and/or Vantage YR2000 software. Revenue
from full year 2000 renovation and RQE contracts is recognized using the
percentage-of-completion method and is based on the ratio that labor-hours
incurred to date bear to estimated total labor-hours at completion, provided
that a contract or purchase order has been executed, fees are fixed or
determinable and collection of the related receivable is probable. Revenue from
pilot direct delivery contracts is recognized over the duration of such
contracts as work is performed and defined milestones are attained. Adjustments
to contract cost estimates are made in the periods in which the facts which
require such revisions become known. When the revised estimates indicate a loss,
such loss is provided for currently in its entirety. In cases where VSOE of fair
value of both the license and service component exists under a direct delivery
contract, revenue recognized is allocated between license revenue and other
services revenue for income statement classification purposes based on their
relative fair values. Revenue from technology transfer arrangements, product and
sales training and consulting services is billed on a time-and-materials basis
and is recognized as the services are provided. Revenue from software product
maintenance contracts on the Company's licensed software products, including
client support bundled with the initial license fee, is deferred and recognized
ratably over the contractual periods during which the services are provided.

Financial Controls

In 1998, the Company restated its financial results for the third and
fourth quarters of 1997 and the first and second quarters of 1998. The
restatements primarily related to revenue recording. As a result of the
restatements, the Company revised its financial controls. The senior financial
personnel involved in revenue recording have carefully reviewed the provisions
of Statement of Position 97-2, Software Revenue Recognition and Staff Accounting
Bulletin 101, Revenue Recognition in Financial Statements with particular
emphasis on multiple element arrangements. A control has been added to the
revenue recording process to confirm software delivery prior to revenue. In
addition, a software receipt acknowledgement signed by the customer is generally
obtained to confirm software delivery. The Company's legal staff is now
responsible for informing the finance staff of any acceptance conditions
contained within any contract. The finance staff is now responsible for ensuring
any acceptance conditions are met prior to revenue recording. Finally, the
Company's Chief Financial Officer reviews all significant revenue transactions
for proper recording.

Client Concentration

For the year ended December 31, 1999, Bull and Compaq accounted for 21.7%
and 11.8% of the Company's total revenue, respectively. For the year ended
December 31, 1998, AT&T and Bull accounted for 12.2% and 10.0% of the Company's
total revenue, respectively. For the year ended December 31, 1997, no single
customer accounted for more than 10% of the Company's total revenue. The
Company's ten largest clients in the years ended December 31, 1999, 1998 and
1997 accounted for approximately 70.1%, 52.4% and 63.8% of the Company's total
revenue, respectively.

Results of Operations

The following table sets forth for the periods indicated the percentage of
total revenue of certain line items included in the Company's consolidated
statement of operations:

Year Ended December 31,
-----------------------------
1999 1998 1997
----- ----- -----

Revenue:
Outsourcing services ............................................ 52.9% 31.5% 28.8%
License ......................................................... 18.6 30.0 53.5
Other services .................................................. 28.5 38.5 17.7
----- ----- -----
Total revenue(1) .......................................... 100.0 100.0 100.0
----- ----- -----
Cost of revenue:
Cost of outsourcing services .................................... 42.7 24.0 24.0
Cost of license ................................................. 2.1 5.2 1.7
Cost of other services .......................................... 18.0 28.9 13.5
----- ----- -----
Total cost of revenue ..................................... 62.8 58.1 39.2
----- ----- -----
Gross profit .......................................................... 37.2 41.9 60.8
----- ----- -----
Operating expenses:
Sales and marketing ............................................. 12.9 42.0 22.3
Research and development ........................................ 11.8 27.1 21.0
General and administrative ...................................... 31.9 23.7 10.9
Write-off of acquired in-process research and development ....... -- -- 178.3
Impairment of long-lived assets ................................. 8.6 16.5 --
Restructuring charges (credits) ................................. (4.1) 18.7 --
----- ----- -----
Total operating expenses .................................. 61.1 128.0 232.5
----- ----- -----
Loss from operations .................................................. (23.9) (86.1) (171.7)
Interest income, net .................................................. 0.8 1.5 2.4
----- ----- -----
Loss before gain on sale of majority-owned subsidiary, income taxes and
minority interest in majority-owned subsidiary ..................... (23.1) (84.6) (169.3)
Gain on sale of majority-owned subsidiary ............................. -- (0.1) --
Provision for income taxes ............................................ -- 0.1 0.7
----- ----- -----
Loss before minority interest ......................................... (23.1) (84.6) (170.0)
Minority interest in majority-owned subsidiary ........................ -- -- --
----- ----- -----
Net loss .................................................. (23.1)% (84.6)% (170.0)%
===== ===== =====

- ----------
(1) Revenue from related parties in the years ended December 31, 1999, 1998
and 1997 represented 0%, 4.2%, and 11.3% of total revenue, respectively.

Year Ended December 31, 1999 Compared to Year Ended December 31, 1998

Revenue

Total revenue decreased 64.5% to $11,198,000 in the year ended December
31, 1999 from $31,532,000 in the year ended December 31, 1998. This decrease in
revenue was primarily due to a decrease in other services revenue as well as the
licensing of the Company's products, and to a lesser extent, outsourcing
services revenue.

The Company anticipates that total revenue for the year 2000 will be
substantially below the level achieved in 1999.

Outsourcing Services. Outsourcing services revenue decreased 40.3% to
$5,923,000 in the year ended December 31, 1999 from $9,925,000 in the year ended
December 31, 1998. As a percentage of total revenue, outsourcing services
revenue increased to 52.9% in the year ended December 31, 1999 from 31.5% in the
year ended December 31, 1998. The increase in outsourcing services revenue as a
percentage of total revenue reflects the decreased contribution of other
services and license revenue to total revenue during the year ended December 31,
1999 when compared to the same period in the prior year. The decrease in
outsourcing revenue in absolute dollars in the year ended December 31, 1999
compared to December 31, 1998 was primarily attributable to the sale of a
foreign subsidiary in July 1998, and the recording of lower amounts of revenue
under existing outsourcing engagements due to reduced workload or contract
terminations. Outsourcing revenue in 1999 included $2,068,000 associated with
six contracts that terminated during the year. Outsourcing services remain a
major component of the Company's business. Without the addition of new business,
the Company's outsourcing revenue in the future will be significantly below the
$5,923,000 recorded in 1999.

License. License revenue decreased 77.9% to $2,087,000 in the year ended
December 31, 1999 from $9,444,000 in the year ended December 31, 1998. As a
percentage of total revenue, license revenue decreased to 18.6% in the year
ended December 31, 1999 from 30.0% in the year ended December 31, 1998. The
decrease in license revenue for 1999 in absolute dollars was primarily
attributable to a decrease in the delivery of licensed software to end users and
decreased license fees from value-added integrators. The market for the
Company's year 2000 tools significantly eroded in 1998 and 1999 resulting in
substantial declines in license revenue. The Company anticipates no year 2000
related license revenue in the future. The Company will continue to pursue
licenses of its outsourcing methodology and SAM Relay and SAM Workbench tools
and future revenue is dependent on the success of such efforts.

Other Services. Other services revenue decreased 73.8% to $3,188,000 in
the year ended December 31, 1999 from $12,163,000 in the year ended December 31,
1998. As a percentage of total revenue, other services revenue decreased to
28.5% in the year ended December 31, 1999 from 38.5% in the year ended December
31, 1998. The decrease in other services revenue in absolute dollars was
primarily attributable to a decrease in direct delivery, consulting and client
support services relating to the Company's year 2000 products and services.
Given the reduction in demand for its year 2000 services and the reduction in
internal resources announced at the end of March 1999, the Company anticipates
minimal year 2000 related service revenue in the future. Future revenue from
other services is dependent on the Company's success in licensing its
methodology, and its SAM Workbench and SAM Relay tools which would generate
maintenance, consulting, and training revenue; as well as the development of
other new successful offerings.

Cost of Revenue

Cost of Outsourcing Services Revenue. Cost of outsourcing services revenue
consists primarily of salaries, benefits, networking, and overhead costs
associated with delivering outsourcing services to clients. The cost of
outsourcing services revenue decreased 36.9% to $4,778,000 in the year ended
December 31, 1999 from $7,577,000 for the year ended December 31, 1998. Cost of
outsourcing services revenue as a percentage of outsourcing services revenue
increased to 80.7% in the year ended December 31, 1999 from 76.3% in the year
ended December 31,

1998. Costs in 1999 were negatively impacted by expenditures in anticipation of
and to generate new business that did not materialize. In addition, the Company
incurred costs in connection with an agreement with Micah Technology Services,
Inc. ("Micah") for which it received no payments. The Company has filed a
lawsuit against Micah to attempt to recover amounts due under such agreement See
"Part I-Item 3. Legal Proceedings."

Cost of License Revenue. Cost of license revenue consists primarily of
amortization of intangibles related to the MDI acquisition and salaries,
benefits and related overhead costs associated with license-related materials
packaging and freight. Cost of license revenue was $238,000 in the year ended
December 31, 1999, or 11.4% of license revenue. Cost of license revenue was
$1,631,000, or 17.3% of license revenue, in the year ended December 31, 1998.
The decrease in cost of license revenue in absolute dollars was primarily
related to the reduction of amortization expense of intangibles related to the
MDI acquisition as a result of the impairment charge recorded against the MDI
related intangibles by the Company in the third quarter of 1998.

Cost of Other Services Revenue. Cost of other services revenue consists
primarily of salaries, benefits, subcontracting costs and related overhead costs
associated with delivering other services to clients. Cost of other services
revenue decreased 77.9% to $2,013,000 in the year ended December 31, 1999 from
$9,110,000 in the year ended December 31, 1998. Cost of other services revenue
as a percentage of other services revenue decreased to 63.1% in the year ended
December 31, 1999 from 74.9% in the year ended December 31, 1998. Costs
decreased in absolute dollars in the year ended December 31, 1999 due to reduced
staffing for the Company's client support, training and consulting organizations
related to fewer customers for the Company's year 2000 products and services,
including year 2000 renovations and RQE services.

Operating Expenses

Sales and Marketing. Sales and marketing expenses consist primarily of
salaries, commissions and related overhead costs for sales and marketing
personnel, sales referral fees to third parties, advertising programs, and other
promotional activities. Sales and marketing expenses decreased 89.1% to
$1,450,000 in the year ended December 31, 1999 from $13,244,000 in the year
ended December 31, 1998. As a percentage of total revenue, sales and marketing
expenses decreased to 12.9% in the year ended December 31, 1999 from 42.0% in
the year ended December 31, 1998. The decrease in expenses in absolute dollars
was primarily attributable to dramatically reduced staffing, commissions and
promotional activities.

Research and Development. Research and development expenses consist
primarily of salaries, benefits and related overhead costs for engineering and
technical personnel and outside engineering consulting services associated with
developing new products and enhancing existing products. Research and
development expenses decreased 84.6% to $1,316,000 in the year ended December
31, 1999 from $8,528,000 in the year ended December 31, 1998. As a percentage of
total revenue, research and development expenses decreased to 11.8% in the year
ended December 31, 1999 from 27.1% in the year ended December 31, 1998. The
decrease in research and development expenses in absolute dollars was primarily
attributable to dramatically reduced staffing for the product development
efforts for the Company's year 2000 products and services, mass change
technologies and other software tools.

General and Administrative. General and administrative expenses consist
primarily of salaries and related costs for the finance and accounting, human
resources, legal, information systems, and other administrative departments of
the Company, as well as contracted legal and accounting services. General and
administrative expenses decreased 52.2% to $3,570,000 in the year ended December
31, 1999 from $7,466,000 in the year ended December 31, 1998. As a percentage of
total revenue, general and administrative expenses increased to 31.9% in the
year ended December 31, 1999 from 23.7% in the year ended December 31, 1998. In
the year ended December 31, 1999, the decrease in general and administrative
expenses in absolute dollars was primarily due to changes to charges related to
accounts receivable and reduced staffing. In 1999, general and administrative
expenses included a $321,000 credit associated with a reduction in the Company's
allowance for doubtful accounts as a result of the successful collection of
receivables for which specific allowances had been established in 1998. In 1998,
general and

administrative expenses included a $1,481,000 increase in the Company's
allowance for doubtful accounts. In 1999, excess space that could not be
segregated and included in restructuring was charged to general and
administrative expenses. The total of such excess facility-related charges was
approximately $500,000 for the year 1999.

Impairment of Long-Lived Assets. The Company periodically assesses whether
any events or changes in circumstances have occurred that would indicate that
the carrying amount of a long-lived asset might not be recoverable. When such an
event or change in circumstance occurs, the Company evaluates whether the
carrying amount of such asset is recoverable by comparing the net book value of
the asset to estimated future undiscounted cash flows, excluding interest
charges, attributable to such asset. If it is determined that the carrying
amount is not recoverable, the Company recognizes an impairment loss equal to
the excess of the carrying amount of the asset over the estimated fair value of
such asset.

Year Ended 1999

In June 1999, as a result of the continuing downsizing of the Company's
operations and continuing decline in operating results, the Company reviewed the
carrying amount of its property and equipment and committed to a plan to dispose
certain of its assets, primarily excess computer equipment and furniture
relating to its restructured operations, either by sale or by abandonment. The
fair value of the assets to be disposed of was measured at management's best
estimate of salvage value, by using the current market values or the current
selling prices for similar assets. Based upon management's review, the carrying
amount of assets having a net book value of $1,143,000 was written-down to a
total amount of $389,000, representing the lower of carrying amount or fair
value (salvage value) and the Company recorded an impairment charge totaling
$754,000. The reduction in depreciation expenses resulting from this write-down
was approximately $82,000 on a quarterly basis beginning in the third quarter of
1999. The Company completed its sale of assets associated with its June 1999
impairment charge in the third quarter of 1999 and the sale proceeds received
were not significantly different from original estimates.

During the third quarter of 1999, the Company made a decision to transfer
the research and development responsibility for its SAM Workbench tool from
India to the United States. As a result of that decision, the personnel of its
Indian subsidiary were no longer required and were transferred (with the
exception of one) to another company without cost. After the personnel transfer
which occurred in September 1999, the Company ceased using the assets and
anticipated no future productive use for such assets. Accordingly, the Company
recorded an impairment charge of $145,000 against assets having a net book value
of $182,000 to write down the assets involved, which consisted of primarily of
leasehold improvements and computer equipment, to their estimated fair value
(salvage value) of $37,000. The estimated salvage value of 20% of book value was
determined through discussions with the Company's subsidiary manager in India
regarding selling prices for similar assets. The Company concluded a sale
agreement for the assets in February 2000 for $55,000 and the facility lease in
India was extended by one month to facilitate completion of the sale of assets.
The reduction in depreciation expense from the asset write-down was
approximately $10,000 on a quarterly basis beginning in the fourth quarter of
1999.

During the third quarter of 1999, the Company completed its review of its
product offering going forward. This review included its patent associated with
its mass change engine that had a remaining capitalized cost of $63,000. The
Company concluded that it could not afford and, therefore, would not develop any
future products based upon the patented technology. Further, the Company was no
longer generating revenue from its existing products based on the patented
technology. In addition, during the third quarter, the Company investigated
whether there was an opportunity to generate any income from the pursuit of
possible patent infringements and concluded such generation was unlikely. The
Company does not believe there is any opportunity to sell or license its
patented mass change engine technology. Therefore, according to Paragraphs 6 and
7 of SFAS 121, the Company recorded an impairment charge for the entire
remaining capitalized cost. The write-down was included in the third quarter
impairment charge. Savings in amortization expense from this write-down was
$17,000 on a quarterly basis beginning in the fourth quarter of 1999.

Year Ended 1998

Due to lower than anticipated revenue and greater than expected losses
during the quarter ended September 30, 1998, the Company adopted a plan to stop
development of all existing and in-process products originally acquired from MDI
in December 1997, including all Vantage YR2000 renovation and testing software
tools and the generic mass change product. Substantially all direct sales
efforts relating to existing Vantage YR2000 products were also stopped. In
connection with these actions, the Company also undertook a restructuring of its
operations (See Note 6 of Notes to the Company's Consolidated Financial
Statements) which included the closure of the Company's research and development
facilities in Cincinnati, Ohio and Lisle, Illinois and the termination of
substantially all the employees at these facilities. As a result of these
events, management concluded that an assessment of the recoverability of
intangible assets recorded in connection with the acquisition of MDI in December
1997 was required at September 30, 1998. The Company determined that its
property and equipment at these locations was not subject to impairment as
substantially all such assets were scheduled to be redeployed.

In connection with the assessment, management prepared forecasts of the
expected future cash flows related to these intangible assets on an undiscounted
basis and without interest charges. Due to the fact that product development
efforts had been stopped, the Company concluded that the existing technology
acquired as part of the MDI acquisition would only be used in existing Vantage
YR2000 products. As a result of this analysis, management determined that the
estimated undiscounted net cash flows to be generated by acquired technology
recorded as part of the MDI acquisition were less than the asset's net book
value as of September 30, 1998. Accordingly, the acquired technology was
written-down to $289,000, its estimated fair value, using a discounted cash flow
model. With regard to intangible assets relating to assembled workforce and
goodwill acquired from MDI, management concluded that the net book value of
these amounts could no longer be supported due to the termination of all former
MDI employees and the shift of the Company's strategy away from MDI-related
products. Accordingly, the Company recorded an impairment charge totaling
$4,294,000 during the quarter ended September 30, 1998.

In December 1998, as a result of the significant downsizing of the
Company's operations (See Note 6 of Notes to the Company's Consolidated
Financial Statements) and continuing decline in operating results, the Company
reviewed the carrying amount of its property and equipment at December 31, 1998
and committed to a plan to dispose certain of its assets, primarily excess
computer equipment and furniture relating to the restructured operations, either
by sale or abandonment. The plan was completed by September 30, 1999. The fair
value of the assets to be disposed of was measured at management's best estimate
of salvage value, by using the current market values or the current selling
prices for similar assets. Costs to sell were estimated to be insignificant.
Based upon management's review, the carrying amounts of assets having a net book
value of $1,145,000 were written-down to a total amount of $221,000,
representing the lower of carrying amount or fair value (salvage value) and the
Company recorded an impairment charge totaling $924,000. The assets to be
disposed of were not depreciated or amortized while they were held for disposal
and the reduction in depreciation expense resulting from the write-down was
approximately $48,000 on a quarterly basis beginning in the first quarter of
1999.

Restructuring Charges

Overview

Under the Company's restructurings in 1998 and 1999, the Company
terminated more than 220 people. Severance benefits generally included salary
continuation for varying periods of up to one year, benefit continuation over
the same period, and outplacement support. Under the Company's severance
offerings, employees were required to sign a release before receiving any
payments. In addition, salary continuation benefits stopped if a person obtained
other employment.

New Hampshire. In most cases, the Company had many years remaining under
non-cancelable leases. The Company's largest lease was for its 100,000 square
foot headquarters facility in Billerica which had a lease termination in
February 2006. Under its restructuring accruals, the Company recorded charges
for the estimated difference between anticipated sublease income and the
estimated expenses that would be incurred for the space in the future. The
estimates included the following factors:

-1) the difference between estimated sublease income and rent payments
-2) estimated time the space would remain unoccupied earning no sublease
income
-3) estimated marketing costs including brokerage commissions
-4) estimated building operating expense charges in the future
-5) estimated costs to make the facilities ready for sublease

The estimates were complicated by the fact that the facilities were
located in several different real estate markets. The Company's estimates
included input from the Company's real estate brokers.

Due to the Company's degrading financial condition, there was a change
between the original estimates and the final charges incurred. Rather than
sublease the buildings, the Company entered into settlement agreements with the
landlords for its Nashua, Cincinnati, Lisle and Billerica facilities. The
Company believes that the settlements were very favorable to the Company
(resulting in releases from the restructuring accrual) because the Company had
ceased making rent payments for three facilities (Cincinnati, Lisle and
Billerica), and had discussed filing for protection from creditors in its public
filings. If the Company had not settled the leases under such distressed
conditions, the charges incurred would undoubtedly have been higher resulting in
a lower or zero release.

Year Ended 1999

On March 29, 1999, the Company announced its intention to restructure. The
restructure plan was finalized on March 31, 1999 and the Company recorded a
charge of $291,000, consisting of severance payments associated with the
termination of approximately 30% of the Company's employees representing
substantially all of its sales, marketing and year 2000 delivery personnel (40
employees). Payments related to terminated employees were completed by May 28,
1999. The restructuring resulted in a quarterly reduction of approximately
$1,000,000 in salary and related costs beginning in the third quarter of 1999.

The amounts accrued to and payments against the accrued restructuring
during the first quarter of 1999 and the composition of the remaining balance at
March 31, 1999 were as follows:

Balance Q1 1999 Q1 1999 Balance
December 31, 1998 Accrual Payments March 31, 1999
----------------- ------- -------- --------------
(in thousands)

Provision for severance and benefit payments to
Terminated employees ........................................ $ 536 $ 291 $ (212) $ 615
Provisions related to closure of facilities and reduction of
Occupied space .............................................. 2,144 -- (361) 1,783
------ ------ ------ ------

Total .................................................... $2,680 $ 291 $ (573) $2,398
====== ====== ====== ======

marketing the vacated space and changes in market conditions. The estimated
sublease date was changed from December 1, 1999 to January 1, 2000. The assumed
sublease discount from the lease-related payments due under lease was lowered to
12%. The assumption regarding the discount period was changed to cover the
entire lease term. Finally, estimated construction costs and commissions were
also updated. The additional restructuring resulted in a quarterly reduction in
lease-related costs of approximately $87,000 beginning in the third quarter of
1999.

Due to the Company's degraded financial condition, in June 1999, the
Company reached a settlement with American Financial Group, Inc. ("AFG") and its
subsidiaries and affiliates for release from its real estate lease in
Cincinnati, Ohio and certain other obligations. The Company had completely
vacated the facility by June 30, 1999 and had no remaining obligations or
liabilities associated with the facility. Of the total settlement, $136,000 was
associated with the real estate lease and is included within the restructuring
payments and reclassifications during the second quarter of 1999. The settlement
was more favorable than the Company's original sublease assumptions and resulted
in a release of $272,000 from the original estimated charges. The second quarter
payments and reclassifications also includes a $296,000 adjustment to reclassify
the rent levelization accrual associated with the vacated space in its Billerica
headquarters facility from other accrued expenses into the restructure accrual.
The Company's lease for its Billerica, MA facility that commenced in February
1998 contained lower rent payments during the early years offset by higher
payments in later years. In accordance with paragraph 15 of SFAS 13, the Company
therefore recorded monthly rent expense on a straight-line (levelized) basis
(total of all months' rent divided by the number of lease months). Through June
1999, the rent expense recorded exceeded the rent payments due under the lease
and the difference between the two amounts was credited to a rent levelization
accrual. The presumption underlying this accounting was that the Company would
eventually pay rents that exceeded the levelized rent and draw down the
liability. In the second quarter of 1999, the Company concluded that the
levelization liability associated with space included in restructuring should
have been relieved at the time the space was included in restructuring. It
therefore reclassified the rent levelization liability associated with the
vacated portion of the building to the restructuring accrual. Of the total
adjustment, $142,000 related to the 25,000 square feet that was added to
restructuring in the second quarter of 1999 and the balance of the $154,000 was
associated with earlier restructurings. The levelization liability associated
with the portion of the building, which was still being used by the Company,
remained as part of operating liabilities.

The total facilities related payments/reclassifications for the second
quarter of 1999 were as follows:

Rent levelization reclassification............ $ 296,000
Cincinnati settlement (facility portion)...... (136,000)
All other net payments........................ (55,000)
----------
Total......................................... $105,000
==========

At the end of the second quarter of 1999, the Company re-evaluated its
estimated costs associated with its previous restructure charges based upon
activity and experience to date. This evaluation included a re-estimate of the
remaining costs to be incurred in the future under the previous restructurings.
The $813,000 release in the second quarter of 1999 represented the difference
between the remaining restructure accrual and the future estimated costs. Of the
total release, $75,000 was related to the provision of severance and benefit
payments for terminated employees and $738,000 was related to the provision
related to the closure of facilities and the reduction of occupied space. The
$75,000 employee-related release resulted from differences in actual experience
and original estimates due primarily to the fact that several employees obtained
early employment or did not sign releases, and therefore, received lesser or no
payments.

The $738,000 facility related release in the second quarter of 1999 broke
down as follows:

Billerica related...... $ (502,000)
Cincinnati related..... (272,000)

Lisle related.......... 36,000
----------
Total................... $ (738,000)
==========

The Billerica related release resulted from the change in sublease
assumptions discussed above. The Cincinnati related release resulted from the
favorable settlement discussed above. The Lisle related negative amount was due
to the fact that a settlement agreement had been negotiated (but not concluded)
and it exceeded the remaining accrual.

The combination of the 1999 second quarter accrual of $517,000 and the
1999 second quarter release of $813,000 resulted in a net favorable impact of
$296,000 to the results of operations for the three months ended June 30, 1999.

The amounts accrued to and released from and payments and adjustments made
against the restructure accrual during the second quarter of 1999 along with the
composition of the remaining balance at June 30, 1999 were as follows:

Q2 1999
Balance Payments/ Q2 1999 Q2 1999 Balance
March 31, 1999 Reclassifications Accrual Release June 30, 1999
-------------- ----------------- ------- ------- -------------
(in thousands)

Provisions for severance and benefit payments
to terminated employees ...................... $ 615 $ (425) $ -- $ (75) $ 115
Provision related to closure of facilities and
reduction of occupied space .................. 1,783 105 517 (738) 1,667
------ ------ ------ ------ ------
Total ............................................ $2,398 $ (320) $ 517 $ (813) $1,782
====== ====== ====== ====== ======

In August 1999, the Company executed a lease termination agreement for its
Lisle, Illinois facility. Under the agreement, the Company paid $100,000 and
relinquished its $16,000 security deposit. These amounts were charged against
the accrued restructuring liability during the third quarter of 1999.

During the third quarter of 1999, the Company developed a workable plan to
relocate its headquarters from Billerica to its existing facility in
Westborough, Massachusetts. The plan, along with its degraded financial
condition, enabled the Company to negotiate a favorable settlement of its
Billerica lease. In September 1999, the Company entered into a settlement
agreement with BCIA New England Holdings LLC. Under the settlement, the Company
agreed to pay $200,000 in cash, relinquish its $300,000 security deposit, issue
500,000 shares of common stock and provide $71,000 of furniture and equipment.
All of these items were charged against the accrued restructuring liability
during the third quarter of 1999. The Company also charged the liability for a
$734,000 write-off of leasehold improvements and other fixed assets directly
tied to its Billerica facility. The favorable Billerica settlement resulted in a
release from the restructuring accrual of $392,000.

The third quarter payments and reclassifications also include a $110,000
payment for the settlement of two telephone leases and the elimination of the
associated $270,000 capital lease liability, and a $149,000 adjustment to
reclassify the remaining rent levelization accrual for the Billerica facility
from other accrued expenses into the restructure accrual.

The total facilities related restructuring payments/reclassifications for
the third quarter of 1999 broke down as follows:

Billerica stock issued (valued at 90% of closing price) ... $ (89,000)
Rent levelization reclassification ......................... 149,000
All other net payments ..................................... (30,000)
---------
Total ...................................................... $(586,000)
=========

The total payments/reclassifications related to write-off of fixed assets,
leasehold improvements, and telephone lease related items for the third quarter
of 1999 broke down as follows:

Billerica furniture provided ................ $ (71,000)
Leasehold and other fixed asset write-off ... (734,000)
Telephone leases settlement payment ......... (110,000)
Elimination of telephone capital leases ..... 270,000
---------
Total ....................................... $(645,000)
=========

The $436,000 facility related release in the third quarter of 1999 broke
down as follows:

Billerica related........... $(392,000)
Lisle related............... (44,000)
---------
Total....................... $(436,000)

The Lisle related release resulted from the settlement of the Lisle
telephone system lease for less than the capitalized lease liability.

In total, the Company recorded a net favorable impact of $450,000
associated with restructuring to the results of operations for the three months
ended September 30, 1999.

The amounts accrued to and released from and payments and adjustments made
against the restructure accrual during the third quarter of 1999 along with the
composition of the remaining balance at September 30, 1999 were as follows:

Q3 1999
Balance Payments/ Q3 1999 Balance
June 30, 1999 Reclassifications Release September 30, 1999
------------- ----------------- ------- ------------------
(in thousands)

Provisions for severance and benefit
payments to terminated employees .............. $ 115 $ (101) $ (14) $ --
Provision related to closure of facilities
and reduction of occupied space ............... 1,667 (586) (436) 645
Write-off of fixed assets, leasehold
improvements, and telephone lease related items ... -- (645) -- (645)
------- ------- ------- -------

Total ............................................. $ 1,782 $(1,332) $ (450) $ --
======= ======= ======= =======

Year Ended 1998

In March 1998, the Company announced its intention for a strategic
restructuring to refocus the Company's investments and to reduce its operating
expenses. The Company effected this restructuring, which was finalized in the
second quarter of 1998, and recorded a total charge of $1,439,000. The charge
included severance-related payments of $947,000 associated with the termination
of approximately 12% of the Company's employees in April 1998 (48 employees). At
June 30, 1998, all 48 employees had been terminated with no further terminations
remaining under the restructuring. In addition, $165,000 of the total
restructuring charge related to support costs for a discontinued product. The
final $327,000 of the restructuring charge related to the closure of two
research and

development and outsourcing centers (Westborough, Massachusetts, and Nashua, New
Hampshire) consisting primarily of accrual of lease costs, net of estimated
sublease income. Under its plan, the Company committed to vacate the majority of
its Westborough facility effective June 1998. The $162,000 accrued for
Westborough was computed as 100% of the lease-related payments for the period
from June 1998 through the expiration of the lease for only that portion of the
facility which was vacated. The Company estimated that it would be unable to
sublease the space prior to the expiration of lease in December 1998, primarily
due to the short period of time for which the space would be available to
potential sublessees. The lease did expire in December 1998 and was not renewed.
The assumption underlying the $165,000 charge recorded for the Nashua facility
was that it would remain unoccupied for nine months and that it would be
subleased thereafter at a 20% discount from the lease-related payments due under
the Company's lease. Payments related to terminated employees were completed in
June 1998 for 45 employees and were completed by September 1999 for the
remaining 3 employees. Payments related to the closure and reduction of
facilities were originally expected to be complete by April 2003. However,
payments ended as of December 31, 1998, upon the execution of a settlement
agreement with the Company's Nashua landlord. The restructuring resulted in a
reduction of approximately $950,000 in salary and related costs and $90,000 in
facility-related costs on a quarterly basis beginning in second quarter of 1998.

In September 1998, the Company announced its intention to restructure and
recorded a total restructuring charge of $3,372,000. The charge included
$1,909,000 for severance-related payments associated with the termination of
approximately 33% of the Company's employees at that time (89 employees). At
September 30, 1998, all 89 employees had been terminated with no further
terminations remaining under the restructuring. The charge also included
$1,463,000 related to the closure of two research and development centers
(Cincinnati, Ohio and Lisle, Illinois) and a 30,000 square foot reduction of
occupied space at the Company's headquarters facility in Billerica, MA. The
accrual consisted primarily of estimated lease costs, net of estimated sublease
income. The $837,000 charge associated with Billerica, assumed that the vacated
space would remain empty for nine months and would be subsequently subleased
thereafter at a 20% discount from the lease-related payments due under the
Company's lease for the following four years. Thereafter, for the last 2 and
one-half years of the lease, the Billerica sublease income was estimated to
equal the amounts due under the Company's lease. The assumption for the
Cincinnati charge of $442,000 and the Lisle charge of $184,000 was that space
would remain empty for six months and would be subsequently subleased thereafter
at a 20% discount from the lease-related payments due under the Company's lease
until lease termination. Payments related to terminated employees were completed
by December 1998 for 82 employees and were completed by September 1999 for the
remaining 7 employees. Payments related to the closure of facilities and
reduction of occupied space were originally expected to be completed by June
2003, however payments ended as of September 30, 1999 upon the execution of a
settlement agreement with the Company's Billerica landlord. The restructuring
resulted in a reduction of approximately $1,900,000 in salary and related costs
and $250,000 in lease-related costs on a quarterly basis beginning in the fourth
quarter of 1998.

In December 1998, the Company announced its intention to restructure and
recorded a total restructuring charge of $1,316,000. The charge included
$408,000 for severance-related payments associated with the termination of
approximately 22% of the Company's employees (45 employees). At December 31,
1998, all 45 employees had been terminated with no further terminations
remaining under the restructuring. In addition, $908,000 of the restructuring
charge related to its Billerica headquarters facility including a further
reduction (20,000 additional square feet) of occupied space and consisted
primarily of accrual of lease costs, net of estimated sublease income generally
consistent with previously assumptions. However, the assumption on the amount of
time the total 50,000 square feet of vacated space would remain unoccupied was
extended from June 30, 1999 until November 30, 1999 based on the progress of the
marketing efforts to date. Payments related to the terminated employees were
completed by December 31, 1998. Payments related to the reduction of occupied
space were originally expected to be complete by June 2003, however payments
ended as of September 30, 1999 upon the execution of a settlement agreement with
the Company's Billerica landlord. The restructuring resulted in a reduction of
approximately $950,000 in salary and related costs and $70,000 in lease-related
costs on a quarterly basis beginning in the first quarter of 1999. In December
of 1998, through its marketing activity, the Company found a new tenant for its
Nashua, New Hampshire facility and executed a settlement agreement with its
landlord rather than entering into a sublease. The settlement resulted in a
$58,000 release from the restructuring accrual.

The amounts accrued to, charged against and other adjustments made to the
restructuring accrual during the year ended December 31, 1998 and the
composition of the remaining balance at December 31, 1998 were as follows:

Balance Balance
December 1998 1998 Other December 31,
31, 1997 Accrual Charges Adjustments 1998
----- ------- ------- ------- -------
(in thousands)

Provision for severance and benefit payments to
Terminated employees ........................... $ -- $ 3,264 $(2,558) $ (170) $ 536
Provisions related to closure of facilities and
reduction of occupied space .................... -- 2,698 (503) (51) 2,144
Support costs for discontinued product ............ -- 165 (165) -- --
----- ------- ------- ------- -------
Total ....................................... $ -- $ 6,127 $(3,226) $ (221) $ 2,680
===== ======= ======= ======= =======

Interest Income, Net

Interest income and expense is primarily composed of interest income from
cash balances and interest expense on debt. The Company had interest income,
net, of $92,000 in the year ended December 31, 1999 compared to interest income,
net, of $485,000 in the year ended December 31, 1998. This change in interest
income (expense), net was primarily attributable to decreased interest income
from decreased cash balances.

Provision for Income Taxes

The Company's income tax provision was $2,000 and $25,000 in 1999 and
1998, respectively. The Company recorded no U.S. Federal or State tax provision
in 1999 or 1998 due to the taxable losses incurred. The $2000 in 1999 was for
city-related income taxes and the $25,000 in 1998 was for foreign income tax
provisions.

The Company had net deferred tax assets of $35,996,000 and $35,520,000 at
December 31, 1999 and 1998, respectively. At December 31, 1999 and 1998, the
Company has provided a valuation allowance for the full amount of its net
deferred tax assets since, based on the weight of available evidence, management
has concluded that it is more likely than not (defined as a likelihood of
slightly more than 50%) that these future benefits will not be realized.
Moreover, as a result of the Rocket investment, the Company triggered a
limitation to its use of its tax loss carry-forwards (See Note 13 of the Notes
to the Consolidated Financial Statements). If the Company achieves
profitability, a portion of its net deferred tax assets may be available to
offset future income tax liabilities and expense.

Minority Interest in Majority-owned Subsidiary

The minority interest in majority-owned subsidiary represents the equity
interest in the operating results of Persist, the Company's majority-owned
Spanish subsidiary, held by stockholders of Persist, S.A. ("Persist') other than
the Company. The Company had no minority interest in majority-owned subsidiary
in the twelve months ended December 31, 1999 since it divested its majority
interest in July 1998. The Company established a branch in Spain in 1999 to
provide outsourcing services and its operations terminated at the end of 1999.

Year Ended December 31, 1998 Compared To Year Ended December 31, 1997

Revenue

Total revenue decreased 20.6% to $31,532,000 in the year ended December
31, 1998 from $39,709,000 in the year ended December 31, 1997. This decrease in
revenue was primarily due to a decrease in the licensing of the Company's Auto
Enhancer/2000 software and revenue attributable to Vantage YR2000 products.

In 1998, the market for year 2000 products and services and the Company's
penetration of the market were far lower than anticipated by both the Company
and market analysts. In early 1998, the Company experienced a reduction in
license revenue. Although the sales pipeline remained healthy, the amount of
business that was actually closed was below the fourth quarter of 1997 level. At
the same time, the Company experienced an increase in demand for renovation and
renovation quality evaluation services. In the second quarter of 1998, based
upon sales campaigns underway and customer feedback, the Company was
anticipating substantial increases in demand for such services going forward. In
response, the Company began increasing its capacity to deliver such services
through increased resources and the establishment of third party relationships.
The sales pipeline remained healthy, throughout the third quarter but the amount
of business actually closed was far below expectations and there was no
significant increase in the fourth quarter. The experience of the Company was
shared by many of its Year 2000 competitors. From the Company's perspective, the
overall market for tools sales and the market prices for its year 2000 services
declined significantly over the course of 1998. During 1998, one customer, AT&T,
accounted for 12.2% of total revenue. In July, 1998, the Company divested 100%
of its equity interest in its majority-owned Spanish subsidiary, Persist, to
Persist for cash proceed totaling $470,000. Accordingly, the results of
operations of Persist subsequent to the date of disposition have been excluded
from the Company's consolidated results. Persist generated $1,232,000 of revenue
in 1998 compared to $1,925,000 in 1997. International revenue decreased to
$4,119,000 in 1998 from $4,154,000 in 1997. Persist generated 29.9% of the
Company's international revenue in 1998 compared to 46.3% of international
revenue in 1997. In 1999, the Company established a branch in Spain to provide
outsourcing services to its clients.

Outsourcing Services. Outsourcing services revenue decreased 13.3% to
$9,925,000 in the year ended December 31, 1998 from $11,447,000 in the year
ended December 31, 1997. As a percentage of total revenue, outsourcing services
revenue increased to 31.5% in the year ended December 31, 1998 from 28.8% in the
year ended December 31, 1997. The decrease in outsourcing services revenue in
absolute dollars was primarily the result of the divestiture of Persist and the
termination of an Engineering Consultant Services Agreement between the Company
and one of its clients that specifically provided that the client could
terminate the Agreement for convenience on 180 days notice. Due to changes in
the client's business needs and circumstances, the client decided to terminate
the Agreement. The increase in outsourcing services revenue as a percentage of
total revenue is a result of the substantial reduction in license revenue
between the years 1997 and 1998.

License. License revenue was $9,444,000 in the year ended December 31,
1998, or 30.0% of total revenue, compared to $21,255,000, or 53.5% of total
revenue, in the year ended December 31, 1997. License revenue decreased 55.6% in
1998. Direct delivery of licensed software to end users and license fees from
valued added integrators declined because the market for tools turned out to be
far less than forecasted. Line of code based licenses purchased by the Company's
value added integrators were not completely consumed and therefore there were
few additional orders from such customers. It is the Company's view that many
end users choose to manually renovate code with internal resources rather than
purchase tools or renovation services.

Other Services. Other services revenue increased 73.6% to $12,163,000 in
the year ended December 31, 1998 from $7,007,000 in the year ended December 31,
1997. As a percentage of total revenue, other services revenue was 38.5% in the
year ended December 31, 1998 and 17.7% in the year ended December 31, 1997. The
increase in other services revenue was primarily the result of the Company's
providing renovation and renovation quality evaluation services directly to
clients offset by a decrease in consulting services revenue. During the first
half of 1998, the Company experienced significant growth in both actual business
and the sales pipeline of potential business. It was, therefore, anticipating
even higher revenues from such services in the second half of the year. Due to
the degrading financial condition of the Company, increased competition,
decreasing prices, and a lessening of client commitments, the Company's revenue
from such services did not continue to grow as anticipated.

Cost of Revenue

Cost of Outsourcing Services Revenue. Cost of outsourcing services revenue
consists primarily of salaries, benefits and overhead costs associated with
delivering outsourcing services to clients. The cost of outsourcing services
revenue decreased 20.5% to $7,577,000 in the year ended December 31, 1998 from
$9,536,000 for the year ended December 31, 1997. Cost of outsourcing services
revenue as a percentage of outsourcing services revenue decreased to 76.3% in
the year ended December 31, 1998 from 83.3% in the year ended December 31, 1997.
The decrease in costs of outsourcing services revenue in absolute dollars was
primarily the result of reduction of the resources associated with the
termination of the above-referenced Engineering Consultant Services Agreement
between the Company and one of its clients.

Cost of License Revenue. Cost of license revenue consists primarily of
salaries, benefits, amortization expense of intangibles related to the MDI
acquisition and related overhead costs associated with license-related materials
packaging and freight. Cost of license revenue was $1,631,000 in the year ended
December 31, 1998, or 17.3% of license revenue. Cost of license revenue was
$690,000, or 3.2% of license revenue, in the year ended December 31, 1997. The
increase in cost of license revenue in absolute dollars was primarily
attributable to the amortization of intangibles related to the MDI acquisition.

Cost of Other Services Revenue. Cost of other services revenue consists
primarily of salaries, benefits and related overhead costs associated with
delivering other services to clients. Cost of other services revenue increased
70.1% to $9,110,000 in the year ended December 31, 1998 from $5,357,000 in the
year ended December 31, 1997.

Cost of other services revenue as a percentage of other services revenue
decreased to 74.9% in the year ended December 31, 1998 from 76.5% in the year
ended December 31, 1997. Costs increased in absolute dollars in the year ended
December 31, 1998 were primarily the result of increased staffing for actual and
anticipated increases in demand for the Company's renovation and renovation
quality evaluation services.

Operating Expenses

Sales and Marketing. Sales and marketing expenses consist primarily of
salaries, commissions and related overhead costs for sales and marketing
personnel; sales referral fees to third parties; advertising programs; and other
promotional activities. Sales and marketing expenses increased 49.4% to
$13,244,000 in the year ended December 31, 1998 from $8,864,000 in the year
ended December 31, 1997. As a percentage of total revenue, sales and marketing
expenses increased to 42.0% in the year ended December 31, 1998 from 22.3% in
the year ended December 31, 1997. The increase in expenses in absolute dollars
and as a percentage of revenue was primarily attributable to increased staffing,
commissions, and promotional activities.

Research and Development. Research and development expenses consist
primarily of salaries, benefits and related overhead costs for engineering and
technical personnel and outside engineering consulting services associated with
developing new products and enhancing existing products. Research and
development expenses increased 2.5% to $8,528,000 in the year ended December 31,
1998 from $8,324,000 in the year ended December 31, 1997. As a percentage of
total revenue, research and development expenses increased to 27.1% in the year
ended December 31, 1998 from 21.0% in the year ended December 31, 1997. The
increase in research and development dollars in absolute terms was primarily
attributable to increased staffing for the product development efforts of the
Company's year 2000 products and services and mass change technologies including
an increase in staffing through new hires, internal transfers and the
acquisition of MDI. During the Company's employment reductions in September
1998, December 1998 and April 1999, the majority of its research and development
resources were eliminated.

General and Administrative. General and administrative expenses consist
primarily of salaries and related costs for the finance and accounting, human
resources, legal services, information systems and other administrative
departments of the Company, as well as legal and accounting expenses and the
amortization of intangible assets associated with the Vista acquisition. General
and administrative expenses also include allowance for doubtful accounts and any
specific write-offs of uncollectible receivables. General and administrative
expenses increased 73.1% to $7,466,000 in the year ended December 31, 1998 from
$4,312,000 in the year ended December 31, 1997. As a percentage of total
revenue, general and administrative expenses increased to 23.7% in the year
ended December 31, 1998 from 10.9% in the year ended December 31, 1997. The
increase in general and administrative expenses in absolute dollars was
primarily due to a $1,481,000 increase in the Company's allowance for doubtful
accounts reserve, additions to the Company's administrative staff to support
certain anticipated growth, higher professional fees and increases in other
general corporate expenses as well as increased costs associated with being a
publicly traded company. The increase in the allowance for doubtful accounts
included $667,000 for a receivable associated with a single customer which was
written off against the allowance during the year. At the time of the $667,000
receivable write-down, the customer involved owed the Company $1,667,000. The
customer contended that the AutoEnhancer2000 tools that it had licensed were
more complex than other tools it had licensed even though it had increased its
line of code based license after it purchased the initial license. Despite the
Company's efforts to work with the customer in the effective use of the tools as
well as the fact that other customers successfully used the tools, the customer
involved continued to withhold payment of the total amount owed. The customer
ultimately indicated that it made a business decision to stop pursuing year 2000
renovation work. Rather than enter into a potential protracted legal battle, the
Company settled the dispute by agreeing to forgive $667,000 and has since
collected the $1 million balance of the amount owed. The balance of the
Company's increase to its allowance for doubtful accounts was based upon
collection difficulty and deterioration in the accounts receivable aging for
certain other customers.

Write-off of Acquired in-Process Research and Development. In connection
with the acquisition of MDI, the Company recorded a charge to operations of
$70,800,000 representing purchased in-process technology that had not yet
reached technological feasibility and had no alternative future use (see Note 3
to the consolidated financial statements). The value was determined via an
independent appraisal by estimating the costs to develop the purchased
in-process technology into commercially viable products, estimating the
resulting net cash flows from such projects, and discounting the net cash flows
back to their present value. As described below, the discount rate utilized
includes a factor that takes into account the uncertainty surrounding the
successful development of the purchased in-process technology. In addition, the
Company recorded intangible assets of $5,503,000, which included approximately
$4,800,000 attributable to developed technology. Immediately following the
acquisition, the amounts allocated to intangible assets were being amortized on
a straight-line basis over their expected useful lives of five years.

At the time of acquisition, the Company expected that the remaining
acquired in-process research and development would be successfully developed;
however, there could be no assurance that commercial viability of these projects
would be achieved. If these projects were not successfully developed, future
revenue and profitability of the Company would be adversely affected.
Additionally, the value of the intangible assets would become impaired.

At the time of acquisition, the nature of the efforts required to develop
the purchased in-process technology into commercially viable software products
principally related to the completion of all planning, designing, prototyping,
verification and testing activities that were necessary to establish that the
software could be produced to meet its design specifications, including
functions, features and technical performance requirements. The acquired
projects included continued development of MDI's core technologies aiming to
significantly enhance their features and functionality in order to gain an
increasing share of the Year 2000 software market. In addition, the Company
intended to continue to focus product plans around developing comprehensive
testing capabilities for MDI's Vantage YR2000 product and a "mass change"
software engine with capabilities other than Year 2000 corrections, including a
Euro currency conversion application.

The resulting forecasted net cash flows from such projects were based on
management's estimates of revenues, cost of sales, research and development
costs, selling, general and administrative costs, and income taxes from such
projects. These estimates were based on the following assumptions:

Revenues attributable to the in-process technology were assumed to
increase during the period 1998 through 2003 at annual rates ranging from 30% to
96%. Such projections were based on assumed penetration of the existing customer
base, new customer transactions, historical retention rates and experiences of
prior product releases. The projections reflect increasing revenue in the first
six years (1998 to 2003) as the products derived from the in-process technology
are generally released and penetrate the market. As the products derived from
the in-process technology mature and are replaced by subsequent future,
yet-to-be-defined technology, the relative proportion of total revenues due to
in-process technology was projected to decline from 97% in 1999 to 0% in 2005.

Operating income (loss) as a percentage of revenue attributable to the
in-process technology was projected to grow during the period 1998 through 2003
from 18% to 59%. During the same period, sales, general and administrative
expense as a percentage of revenue related to the in-process technology was
projected to range between 58% and 40%. Research and development expense as a
percentage of revenue related to in process technology was projected to decline
from a high of 23% in 1998 to a low of 1% in 2003.

inherent uncertainties in the estimates described above including the
uncertainty surrounding the successful development of the purchased in-process
technology, the useful life of such technology, the profitability levels of such
technology and the uncertainty of technological advances that are unknown at
this time.

The cost to complete the in-process development was originally estimated
at approximately $18.7 million to be incurred through the end of the year 2000.
These costs were largely for personnel involved in the planning, design, coding,
integration, testing and modification of products to be derived from the
in-process technologies. The Company estimated that in-process projects relating
to future versions of the Vantage YR2000 product were 60% to 80% complete and
projects relating to the "mass change" engine were less than 50% complete at the
December 1, 1997 acquisition date.

Due to lower than anticipated revenue and losses in excess of expectations
during the quarter ended September 30, 1998, the Company stopped development of
all new versions of existing Vantage YR2000 products, the Vantage YR2000 testing
product and the generic mass change software product. As a result of these
actions, the Company closed its research and development centers in Cincinnati,
Ohio, and Lisle, Illinois, terminated substantially all employees at those
facilities and recorded a related restructuring charge (Note 6). Through
December 31, 1998, the Company had incurred approximately $2,200,000 in costs to
develop these in-process technologies. The Company does not expect to incur
additional development costs for these in-process technologies.

Due to lower than anticipated revenue and greater than expected losses,
during the quarter ended September 30, 1998, the Company adopted a plan to stop
development of all existing and in-process products originally acquired from MDI
in December 1997, including all Vantage YR2000 renovation and testing software
tools and the generic mass change product. Substantially all direct sales
efforts relating to existing Vantage YR2000 products were also stopped. In
connection with these actions, the Company also undertook a restructuring of its
operations (See Note 6 of Notes to the Company's Consolidated Financial
Statements) which included the closure of the Company's research and development
facilities in Cincinnati, Ohio and Lisle, Illinois and the termination of
substantially all the employees at these facilities. As a result of these
events, management concluded that an assessment of the recoverability of
intangible assets recorded in connection with the acquisition of MDI in December
1997 was required at September 30, 1998. The Company determined that its
property and equipment at these locations was not subject to impairment as
substantially all such assets were scheduled to be redeployed.

Restructuring Charges. In March 1998, the Company announced its
intention for a strategic restructuring to refocus the Company's investments and
to reduce its operating expenses. The Company effected this restructuring, which
was finalized in the second quarter of 1998, and recorded a total charge of
$1,439,000. The charge included severance-related payments of $947,000
associated with the termination of approximately 12% of the Company's employees
in April 1998 (48 employees). At June 30, 1998, all 48 employees had been
terminated with no further terminations remaining under the restructuring. In
addition, $165,000 of the total restructuring charge related to support costs
for a discontinued product. The final $327,000 of the restructuring charge
related to the closure of two research and development and outsourcing centers
(Westborough, Massachusetts, and Nashua, New Hampshire) consisting primarily of
accrual of lease costs, net of estimated sublease income. Under its plan, the
Company committed to vacate the majority of its Westborough facility effective
June 1998. The $162,000 accrued for Westborough was computed as 100% of the
lease-related payments for the period from June 1998 through the expiration of
the lease for only that portion of the facility which was vacated. The Company
estimated that it would be unable to sublease the space prior to the expiration
of lease in December 1998, primarily due to the short period of time for which
the space would be available to potential sublessees. The lease did expire in
December 1998 and was not renewed. The assumption underlying the $165,000 charge
recorded for the Nashua facility was that it would remain unoccupied for nine
months and that it would be subleased thereafter at a 20% discount from the
lease-related payments due under the Company's lease. Payments related to
terminated employees were completed in June 1998 for 45 employees and were
completed by September 1999 for the remaining 3 employees. Payments related to
the closure and reduction of facilities were originally expected to be complete
by April 2003. However, payments ended as of December 31, 1998, upon the
execution of a settlement agreement with the Company's Nashua landlord. The
restructuring resulted in a reduction of approximately $950,000 in salary and
related costs and $90,000 in facility-related costs on a quarterly basis
beginning in second quarter of 1998.

however payments ended as of September 30, 1999 upon the execution of a
settlement agreement with the Company's Billerica landlord. The restructuring
resulted in a reduction of approximately $1,900,000 in salary and related costs
and $250,000 in lease-related costs on a quarterly basis beginning in the fourth
quarter of 1998.

In December 1998, the Company announced its intention to restructure and
recorded a total restructuring charge of $1,316,000. The charge included
$408,000 for severance-related payments associated with the termination of
approximately 22% of the Company's employees (45 employees). At December 31,
1998, all 45 employees had been terminated with no further terminations
remaining under the restructuring. In addition, $908,000 of the restructuring
charge related to its Billerica headquarters facility including a further
reduction (20,000 additional square feet) of occupied space and consisted
primarily of accrual of lease costs, net of estimated sublease income generally
consistent with previously assumptions. However, the assumption on the amount of
time the total 50,000 square feet of vacated space would remain unoccupied was
extended from June 30, 1999 until November 30, 1999 based on the progress of the
marketing efforts to date. Payments related to the terminated employees were
completed by December 31, 1998. Payments related to the reduction of occupied
space were originally expected to be complete by June 2003; however, payments
ended as of September 30, 1999 upon the execution of a settlement agreement with
the Company's Billerica landlord. The restructuring resulted in a reduction of
approximately $950,000 in salary and related costs and $70,000 in lease-related
costs on a quarterly basis beginning in the first quarter of 1999. In December
of 1998, through its marketing activity, the Company found a new tenant for its
Nashua, New Hampshire facility and executed a settlement agreement with its
landlord rather than entering into a sublease. The settlement resulted in a
$58,000 release from the restructuring accrual.

Balance Balance
December 1998 1998 Other December 31,
31, 1997 Accrual Charges Adjustments 1998
-------- ------- ------- ----------- ----
(in thousands)

Provision for severance and benefit payments to
Terminated employees ........................... $ -- $ 3,264 $(2,558) $ (170) $ 536
Provisions related to closure of facilities and
reduction of occupied space .................... -- 2,698 (503) (51) 2,144
Support costs for discontinued product ............ -- 165 (165) -- --
------- ------- ------- ------- -------
Total ....................................... $ -- $ 6,127 $(3,226) $ (221) $ 2,680
======= ======= ======= ======= =======

Interest Income, Net

Interest income and expense is primarily composed of interest income from
cash balances and interest expense on debt. The Company had interest income,
net, of $485,000 in the year ended December 31, 1998 compared to interest
income, net, of $948,000 in the year ended December 31, 1997. This change in
interest income (expense), net was primarily attributable to decreased interest
income from decreased cash balances.

Provision for Income Taxes

The Company's income tax provision was $25,000 and $260,000 in 1998 and
1997, respectively. The 1998 provision relates to foreign income taxes. The
Company recorded no U.S. Federal or State taxes in 1998 due to taxable losses
incurred. The Company's effective tax rate for 1997 was significantly impacted
by the write-off of the acquired in-process research and development which is
not immediately deductible by the Company and for which a deferred tax asset
valuation allowance was provided. Accordingly, the Company did not realize a tax
benefit in 1997 as a result of its net loss. The provision was the result of an
increase in taxable income and international taxes, which was substantially
offset by the Company's expected utilization in 1997 of previously generated net
operating

loss carryforwards.

The Company had net deferred tax assets of $35,520,000 and $24,072,000 at
December 31, 1998 and 1997, respectively. At December 31, 1998 and 1997, the
Company has provided a valuation allowance for the full amount of its net
deferred tax assets since, based on the weight of available evidence, management
has concluded that it is more likely than not (defined as a likelihood of
slightly more than 50%) that these future benefits will not be realized.
Moreover, as a result of the Rocket investment, the Company triggered a
limitation to its use of its tax loss carry-forwards (See Note 13 of the Notes
to the Consolidated Financial Statements). If the Company achieves
profitability, these net deferred tax assets may be available to offset future
income tax liabilities and expense.

Minority Interest in Majority-Owned Subsidiary

The minority interest in majority-owned subsidiary represents the equity
interest in the operating results of Persist, the Company's majority-owned
Spanish subsidiary, held by stockholders of Persist other than the Company. The
minority interest in majority-owned subsidiary increased to a gain of $4,000 in
the year ended December 31, 1998 from a loss of $4,000 in the year ended
December 31, 1997. This change was the result of the decreased profitability of
Persist. The Company sold its majority interest in Persist to the minority
shareholders in July, 1998. The Company established a branch in Spain in 1999 to
provide outsourcing services and its operations terminated at the end of 1999.

Liquidity and Capital Resources

The Company has financed its operations and capital expenditures primarily
with the proceeds from sales of the Company's convertible preferred stock and
common stock, borrowings, advance payments for services from clients and
internally generated cash flows. The Company's cash balances were $2,475,000 and
$3,378,000 at December 31, 1999 and 1998, respectively. The Company's working
capital was $1,640,000 and $1,805,000, at December 31, 1999 and 1998,
respectively.

The Company's operating activities used cash of $1,178,000 and $7,661,000
during the years ended December 31, 1999 and 1998, respectively. The Company's
use of cash during the year ended December 31, 1999 was primarily caused by a
net loss of $2,583,000 less non-cash depreciation and amortization expense of
$1,442,000, and a charge for impairment of long-lived assets of $961,000. Other
uses included a decrease in accrued restructuring of $1,835,000, a decrease in
deferred revenue of $1,695,000, a decrease in other accrued liabilities of
$1,673,000, a decrease in accounts payable of $451,000, and a decrease in
billings in excess of costs and earnings on uncompleted contracts of $182,000.
These amounts were partially offset by a decrease in accounts receivable of
$3,188,000, a decrease in costs and estimated earnings in excess of billings on
uncompleted contracts of $670,000, a decrease in prepaid expenses and other
current assets of $568,000, the receipt of advance payments from customers of
$296,000, and a decrease in other assets of $116,000.

The Company's investing activities provided cash of $732,000 during the
year ended December 31, 1999 and used cash of $1,313,000 during the year ended
December 31, 1998. Investing activities in the year ended December 31, 1999
consisted principally of the sale of short-term investments of $500,000 and the
sale of property and equipment of $288,000.

The Company's financing activities provided cash of $114,000 and $428,000
during the year ended December 31, 1999 and 1998, respectively. Financing
activities in the year ended December 31, 1999 primarily reflect a decrease in
the amount of restricted cash of $569,000, and proceeds from issuance of common
stock net of issuance cost of $152,000. These amounts were partially offset by
principal payments on capital lease obligations of $338,000 and principal
payments on long-term debt of $269,000.

In September 1996, the Company obtained a revolving line of credit
facility from a bank which bore interest at the bank's prime rate plus 0.5%. The
line of credit expired and all borrowings were payable in full on September 30,
1998. In addition to this line of credit, the Company also entered into an
equipment financing agreement in September 1996. Under this agreement, the bank
agreed to provide up to $1,500,000 for the purchase of certain equipment (as
defined by the agreement) through September 30, 1997. Ratable principal and
interest payments were payable during the period July 1, 1997 through June 1,
2000, and bore interest at the bank's prime rate plus 1%. Both of these
agreements required the Company to comply with certain financial covenants and
were secured by all of the assets of the Company. The bank notified the Company
in October 1998 that the Company was in default under its line of credit
facility and equipment financing agreement and requested that the Company
provide cash collateral for the amount of equipment financing outstanding and
provide cash collateral for a $300,000 standby letter of credit issued by the
bank. The Company provided cash collateral for all amounts outstanding under the
equipment financing agreement in December 1998 and for the $300,000 letter of
credit in October 1998. The letter of credit was drawn upon and the equipment
financing debt was paid in the first quarter of 1999. There were no borrowings
outstanding under the revolving credit facility and under the equipment
financing agreement at December 31, 1999. In 1998, the bank indicated that it
would not renew or further extend the Company's revolving credit facility. The
Company has concluded an accounts receivable purchase agreement with a lender to
permit borrowing against certain acceptable receivables at a rate of 80% of the
face amount of such receivables up to a maximum of $4 million. In exchange for
such agreement, the Company granted the lender a security interest in
substantially all of its assets. There can be no assurance that the Company will
be able to successfully borrow against such agreement, negotiate other borrowing
arrangements or raise additional funds through bank borrowings and/or debt
and/or equity financings.

In July 1999, the Company announced that it reached a settlement with
American Financial Group, Inc. ("AFG") and its subsidiaries and affiliates for
release from its real estate lease in Cincinnati, Ohio and certain other
obligations. Under the settlement, the Company agreed to pay $200,000 in cash
and issue 300,000 shares of Common Stock in exchange for release of its real
estate lease for 20,5000 square feet that required average monthly payments
excluding operating expenses of $36,000 through November 2002. The Company had
not made any payments since October 1998. The settlement also released the
Company from net claims for other services and disputes of $334,500.

In September 1999, the Company relocated its corporate headquarters from
Billerica, Massachusetts to its existing facility located at 112 Turnpike Road,
Westborough, Massachusetts 01581. In September, the Company also reached a
settlement agreement with BCIA New England Holdings LLC for release from its
real estate lease at 2 Federal Street, Billerica, Massachusetts. Under the
settlement, the Company agreed to pay $200,000 in cash, relinquish its $300,000
security deposit, issue 500,000 shares of Common Stock, and provide $71,000 of
furniture and equipment. In exchange, the Company was released from its real
estate lease for 100,000 square feet which required average lease and operating
expense payments of $145,000 per month through February 2006. The Company had
not made any payments since July 1999.

To date, the Company has not invested in derivative securities or any
other financial instruments that involve a high level of complexity or risk.
Excess cash has been, and the Company contemplates that it will continue to be,
invested in interest-bearing, investment grade securities.

Foreign Currency

Assets and liabilities of the Company's majority-owned foreign subsidiary
are translated into U.S. dollars at exchange rates in effect at the balance
sheet date. Income and expense items are translated at average exchange rates
for the period. Accumulated net translation adjustments are included in
stockholders' equity.

Inflation

To date, inflation has not had a material impact on Peritus' results of
operations.

Recently Issued Accounting Standards

In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." The new standard establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. SFAS No. 133 is effective for all
fiscal quarters of fiscal years beginning after June 15, 2000. The Company does
not invest in derivative instruments or engage in hedging activities. As a
result, SFAS No. 133 is not expected to have a material affect on its financial
position or results of operations.

Factors That May Affect Future Results

Failure to Achieve Cash Flow Breakeven/Strategic Initiatives

The Company's ability to achieve a cash flow breakeven position is
critical for achieving financial stability. There can be no assurance that the
Company will achieve a cash flow breakeven in the future.

Financing

There can be no assurance that the Company will be able to obtain
additional funds in the future through equity and/or debt financings or borrow
against its accounts receivable financing agreement.

Over the Counter Listing

Trading of the common stock is conducted in the over-the-counter market
which could make it more difficult for an investor to dispose of, or obtain
accurate quotations as to the market value of, the common stock. In addition,
there are additional sales practice requirements on broker-dealers who sell such
securities to persons other than established customers and accredited investors.
For transactions covered by this rule, the broker-dealer must make a special
suitability determination for the purchaser and must have received the
purchaser's written consent to the transaction prior to sale. If the trading
price of the common stock is below $5.00 per share, trading in the common stock
would also be subject to the requirements of certain rules promulgated under the
Securities Exchange Act of 1934, which require additional disclosure by broker-
dealers in connection with any trades involving a stock defined as a penny stock
(generally any non-NASDAQ equity security that has a market price of less than
$5.00 per share, subject to certain exceptions). Such rules require the
delivery, prior to any penny stock transaction, of a disclosure schedule
explaining the penny stock market and the risks associated therewith, and impose
various sales practice requirements on broker-dealers who sell penny stocks to
persons other than established customers and accredited investors (generally
institutions). For these types of transactions, the broker-dealer must make a
special suitability determination for the purchaser and have received the
purchaser's written consent to the transaction prior to sale. The additional
burdens imposed upon broker-dealers by such requirements may discourage broker-
dealers from effecting transactions in the common stock, which could severely
limit the market liquidity of the common stock and the ability of purchasers in
this offering to sell the common stock in the secondary market.

Risk of Current Strategy

The Company's current strategy is to continue to service its existing
outsourcing customers and to renew expiring contracts. At the same time, the
Company is pursuing new business through the licensing of, and associated
consulting and training for, its outsourcing methodology (technology transfer
services) and SAM Relay and SAM Workbench tools. The Company continues to
enhance its SAM Workbench tool and is planning to increase its sales resources
and marketing efforts associated with the product in the future. The Company is
also considering the development of other service offerings and plans to
selectively renew its efforts to generate new outsourcing business. There can be
no assurance that this current strategy will generate revenues sufficient for
the Company to achieve a cash flow breakeven position.

Potential Fluctuations in Quarterly Performance

The Company's revenue and operating results have varied significantly in
the past and are likely to vary significantly from quarter to quarter in the
future. The Company's quarterly operating results may continue to fluctuate due
to a number of factors, including the timing, size and nature of the Company's
individual outsourcing, technology transfer, insourcing and licensing
transactions; unforeseen difficulties in performing such transactions; the
performance of the Company's value added integrators and distributors; the
timing of the introduction and the market acceptance of new services, products
or product enhancements by the Company or its competitors; the relative
proportions of revenue derived from license fees and professional services;
changes in the Company's operating expenses; personnel changes; foreign currency
exchange rates and fluctuations in economic and financial market conditions.

The timing, size and nature of individual outsourcing, technology
transfer, insourcing and licensing transactions are important factors in the
Company's quarterly operating results. Many such transactions involve large
dollar amounts, and the sales cycle for these transactions is often lengthy and
unpredictable. In addition, the sales cycle associated with these transactions
is subject to a number of uncertainties, including clients' budgetary
constraints, the timing of clients' budget cycles and clients' internal approval
processes. There can be no assurance that the Company will be successful in
closing such large transactions on a timely basis or at all. Most of the
Company's outsourcing engagements are performed on a fixed-price basis and,
therefore, the Company bears the risk of cost overruns and inflation. A
significant percentage of the Company's revenue derived from these engagements
is recognized on the percentage-of-completion method, which requires revenue to
be recorded over the term of a client contract. A loss is recorded at the time
when current estimates of project costs exceed unrecognized revenue. The
Company's operating results may be adversely affected by inaccurate estimates of
contract completion costs.

The Company's expense levels are based, in part, on its expectations as to
future revenue and are fixed, to a large extent, in the short term. As a result,
the Company has been and may continue to be unable to adjust spending in a
timely manner to compensate for any further unexpected revenue shortfall.
Accordingly, any significant shortfall in revenue in addition to those already
experienced in relation to the Company's expectations would have an immediate
and material adverse effect on the Company's business, financial condition and
results of operations.

Due to all of the foregoing factors, the Company believes that
period-to-period comparisons of its operating results are not necessarily
meaningful and that such comparisons cannot be relied upon as indicators of
future performance. There can be no assurance that future revenue and operating
results will not continue to vary substantially. It is also possible that, in a
quarter, the Company's operating results will be below the expectations of
public market analysts and investors. In either case, the price of the Company's
Common Stock has been and could continue to be materially adversely affected.

Need to Develop Additional Products and Services

During 1999, the Company generated significant revenue from, and devoted
significant resources to, products and services that address the year 2000
problem. That demand has diminished significantly and has effectively

disappeared. The Company plans to continue maintenance of and enhancements to
its products and limited development of new products or services. There can be
no assurance that the Company will be able to grow or maintain its outsourcing
business or sell its other products or services. The failure to diversify and
develop additional products and services would have a material adverse effect on
the Company's business, financial condition and results of operations.

Concentration of Clients and Revenue Risk

The Company's revenue is highly concentrated among a small number of
clients. During the year ended December 31, 1999, revenue from three clients
accounted for 40.5% of the year's revenue with one client representing 21.7%.
The contract for one of these three clients (representing 7.0% of the revenue
for the year ended December 31, 1999) terminated in November 1999.

Competition

The market for the Company's products and services is intensely
competitive and is characterized by rapid changes in technology and user needs
and the frequent introduction of new products. In addition, the Company faces
competition in the software maintenance outsourcing services market and the
software maintenance tools market. A number of the Company's competitors are
more established, benefit from greater name recognition and have substantially
greater financial, technical and marketing resources than those of the Company
and certain of the Company's value added integrators and distributors. As a
result, there can be no assurance that the Company's products and services,
including the solutions offered by the Company's value added integrators and
distributors, will compete effectively with those of their respective
competitors. The Company's value added integrators and distributors may also
offer or develop products and services that compete with the Company's products
and services. There can be no assurance that such value added integrators and
distributors will not give higher priority to the sales of these or other
competitive products and services. See "Business--Competition."

Competitive Market for Technical Personnel

The Company depends to a significant extent on its ability to attract,
train, motivate and retain highly skilled software professionals, particularly
project managers, software engineers and other senior technical personnel. The
Company believes that there is a shortage of, and significant competition for,
software development professionals with the skills and experience necessary to
perform the services offered by the Company. The Company's ability to maintain
and renew existing engagements and obtain new business depends, in large part,
on its ability to hire and retain technical personnel with the IT skills that
keep pace with continuing changes in software evolution, industry standards and
technologies and client preferences. The inability to hire additional qualified
personnel could impair the Company's ability to satisfy its client base,
requiring an increase in the level of responsibility for both existing and new
personnel. There can be no assurance that the Company will be successful in
retaining current or future employees.

Fixed-Price, Fixed-Time Contracts

Part of the Company's business is to offer its outsourcing and technology
transfer services on fixed-price, fixed-time frame contracts, rather than
contracts in which payment to the Company is determined solely on a
time-and-materials basis. These contracts are terminable by either party
generally upon prior written notice. Although the Company uses its proprietary
tools and methodologies and its past project experience to reduce the risks
associated with estimating, planning and performing the fixed-price projects,
the Company's standard outsourcing and technology transfer agreements provide
for a fixed-fee based on projected reductions in a client's maintenance costs
and increases in a client's maintenance productivity. The Company's failure to
estimate accurately the resources, costs and time required for a project or its
failure to complete its contractual obligations within the time frame committed
could have a material adverse effect on the Company's business, financial
condition and results of operations.

Potential for Contract Liability

The Company's products and services relating to software maintenance,
especially solutions addressing the year 2000 problem, involve key aspects of
its clients' computer systems. A failure in a client's system could result in a
claim for substantial damages against the Company, regardless of the Company's
responsibility for such failure. The Company attempts to limit contractually its
liability for damages arising from negligent acts, errors, mistakes or omissions
in rendering its products and services. Despite this precaution, there can be no
assurance that the limitations of liability set forth in its contracts would be
enforceable or would otherwise protect the Company from liability for damages.
Additionally, the Company maintains general liability insurance coverage,
including coverage for errors and omissions. However, there can be no assurance
that such coverage will continue to be available on acceptable terms, or will be
available in sufficient amounts to cover one or more large claims, or that the
insurer will not disclaim coverage as to any future claim. The successful
assertion of one or more large claims against the Company that exceed available
insurance coverage or changes in the Company's insurance policies, including
premium increases or the imposition of large deductible or co-insurance
requirements, could have a material adverse effect on the Company's business,
financial condition and results of operations. Furthermore, litigation,
regardless of its outcome, could result in substantial cost to the Company and
divert management's attention from the Company's operations. Any contract
liability claim or litigation against the Company could, therefore, have a
material adverse effect on the Company's business, financial conditions and
results of operations.

Software Errors or Bugs

The Company's software products and tools are highly complex and
sophisticated and could from time to time contain design defects or software
errors that could be difficult to detect and correct. Errors, bugs or viruses
may result in loss of or delay in market acceptance, a failure in a client's
system or loss or corruption of client data. Although the Company has not
experienced material adverse effects resulting from any software defects or
errors, there can be no assurance that, despite testing by the Company and its
clients, errors will not be found in new products, which errors could have a
material adverse effect upon the Company's business, financial condition and
results of operations.

Limited Protection of Proprietary Rights

The Company relies on a combination of patent, copyright, trademark and
trade secret laws and license agreements to establish and protect its rights in
its software products and proprietary technology. In addition, the Company
currently requires its employees and consultants to enter into nondisclosure and
assignment of invention agreements to limit use of, access to and distribution
of its proprietary information. There can be no assurance that the Company's
means of protecting its proprietary rights in the United States or abroad will
be adequate. The laws of some foreign countries may not protect the Company's
proprietary rights as fully or in the same manner as do the laws of the United
States. Also, despite the steps taken by the Company to protect its proprietary
rights, it may be possible for unauthorized third parties to copy aspects of the
Company's products, reverse engineer, develop similar technology independently
or obtain and use information that the Company regards as proprietary.
Furthermore, there can be no assurance that others will not develop technologies
similar or superior to the Company's technology

or design around the proprietary rights owned by the Company.

The Company has entered into license agreements with clients that allow
these clients access to and use of the Company's AutoEnhancer/2000 and Vantage
YR2000 software and SAM Relay and RQE tools source code for certain purposes.
Access to the Company's source code may increase the likelihood of
misappropriation or misuse by third parties.

There can be no assurance that any patent will be issued pursuant to any
pending patent applications or that, if granted, such patents would survive a
legal challenge to their validity or provide meaningful or significant
protection to the Company. In addition, the Company may decide to abandon a
patent application if, among other things, it determines that continued
prosecution of an application would be too costly, the technologies, processes
or methodologies are not critical to the Company's business in the foreseeable
future or it is unlikely that a patent will issue with regard to a particular
application. Some competitors of the Company have announced the filing with the
United States Patent and Trademark Office of patent applications relating to
fixing and assessing the year 2000 problem. The Company expects that the risk of
infringement claims against the Company might increase because its competitors
might successfully obtain patents for software products and processes. The
Company has become aware of a patent relating to fixing the year 2000 problem
based on a "windowing" method. Certain of the Company's technology incorporated
in some of its products may infringe on such patent. The Company is in the
process of reviewing the matter. Any infringement claim or litigation against
the Company could, therefore, have a material adverse effect on the Company's
business, financial condition and results of operations.

The Company maintains trademarks and service marks to identify its various
service offerings, products and software. Although the Company has registered
certain trademarks and service marks with the PTO and has several trademark and
service mark applications pending in the United States and foreign
jurisdictions, not all of the applications have been granted and, even if
granted, there can be no assurance that a particular trademark or service mark
will survive a legal challenge to its validity or provide meaningful or
significant protection to the Company. In addition, the Company has abandoned
the applications of certain trademarks or service marks that it believes are not
critical to its business in the future. In some cases, entities other than the
Company are using certain trademarks and service marks, either in jurisdictions
in which the Company has not filed an application or in which the Company is
using a mark in a different manner than a third party. There may be some risk of
infringement claims against the Company in the event that a service or product
of the Company is too similar to that of another entity that is using a similar
mark.

Dependence on Third-Party Technology

The Company's proprietary software is currently designed, and may in the
future be designed, to work on or in conjunction with certain third-party
hardware and/or software products. If any of these current or future third-party
vendors were to discontinue making their products available to the Company or to
licensees of the Company's software or to increase materially the cost to the
Company or its licensees to acquire, license or purchase the third-party
vendors' products, or if a material problem were to arise in connection with the
ability of the Company to design its software to properly use or operate with
third-party hardware and/or software products, the Company would be required to
redesign its software to function with or on alternative third-party products or
attempt to develop internally a replacement for the third-party products. In
such an event, interruptions in the availability or functioning of the Company's
software and delays in the introduction of new products and services may occur
until equivalent technology is obtained. There can be no assurance that an
alternative source of suitable technology

would be available or that the Company would be able to develop an alternative
product in sufficient time or at a reasonable cost. The failure of the Company
to obtain or develop alternative technologies or products on a timely basis and
at a reasonable cost could have a material adverse effect on the Company's
business, financial condition and results of operations.

Rapid Technological Change

The market for the Company's products and services is characterized by
rapidly changing technology, evolving industry standards and new product
introductions and enhancements that may render existing products obsolete. As a
result, the Company's market position could erode further due to unforeseen
changes in the features and functionality of competing products. The process of
developing products and services such as those offered by the Company is
extremely complex and is expected to become increasingly complex and expensive
in the future with the introduction of new platforms and technologies. There can
be no assurance that the Company will develop any new products in a timely
fashion or that the Company's current or future products will satisfy the needs
of its target market especially in light of its current difficult financial
condition.

Potential Adverse Effects of Anti-Takeover Provisions; Possible Issuance of
Preferred Stock

The Company's Amended and Restated Articles of Organization and Amended
and Restated By-laws contain provisions that may make it more difficult for a
third party to acquire, or discourage acquisition bids for, the Company. For
instance, the Company's Amended and Restated By-laws provide that special
meetings of stockholders may be called only by the President, the Board of
Directors or the holders of at least 80% of the voting securities of the
Company. In addition, the Massachusetts General Laws provide that stockholders
may take action without a meeting only by the unanimous written consent of all
stockholders. The Company's Board of Directors is also divided into three
classes, as nearly equal in size as possible, with staggered three-year terms.
The Company is also subject to an anti-takeover provision of the Massachusetts
General Laws which prohibits, subject to certain exceptions, a holder of 5% or
more of the outstanding voting stock of the Company from engaging in certain
activities with the Company, including a merger, stock or asset sale. The
foregoing provisions could limit the price that certain investors might be
willing to pay in the future for shares of the Company's Common Stock. In
addition, shares of the Company's Preferred Stock may be issued in the future
without further stockholder approval and upon such terms and conditions, and
having such rights, privileges and preferences, as the Board of Directors may
determine. The rights of the holders of Common Stock will be subject to, and may
be adversely affected by, the rights of any holders of Preferred Stock that may
be issued in the future. The issuance of Preferred Stock, while providing
desirable flexibility in connection with possible acquisitions and other
corporate purposes, could have the effect of making it more difficult for a
third party to acquire, or discouraging a third party from acquiring, a majority
of the outstanding voting stock of the Company.

Year 2000 Matters

The Year 2000 issue relates to computer programs and systems that
recognize dates using two-digit year data rather than four-digit year data. As a
result, such programs and systems may fail or provide incorrect information when
using dates after December 31, 1999. If the Year 2000 issue were to disrupt the
Company's internal information technology systems, or the information technology
systems of entities with whom the Company has significant commercial
relationships, the Company's business and financial condition could be
materially adversely affected.

The Year 2000 issue is relevant to three areas of the Company's business:
(1) the Company's products, (2) the Company's internal computer systems and (3)
the computer systems of significant suppliers or customers of the company. Each
such area is addressed below.

1. The Company's Products. In some cases, the Company warrants to
its clients that its software will be

year 2000 compliant generally subject to certain limitations or
conditions. The Company also provides solutions consisting of products and
services to address the year 2000 problem involving key aspects of a
client's computer systems. A failure in a client's system or failure of
the Company's software to be year 2000 compliant could result in
substantial damages and therefore have a material adverse effect on the
Company's business, financial condition and results of operations.
Although the Company has not adopted a formal Year 2000 compliance program
for its AutoEnhancer 2000 and Vantage YR2000 products, it will use
commercially reasonable efforts to make its currently marketed products,
including its SAM Workbench and SAM Relay tools, year 2000 compliant.
There can be no assurance that any future efforts will be successful.

2. Internal Systems. The Company's internal computer programs and
operating systems relate to certain segments of the Company's business,
including customer database management, marketing, order processing, order
fulfillment, inventory management, customer service, accounting and
financial reporting. These programs and systems consist primarily of:

o Business Systems. These systems automate and manage business
functions such as customer database management, marketing,
order-taking and order-processing, inventory management, customer
service, accounting and financial reporting,

o Personal Computers and Networks. These systems are used for word
processing, document management and other similar administrative
functions, and

o Telecommunications Systems. These systems provide telephone,
voicemail, e-mail, Internet and intranet connectivity, and enable
the Company to manage overall internal and external
communications.

The Company's Business Systems are licensed from an outside vendor.
These Business Systems installed on or after 1997, have been upgraded to
be Year 2000 compliant. Other Internal Systems consist of widely available
office applications and application suites for word-processing, voicemail
and other office-related functions. The Company maintains recent versions
of all such key applications and all are, to the Company's knowledge, Year
2000 compliant. Accordingly, the Company did not adopt a formal Year 2000
compliance program for its Internal Systems. However, there can be no
assurance that the Company's Internal Systems or the combination thereof
will be Year 2000 compliant. A failure of an Internal System to be Year
2000 compliant could have a material adverse impact on the Company's
business, financial condition and results of operations.

3. Third-Party Systems. The computer programs and operating systems
used by entities with whom the Company has commercial relationships pose
potential problems relating to the Year 2000 issue, which may affect the
Company's operations in a variety of ways. These risks are more difficult to
assess than those posed by internal programs and systems, and the Company has
completed a plan for assessing them. The Company believes that the programs and
operating systems used by entities with whom it has commercial relationships
generally fall into two categories: (A) First, the Company relies upon programs
and systems used by providers of basic services necessary to enable the Company
to reach, communicate and transact business with its suppliers and customers.
Examples of such providers include the United States Postal Service, overnight
delivery services, telephone companies, other utility companies and banks.
Services provided by such entities affects almost all facets of the Company's
operations. However, these third-party dependencies are not specific to the
Company's business, and disruptions in their availability would likely have a
negative impact on most enterprises within the software and services industry
and on many enterprises outside the software and services industry. The Company
believes that all of the most reasonably likely worst-case scenarios involving
disruptions to its operations stemming from the Year 2000 issue relate to
programs and systems in this first category. (B) Second, the Company relies upon
third parties for certain software code or programs that are embedded in, or
work with, its products. The Company believes that the functionality of its
products may be materially diminished by a failure of such third-party software
to be Year 2000 compliant. There can be no assurance that the Company may not
experience unanticipated expenses or be otherwise

adversely impacted by a failure of third-party systems or software to be Year
2000 compliant. The most reasonably likely worst-case scenarios may include: (i)
corruption of data contained in the Company's internal information systems, (ii)
hardware failure, and (iii) failure of infrastructure services provided by
utilities and/or government. The Company included an evaluation of such
scenarios in its plan for assessing the programs and systems of the entities
with whom it has commercial relationships.

The Company has completed the formulation of its plan for assessing its
internal programs and systems and the programs and systems of the entities with
whom it has commercial relationships and the identification of related risks and
uncertainties. The Company has not identified any material risks and
uncertainties to date. The Company does not currently anticipate that the total
cost of any Year 2000 remediation efforts that may be needed will be material.

Item 7A. Quantitative And Qualitative Disclosures About Market Risk

As of December 31, 1999, the Company was exposed to market risks which
primarily include changes in U.S. interest rates. The Company maintains a
significant portion of its cash and cash equivalents in financial instruments
with purchased maturities of three months or less. These financial instruments
are subject to interest rate risk and will decline in value if interest rates
increase. Due to the short duration of these financial instruments, an immediate
increase in interest rates would not have a material effect on the Company's
financial condition or results of operations.

Item 8. Financial Statements and Supplementary Data

PERITUS SOFTWARE SERVICES, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Financial Statements:

Report of Independent Accountants......................................................................... 51

Consolidated Balance Sheet as of December 31, 1999 and 1998............................................... 52

Consolidated Statement of Operations for the three years ended December 31, 1999.......................... 53

Consolidated Statement of Comprehensive Loss for the three years ended December 31, 1999.................. 54

Consolidated Statement of Changes in Stockholders' Equity for the three years ended December 31, 1999..... 55

Consolidated Statement of Cash Flows for the three years ended December 31, 1999.......................... 56

Notes to Consolidated Financial Statements................................................................ 58
Financial Statement Schedule:

For the three years ended December 31, 1999

II. Valuation and Qualifying Accounts............................................................. 95

All other schedules are omitted because they are not applicable or the
required information is shown in the consolidated financial statements or notes
thereto.

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders of
Peritus Software Services, Inc.

In our opinion, the consolidated financial statements listed in the
accompanying index present fairly, in all material respects, the financial
position of Peritus Software Services, Inc. and its subsidiaries at December 31,
1999 and 1998, and the results of their operations and their cash flows for each
of the three years in the period ended December 31, 1999, in conformity with
accounting principles generally accepted in the United States. These financial
statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States, which require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for the opinion expressed above.

PRICEWATERHOUSECOOPERS LLP

Boston, Massachusetts
March 28, 2000

PERITUS SOFTWARE SERVICES, INC.

CONSOLIDATED BALANCE SHEET
(In Thousands, Except Share-Related Data)

December 31,
1999 1998
--------- ---------
ASSETS

Current assets:
Cash and cash equivalents .......................................................... $ 2,475 $ 2,809
Restricted cash .................................................................... -- 569
Short-term investments ............................................................. -- 500
Accounts receivable, net of allowance for doubtful accounts of $25 and $726,
respectively, and including amounts receivable from related parties of $0 and
$42, respectively ............................................................... 532 3,720

Costs and estimated earnings in excess of billings on uncompleted contracts ........ 281 951
Prepaid expenses and other current assets .......................................... 248 816
--------- ---------
Total current assets ......................................................... 3,536 9,365
Property and equipment, net .............................................................. 702 3,848
Intangible and other assets, net ......................................................... 55 510
--------- ---------
$ 4,293 $ 13,723
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of capital lease obligations ....................................... $ 13 $ 90
Current portion of long-term debt .................................................. -- 269
Customer advances .................................................................. 296 --
Accounts payable ................................................................... 11 462
Billings in excess of costs and estimated earnings on uncompleted contracts ........ 253 435
Deferred revenue ................................................................... 195 1,890
Other accrued expenses and current liabilities ..................................... 1,128 4,414
--------- ---------
Total current liabilities .................................................... 1,896 7,560
Capital lease obligations ................................................................ 25 286
Long-term debt ........................................................................... -- --
Long-term restructuring .................................................................. -- 1,067
--------- ---------
Total liabilities ............................................................ 1,921 8,913
--------- ---------
Commitments and contingencies (Notes 6, 18 and 19) ....................................... -- --
Stockholders' equity:
Common stock, $.01 par value; 50,000,000 shares authorized; 17,173,975 and
16,349,986 shares issued and outstanding at December 31, 1999 and 1998,
respectively .................................................................... 172 164
Additional paid-in capital ............................................................... 105,279 105,135
Accumulated deficit ...................................................................... (103,071) (100,488)
Accumulated other comprehensive loss ..................................................... (8) (1)
--------- ---------
Total stockholders' equity ................................................... 2,372 4,810
--------- ---------
$ 4,293 $ 13,723
========= =========

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

PERITUS SOFTWARE SERVICES, INC.

CONSOLIDATED STATEMENT OF OPERATIONS
(In Thousands, Except Per Share-Related Data)

Year Ended December 31,
--------------------------------------
1999 1998 1997
-------- -------- --------

Revenue:
Outsourcing services, including $0, $872, and $4,478 from related
parties, respectively .................................................. $ 5,923 $ 9,925 $ 11,447
License, including $0, $255, and $0 from related parties,
respectively ........................................................... 2,087 9,444 21,255
Other services, including $0, $204, and $0 from related parties,
respectively ........................................................... 3,188 12,163 7,007
-------- -------- --------
Total revenue ....................................................... 11,198 31,532 39,709
-------- -------- --------
Cost of revenue:
Cost of outsourcing services, including $0, $750, and $2,467 from
related parties, respectively .......................................... 4,778 7,577 9,536
Cost of license ........................................................... 238 1,631 690
Cost of other services, including $0, $56, and $0 from related parties,
respectively ........................................................... 2,013 9,110 5,357
-------- -------- --------
Total cost of revenue ............................................... 7,029 18,318 15,583
-------- -------- --------
Gross profit .................................................................... 4,169 13,214 24,126
-------- -------- --------
Operating expenses:
Sales and marketing ....................................................... 1,450 13,244 8,864
Research and development .................................................. 1,316 8,528 8,324
General and administrative ................................................ 3,570 7,466 4,312
Write off of acquired in-process research and development ................. -- -- 70,800
Impairment of long-lived assets ........................................... 961 5,218 --
Restructuring charges (credits) ........................................... (455) 5,906 --
-------- -------- --------
Total operating expenses ............................................ 6,842 40,362 92,300
-------- -------- --------
Loss from operations ................................................ (2,673) (27,148) (68,174)
Interest income ................................................................. 116 548 1,163
Interest expense ................................................................ (24) (63) (215)
-------- -------- --------
Loss before gain on sale of majority-owned subsidiary, income taxes and
minority interest in majority-owned subsidiary ......................... (2,581) (26,663) (67,226)
Gain on sale of majority-owned subsidiary ....................................... -- (11) --
Provision for income taxes ...................................................... 2 25 260
-------- -------- --------
Loss before minority interest in majority-owned subsidiary ................ (2,583) (26,677) (67,486)
Minority interest in majority-owned subsidiary .................................. -- (4) 4
-------- -------- --------
Net loss .................................................................. (2,583) (26,673) (67,490)
Accrual of dividends on Series A and B preferred stock .......................... -- -- 675
Accretion to redemption value of redeemable stock ............................... -- -- 57
-------- -------- --------
Net loss available to common stockholders ....................................... $ (2,583) $(26,673) $(68,222)
======== ======== ========
Net loss per share:
Basic ..................................................................... $ (0.15) $ (1.65) $ (7.03)
======== ======== ========
Diluted ................................................................... $ (0.15) $ (1.65) $ (7.03)
======== ======== ========
Weighted average shares outstanding:
Basic ..................................................................... 16,684 16,177 9,708
======== ======== ========
Diluted ................................................................... 16,684 16,177 9,708
======== ======== ========

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

PERITUS SOFTWARE SERVICES, INC.

Consolidated Statement of Comprehensive Loss
(In Thousands)

Year Ended December 31,
--------------------------------------
1999 1998 1997
-------- -------- --------

Net loss .......................................... $ (2,583) $(26,673) $(67,490)
Other comprehensive income (loss) net of taxes:

Foreign currency translation adjustments ...... (7) 83 (62)
-------- -------- --------
Comprehensive loss ................................ $ (2,590) $(26,590) $(67,552)
======== ======== ========

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

PERITUS SOFTWARE SERVICES, INC.

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(In Thousands, Except Share-Related Data)

Additional
Paid-in Class A Class B
Common Stock Capital Common Stock Common Stock
------------ ------- ------------ ------------
Number Number Number
of Shares Amount of Shares Amount of Shares
---------- ---------- ---------- ---------- ----------

Balance, December 31, 1996 ..................... -- $ -- $ -- 6,038,615 $ 2,207 101,196
Sale of common stock pursuant to exercise
of stock options ............................ 52,002 1 51 165,781 23 --
Accrual of cumulative dividends on
Redeemable convertible preferred stock
and accretion to redemption value on
redeemable stock ............................ -- -- -- -- -- --
Termination of stock purchase right ............ -- -- 326 -- -- --
Conversion of Class A and Class B common
stock to common stock ....................... 6,305,592 63 2,331 (6,204,396) (2,230) (101,196)
Conversion of Series A and Series B
Redeemable convertible preferred stock to
common stock ................................ 3,721,707 37 12,657 -- -- --
Sale of common stock in connection with
initial public offering, net of issuance
costs ....................................... 2,800,000 28 40,636 -- -- --
Cumulative translation adjustment .............. -- -- -- -- -- --
Sale of common stock pursuant to exercise
of warrants ................................. 312,500 3 497 -- -- --
Issuance of common stock in connection with
acquisition of Millennium Dynamics, Inc. ....... 2,175,000 22 47,310 -- -- --
Net loss ....................................... -- -- -- -- -- --
---------- ---------- ---------- ---------- ---------- ----------
Balance, December 31, 1997 ..................... 15,366,801 154 103,808 -- -- --
Sale of common stock pursuant to exercise
of stock options ............................ 883,185 9 1,018 -- -- --
Sale of common stock pursuant to employee
stock purchase plan ......................... 100,000 1 309 -- -- --
Repayment of receivable from stockholder ....... -- -- -- -- --
Cumulative translation adjustment .............. -- -- -- -- --
Net loss ....................................... -- -- -- -- -- --
---------- ---------- ---------- ---------- ---------- ----------
Balance, December 31, 1998 ..................... 16,349,986 164 105,135 -- -- --
Sale of common stock pursuant to exercise
of stock options ............................ 1,000 -- -- -- -- --
Sale of common stock pursuant to employee
stock purchase plan ......................... 22,989 -- 4 -- -- --
Issuance of common stock ....................... 800,000 8 140 -- -- --
Cumulative translation adjustment .............. -- -- -- -- -- --
Net loss ....................................... -- -- -- -- -- --
---------- ---------- ---------- ---------- ---------- ----------
Balance, December 31, 1999 ..................... 17,173,975 $ 172 $ 105,279 -- $ -- --
========== ========== ========== ========== ========== ==========

Accumulated Total
Receivable Other Stockholder's
Class B Accumulated from Comprehensive Equity
Common Stock Deficit Stockholder Loss (Deficit)
------------ ------- ----------- ---- ---------

Amount
----------

Balance, December 31, 1996 ..................... $ 164 $ (5,593) $ (58) $ (22) $ (3,302)
Sale of common stock pursuant to exercise
of stock options ............................ -- -- -- -- 75
Accrual of cumulative dividends on
Redeemable convertible preferred stock
and accretion to redemption value on
redeemable stock ............................ -- (732) -- -- (732)
Termination of stock purchase right ............ -- -- -- -- 326
Conversion of Class A and Class B common
stock to common stock ....................... (164) -- -- -- --
Conversion of Series A and Series B
Redeemable convertible preferred stock to
common stock ................................ -- -- -- -- 12,694
Sale of common stock in connection with
initial public offering, net of issuance
costs ....................................... -- -- -- -- 40,664
Cumulative translation adjustment .............. -- -- -- (62) (62)
Sale of common stock pursuant to exercise
of warrants ................................. -- -- -- -- 500
Issuance of common stock in connection with
acquisition of Millennium Dynamics, Inc. ....... -- -- -- -- 47,332
Net loss ....................................... -- (67,490) -- -- (67,490)
---------- ---------- ---------- ---------- ----------
Balance, December 31, 1997 ..................... -- (73,815) (58) (84) 30,005
Sale of common stock pursuant to exercise
of stock options ............................ -- -- -- -- 1,027
Sale of common stock pursuant to employee
stock purchase plan ......................... -- -- -- -- 310
Repayment of receivable from stockholder ....... -- -- 58 -- 58
Cumulative translation adjustment .............. -- -- -- 83 83
Net loss ....................................... -- (26,673) -- -- (26,673)
---------- ---------- ---------- ---------- ----------
Balance, December 31, 1998 ..................... -- (100,488) -- (1) 4,810
Sale of common stock pursuant to exercise
of stock options ............................ -- -- -- -- --
Sale of common stock pursuant to employee
stock purchase plan ......................... -- -- -- -- 4
Issuance of common stock ....................... -- -- -- -- 148
Cumulative translation adjustment .............. -- -- -- (7) (7)
Net loss ....................................... -- (2,583) -- -- (2,583)
---------- ---------- ---------- ---------- ----------
Balance, December 31, 1999 ..................... $ -- $ (103,071) $ -- $ (8) $ 2,372
========== ========== ========== ========== ==========

PERITUS SOFTWARE SERVICES, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS
(In Thousands, Except Share-Related Data)

Year Ended December 31,
--------------------------------
1999 1998 1997
-------- -------- --------

Increase (Decrease) in Cash and Cash Equivalents
Cash flows from operating activities:
Net loss ..................................................................... $ (2,583) $(26,673) $(67,490)
Adjustments to reconcile net loss to net cash provided by (used for)
operating activities:
Depreciation and amortization .......................................... 1,442 3,083 1,327
Minority interest in majority-owned subsidiary ......................... -- (4) 4
Impairment of long-lived assets ........................................ 961 5,218 --
Gain on sale of majority-owned subsidiary .............................. -- (11) --
Write off of acquired in process research and development .............. -- -- 70,800
Changes in assets and liabilities, net of effects from acquisitions:
Accounts receivable .............................................. 3,188 8,671 (6,193)
Costs and estimated earnings in excess of billings on
uncompleted contracts .......................................... 670 1,596 (9)
Unbilled license revenue from related parties .................... -- -- 1,400
Prepaid expenses and other current assets ........................ 568 (137) (438)
Other assets ..................................................... 116 (125) --
Accounts payable ................................................. (451) (979) 495
Proceeds from customer advance ................................... 296 -- --
Billings in excess of costs and estimated earnings on
uncompleted contracts .......................................... (182) 331 74
Deferred revenue ................................................. (1,695) (928) (629)
Other accrued expenses and current liabilities, excluding
accrued restructuring .......................................... (1,673) (383) 885
Accrued restructuring ............................................ (1,835) 2,680 --
-------- -------- --------
Net cash provided by (used for) operating activities ........... (1,178) (7,661) 226
-------- -------- --------

Cash flows from investing activities:
Sale (purchase) of short-term investments .................................... 500 2,500 (3,000)
Cash of majority-owned subsidiary disposed, net of cash received ............. -- (1,074) --
Cash paid for acquisition of business, and related costs, net of cash
acquired .................................................................. -- -- (31,350)
Proceeds from sale of property and equipment ................................. 288 -- --
Purchases of property and equipment .......................................... (56) (2,739) (2,018)
-------- -------- --------
Net cash provided by (used for) investing activities ........ 732 (1,313) (36,368)
-------- -------- --------

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

PERITUS SOFTWARE SERVICES, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS--(Continued)
(In Thousands, Except Share-Related Data)

Year Ended December 31,
--------------------------------
1999 1998 1997
-------- -------- --------

Cash flows from financing activities:
Restricted cash ................................................. $ 569 $ (569) $ --
Proceeds from long-term debt .................................... -- -- 200
Principal payments on long-term debt ............................ (269) (292) (1,201)
Principal payments on capital lease obligations ................. (338) (106) (80)
Proceeds from issuance of common stock, net of issuance costs ... 152 1,337 41,239
Proceeds from repayment of note receivable from stockholder ..... -- 58 --
-------- -------- --------
Net cash provided by financing activities ...... 114 428 40,158
-------- -------- --------
Effects of exchange rates on cash and cash equivalents ................ (2) 15 (64)
-------- -------- --------
Net increase (decrease) in cash and cash equivalents .................. (334) (8,531) 3,952
Cash and cash equivalents, beginning of year .......................... 2,809 11,340 7,388
-------- -------- --------
Cash and cash equivalents, end of year ................................ $ 2,475 $ 2,809 $ 11,340
======== ======== ========

Supplemental Disclosure of Cash Flows:
Cash paid for income taxes ............................................ $ 29 $ 78 $ 115
Cash paid for interest ................................................ 24 63 215

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:

In the years ended December 31, 1999, 1998 and 1997, the Company incurred
capital lease obligations of $0, $458 and $0, respectively.

In the year ended December 31, 1997, the Company issued 2,175,000 shares
of common stock valued at $47,332 and paid cash of $30,000 to acquire
substantially all of the assets and assume certain liabilities of Millennium
Dynamics, Inc. (Note 3).

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

PERITUS SOFTWARE SERVICES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. NATURE OF THE BUSINESS AND CURRENT FINANCIAL CONDITION

Peritus Software Services, Inc. (the "Company") was incorporated in
Massachusetts in August 1991. The Company provides software products and
services that enable organizations to improve the productivity, quality and
effectiveness of their information technology systems maintenance, or "software
evolution" functions. The Company derives its revenue from software maintenance
outsourcing services, software and methodology licensing and other services sold
directly to end users or indirectly via value added integrators, and its clients
include primarily Fortune 1000 companies and similarly sized business and
government organizations worldwide.

The Company's consolidated financial statements have been presented on the
basis that it is a going concern, which contemplates continuity of operations,
realization of assets and the satisfaction of liabilities in the ordinary course
of business. The Company experienced net losses of $2,583,000, $26,673,000 and
$67,490,000 in the years ended December 31, 1999, 1998 and 1997, respectively.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The consolidated financial statements include the accounts of the Company
and its wholly-owned and majority-owned subsidiaries. All significant
intercompany balances and transactions have been eliminated.

Revenue Recognition

The Company licenses its software products and methodologies to end users
and to value added integrators for their use in serving their clients. License
fees charged to end users are fixed, with the amount of the fee based on the
estimated total lines of code to be processed, the number of CPUs licensed, or
other defined factors. License fees charged to value added integrators are
generally royalties based on lines of code processed or to be processed or
number of CPUs licensed. Revenue from software licenses to end users is
recognized when licensed software and methodologies have been delivered to the
end user, a contract or purchase order has been executed, fees are fixed or
determinable, collection of the related receivable is probable, and customer
acceptance provisions do not exist. In arrangements where customer acceptance
provisions exist, the Company defers revenue recognition until customer
acceptance occurs or the acceptance provisions have lapsed. The Company
generally does not provide its customers with the right to return software
licenses and, once due, license fees are non-refundable. Revenue from software
licenses to value added integrators is recognized when the licensed software and
methodologies have been delivered to the value added integrator, the fee is
fixed or determinable and collection of the related receivable is probable.
Under arrangements combining software and services, all revenue is recorded
using the percent of completion method as described for other services below.
Under such combined arrangements, vendor specific objective evidence ("VSOE")
for software license is used for income statement classification purposes only
and is determined based upon the prices that exist or are charged for the same
software when licensed separately and distinctly. The VSOE for the service
component under combined arrangements is based upon hourly rates.

Other services provided by the Company include direct delivery contracts
as well as technology transfer arrangements, product training, value added
integrator sales training, consulting services and software product maintenance.
Under direct delivery contracts, the Company provides full and pilot year 2000
renovations and renovation quality evaluation ("RQE") services for clients using
the Company's AutoEnhancer/2000, RQE tool, and/or Vantage YR2000 software.
Revenue from full year 2000 renovation and RQE contracts is recognized using the
percentage-of-completion method and is based on the ratio that labor-hours
incurred to date bear to estimated total labor-hours at completion, provided
that a contract or purchase order has been executed, fees are fixed or
determinable and collection of the related receivable is probable. Revenue from
pilot direct delivery contracts is recognized over the duration of such
contracts as work is performed and defined milestones are attained. Adjustments
to contract cost estimates are made in the periods in which the facts which
require such revisions become known. When the revised estimates indicate a loss,
such loss is provided for currently in its entirety. In cases where VSOE of fair
value of both the license and service component exists under a direct delivery
contract, revenue recognized is allocated between license revenue and other
services revenue for income statement classification purposes based on their
relative fair values. Revenue from technology transfer arrangements, product and
sales training and consulting services is billed on a time-and-materials basis
and is recognized as the services are provided. Revenue from software product
maintenance contracts on the Company's licensed software products, including
client support bundled with the initial license fee, is deferred and recognized
ratably over the contractual periods during which the services are provided.

Concentration of Credit Risk

Financial instruments which potentially expose the Company to
concentrations of credit risk include trade accounts receivable. The Company
primarily sells to Fortune 1000 companies and therefore, generally does not
require collateral. Reserves for potential credit losses are maintained.

Fair Value of Financial Instruments

The Company's financial instruments consist of cash and cash equivalents,
short-term investments, accounts receivable, costs and estimated earnings in
excess of billings on uncompleted contracts, accounts payable, accrued expenses,
billings in excess of costs and estimated earnings on uncompleted contracts,
other long-term liabilities and long-term debt. The carrying amounts of these
instruments at December 31, 1999 approximate their fair values.

Cash Equivalents and Short-Term Investments

The Company considers all highly liquid debt instruments purchased with an
original maturity of three months or less to be cash equivalents. The Company
invests its excess cash primarily in money market accounts, commercial paper and
corporate bonds. Accordingly, these investments are subject to minimal credit
and market risk.

The Company accounts for its investments in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain
Investments in Debt and Equity Securities." SFAS No. 115 requires the Company to
classify its investments among three categories: held-to-maturity, which are
reported at amortized cost; trading securities, which are reported at fair
value, with unrealized gains and losses included in earnings; and
available-for-sale securities, which are reported at fair value, with unrealized
gains and losses excluded from earnings and reported as a separate component of
stockholders' equity. At December 31, 1999, the Company's cash and cash
equivalents included money market accounts and overnight deposits of $1,151,000
and $1,197,000, respectively, which are classified as available for sale. The
fair market value of these investments approximated their amortized cost.

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation
and amortization. Depreciation of property and equipment is provided using the
straight-line method over the estimated useful lives of the assets or, where
applicable, over the lease term.

Software Development Costs

The Company capitalizes qualifying software development costs after
technological feasibility of the software has been established. Costs incurred
prior to the completion of a working model, which is the Company's primary basis
for determining technological feasibility, are charged to research and
development expense. Amortization of capitalized software costs, which is
charged to cost of revenue, is calculated based upon the ratio of current year
revenue from the related software to total revenue or ratably over the useful
life of the software, whichever is greater. During the years ended December 31,
1999, 1998 and 1997, costs subject to capitalization were not significant and
therefore, were not capitalized. At December 31, 1999 and 1998, the Company's
other assets included $0 and $8,000, respectively, in unamortized capitalized
software development costs acquired from Vista Technologies Incorporated
("Vista") during 1996 (Note 3). Amortization expense related to capitalized
software development costs for the years ended December 31, 1999, 1998 and 1997
was $8,000, $46,000 and $50,000, respectively, all of which related to the
capitalized software acquired from Vista.

Intangible Assets

Intangible assets at December 31, 1999 and December 31, 1998 were $0 and
$340,000, respectively. At December 31, 1998, intangible assets related
primarily to the MDI and Vista acquisitions (Note 3) and were being amortized on
a straight-line basis over their expected useful lives of two and three years,
respectively. In connection with an impairment of intangible assets relating to
the MDI acquisition (Note 5), the expected useful lives of such assets were
reduced from five years to two years. Costs associated with obtaining patents
are capitalized as incurred and amortized using the straight-line method over
their estimated economic lives beginning when each patent is issued. For the
years ended December 31, 1999, 1998 and 1997, the Company recorded $17,000,
$23,000 and $12,000, respectively, of amortization expense relating to
capitalized patent costs. In 1999, the Company recorded an impairment charge
eliminating the remaining balance of its capitalized patents (Note 5).

Accounting for Impairment of Long-Lived Assets

In accordance with SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and Long-Lived Assets to be Disposed Of," the Company records
impairment losses on long-lived assets used in operations when indicators of
impairment are present and the undiscounted cash flows estimated to be generated
by those assets are

less than the assets' carrying amount. The Company recorded impairment charges
totaling $961,000 and $5,218,000 during the years ended December 31, 1999 and
December 31, 1998, respectively. (Note 5).

Foreign Currency

Assets and liabilities of the Company's foreign subsidiaries are
translated into U.S. dollars at exchange rates in effect at the balance sheet
date. Income and expense items are translated at average exchange rates for the
period. Accumulated net translation adjustments are included in stockholders'
equity.

Advertising Expense

The Company recognizes advertising expense as incurred. Advertising
expense was approximately $0, $842,000 and $826,000 for the years ended December
31, 1999, 1998 and 1997, respectively.

Accounting for Stock-Based Compensation

The Company accounts for stock-based awards to its employees using the
intrinsic value based method as prescribed by Accounting Principles Board
Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. Accordingly, no compensation expense is recorded for options
issued to employees in fixed amounts and with exercise prices equal to the fair
market value of the Company's common stock at the date of grant. The Company has
adopted the provisions of SFAS No. 123, "Accounting for Stock-Based
Compensation," and related Interpretations, for disclosure only (Note 15). All
stock-based awards to non-employees are accounted for at their fair value in
accordance with SFAS No. 123.

Net Loss Per Share

The Company accounts for net loss per share in accordance with SFAS No.
128, "Earnings per Share." SFAS No. 128 requires the presentation of "basic"
earnings per share and "diluted" earnings per share. Basic earnings per share is
computed by dividing the net income (loss) available to common stockholders by
the weighted average shares of outstanding common stock. For purposes of
calculating diluted earnings per share, the denominator includes both the
weighted average shares of common stock outstanding and dilutive potential
common stock.

Antidilutive potential common stock excluded from the 1999, 1998 and 1997
diluted earnings per share computation includes approximately 278,872, 382,000
and 4,121,000 of common stock shares, respectively, issuable upon the conversion
of convertible preferred stock and the exercise of stock options and warrants.

As described in Note 14, all outstanding shares of the Company's
redeemable convertible preferred stock converted to shares of the Company's
common stock upon the closing of the Company's initial public offering.

Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make certain estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the reporting
period. Areas particularly subject to estimation include the allowance for
doubtful accounts, revenue based on percentage-of-completion, the valuation
allowance on deferred tax assets, cash flow projections and salvage value of
assets used in impairment analyses and the timing and amount of future sublease
income on restructured facilities. Actual amounts could differ from those
estimates.

Reclassifications

Certain reclassifications have been made to the consolidated financial
statements for prior years to conform to

the 1999 presentation. These reclassifications have no effect on the Company's
results of operations or financial position.

Recently Issued Accounting Standards

3. ACQUISITION

Effective December 1, 1997, Twoquay, Inc., a wholly owned subsidiary of
the Company, acquired substantially all of the assets and assumed certain
liabilities of the business of Millennium Dynamics, Inc. ("MDI") from American
Premier Underwriters, Inc. ("APU") in exchange for $30 million in cash and
2,175,000 unregistered shares of the Company's common stock. Pursuant to a
Registration Rights Agreement between the Company and APU, the Company agreed to
file a Registration Statement on Form S-3 covering up to all of the shares of
common stock issued to APU by July 6, 1998 and to use its best efforts to cause
such Registration Statement to become effective prior to August 1, 1998. The
Company also granted APU certain incidental rights to register up to 500,000
shares of common stock prior to July 6, 1998 in the event of a secondary
offering of the Company's common stock. Under the terms of the Registration
Rights Agreement, APU also agreed that up to 837,500 of the shares of common
stock issued by the Company would be subject to certain restrictions on sale
through December 31, 1998. In determining the purchase price for accounting
purposes, the shares of common stock issued by the Company in connection with
this transaction have been assigned a value of $47.3 million based on the
average closing sale price of the Company's common stock during the six trading
days beginning on the second trading day immediately preceding the completion
and public announcement of the terms of the acquisition on October 22, 1997,
less a discount of approximately 13% primarily reflecting the illiquid nature of
the unregistered shares of common stock issued by the Company in connection with
this transaction as discussed above. Twoquay changed its name to MDI after the
closing of the acquisition.

The acquisition was accounted for under the purchase method of accounting.
Accordingly, the results of the operations of MDI and the fair market value of
the acquired assets and assumed liabilities have been included in the Company's
financial statements since the effective date of the acquisition. The purchase
price was allocated to the acquired assets and assumed liabilities as follows:

Accounts receivable...................... $ 2,271,000
Unbilled license revenues................ 343,000
Other current assets..................... 135,000
Property and equipment................... 1,011,000
In-process research and development...... 70,800,000
Acquired technology...................... 4,800,000
Assembled workforce...................... 600,000
Goodwill................................. 103,000
Accounts payable......................... (658,000)
Restructuring reserves................... (435,000)
Other current liabilities................ (285,000)
-----------
$78,685,000

The amounts allocated to intangible assets, including acquired in-process
research and development, was determined by an independent appraiser. The amount
allocated to acquired in-process research and development

represented technology which had not reached technological feasibility and had
no alternative future use. Accordingly, the amount of $70,800,000 was charged to
operations at the effective date of the acquisition. (Note 4) At the time of
acquisition, the amounts allocated to intangible assets were being amortized on
a straight-line basis over their expected useful lives.

In connection with the acquisition, the Company recorded a reserve of
approximately $435,000 of which approximately $221,000 related to provisions for
the closure of certain MDI facilities and $214,000 related to severance benefits
for terminated MDI employees. At December 31, 1998, approximately $12,000 of
these costs remained to be paid and they were paid in 1999.

The following unaudited pro forma data has been prepared as if the
acquisition was completed at the beginning of 1997, and this information is
presented for illustrative purposes only and is not necessarily indicative of
results of operations which would actually have been achieved had the
acquisition occurred at the beginning of such period or which may be achieved in
the future. In addition, the following unaudited pro forma data is adjusted to
reflect the amortization of acquired intangible assets and excludes the write
off of acquired in-process research and development of $70,800,000 due to its
non-recurring nature. Also, the net loss per share and unaudited pro forma net
loss per share data shown below assumes the 2,175,000 shares issued in
connection with the acquisition were outstanding for the entire periods
presented.

For the Year Ended December 31,
-------------------------------
1997
-------------------------------
As Reported Pro Forma
------------- --------------
(Unaudited)

Revenues ............... $ 39,709,000 $ 50,633,000
Net loss ............... (67,490,000) (2,879,000)
Net loss per share:
Basic ............ $ (7.03) $ (0.31)
Diluted .......... $ (7.03) $ (0.31)

4. IN-PROCESS RESEARCH AND DEVELOPMENT

In connection with the acquisition of MDI, the Company recorded a charge
to operations of $70,800,000 representing purchased in-process technology that
had not yet reached technological feasibility and had no alternative future use
(see Note 3 to the consolidated financial statements). The value was determined
via an independent appraisal by estimating the costs to develop the purchased
in-process technology into commercially viable products, estimating the
resulting net cash flows from such projects, and discounting the net cash flows
back to their present value. As described below, the discount rate utilized
includes a factor that takes into account the uncertainty surrounding the
successful development of the purchased in-process technology. In addition, the
Company recorded intangible assets of $5,503,000, which included approximately
$4,800,000 attributable to developed technology. Immediately following
acquisition, the amounts allocated to intangible assets were being amortized on
a straight-line basis over their expected useful lives of five years.

meet its design specifications, including functions, features and technical
performance requirements. The acquired projects included continued development
of MDI's core technologies aiming to significantly enhance their features and
functionality in order to gain an increasing share of the Year 2000 software
market. In addition, the Company intended to continue to focus product plans
around developing comprehensive testing capabilities for MDI's Vantage YR2000
product and a "mass change" software engine with capabilities other than Year
2000 corrections, including a Euro currency conversion application.

Discounting the forecasted net cash flows back to their present value was
based on the Company's weighted-average cost of capital (WACC). The WACC
calculation produces the average required rate of return of an investment in an
operating enterprise, based on various required rates of return from investments
in various areas of that enterprise. The WACC assumed for the Company was 19%.
The discount rate used in discounting the net cash flows from purchased
in-process technology was 22.5%. This discount rate was higher than the WACC due
to the inherent uncertainties in the estimates described above including the
uncertainty surrounding the successful development of the purchased in-process
technology, the useful life of such technology, the profitability levels of such
technology and the uncertainty of technological advances that are unknown at
this time.

The cost to complete the in-process development was originally estimated
at approximately $18.7 million to be incurred through the end of the year 2000.
These costs are largely for personnel involved in the planning, design, coding,
integration, testing and modification of products to be derived from the
in-process technologies. The Company estimates that in-process projects relating
to future versions of the Vantage YR2000 product were 60% to 80% complete and
projects relating to the "mass change" engine were less than 50% complete at the
December 1, 1997 acquisition date.

Due to lower than anticipated revenue and losses in excess of expectations
during the quarter ended September 30, 1998, the Company stopped development of
all new versions of existing Vantage YR2000 products, the Vantage YR2000 testing
product and the generic mass change software product. As a result of these
actions, the Company closed its research and development centers in Cincinnati,
Ohio, and Lisle, IL, terminated substantially all employees at those facilities
and recorded a related restructuring charge (Note 6). Through December 31, 1998,
the Company had incurred approximately $2,200,000 in costs to develop these
in-process technologies. The Company does not expect to incur additional
development costs for these in-process technologies.

5. IMPAIRMENT OF LONG-LIVED ASSETS

The Company periodically assesses whether any events or changes in
circumstances have occurred that would

indicate that the carrying amount of a long-lived asset might not be
recoverable. When such an event or change in circumstance occurs, the Company
evaluates whether the carrying amount of such asset is recoverable by comparing
the net book value of the asset to estimated future undiscounted cash flows,
excluding interest charges, attributable to such asset. If it is determined that
the carrying amount is not recoverable, the Company recognizes an impairment
loss equal to the excess of the carrying amount of the asset over the estimated
fair value of such asset.

Year Ended 1999

Year Ended 1998

stopped. In connection with these actions, the Company also undertook a
restructuring of its operations (See Note 6) which included the closure of the
Company's research and development facilities in Cincinnati, Ohio and Lisle,
Illinois and the termination of substantially all the employees at these
facilities. As a result of these events, management concluded that an assessment
of the recoverability of intangible assets recorded in connection with the
acquisition of MDI in December 1997 was required at September 30, 1998. The
Company determined that its property and equipment at these locations was not
subject to impairment as substantially all such assets were scheduled to be
redeployed.

In December 1998, as a result of the significant downsizing of the
Company's operations (See Note 6) and continuing decline in operating results,
the Company reviewed the carrying amount of its property and equipment at
December 31, 1998 and committed to a plan to dispose certain of its assets,
primarily excess computer equipment and furniture relating to the restructured
operations, either by sale or abandonment. The plan was completed by September
30, 1999. The fair value of the assets to be disposed of was measured at
management's best estimate of salvage value, by using the current market values
or the current selling prices for similar assets. Costs to sell were estimated
to be insignificant. Based upon management's review, the carrying amounts of
assets having a net book value of $1,145,000 were written-down to a total amount
of $221,000, representing the lower of carrying amount or fair value (salvage
value) and the Company recorded an impairment charge totaling $924,000. The
assets to be disposed of were not depreciated or amortized while they were held
for disposal and the reduction in depreciation expense resulting from the write-
down was approximately $48,000 on a quarterly basis beginning in the first
quarter of 1999.

6. RESTRUCTURING CHARGES

Overview

The Company's facility related restructuring charges included amounts
related to closure or reduction in space for facilities in Billerica,
Massachusetts; Westborough, Massachusetts; Cincinnati, Ohio; Lisle, Illinois;
and Nashua, New Hampshire. In most cases, the Company had many years remaining
under non-cancelable leases. The Company's largest lease was for its 100,000
square foot headquarters facility in Billerica which had a lease termination in
February 2006. Under its restructuring accruals, the Company recorded charges
for the estimated difference between anticipated sublease income and the
estimated expenses that would be incurred for the space in the future. The
estimates included the following factors:

-1) the difference between estimated sublease income and rent payments

-2) estimated time the space would remain unoccupied earning no sublease
income

-3) estimated marketing costs including brokerage commissions

-4) estimated building operating expense charges in the future

-5) estimated costs to make the facilities ready for sublease

The estimates were complicated by the fact that the facilities were
located in several different real estate markets. The Company's estimates
included input from the Company's real estate brokers.

Year Ended 1999

The amounts accrued to and payments against the accrued restructuring
during the first quarter of 1999 and the composition of the remaining balance at
March 31, 1999 were as follows:

Balance Q1 1999 Q1 1999 Balance
December 31, 1998 Accrual Payments March 31, 1999
----------------- ------- -------- --------------
(in thousands)

Provision for severance and benefit payments to
Terminated employees ........................................ $ 536 $ 291 $ (212) $ 615

Provisions related to closure of facilities and reduction of
Occupied space .............................................. 2,144 -- (361) 1,783
------ ------ ------ ------

Total .................................................... $2,680 $ 291 $ (573) $2,398
====== ====== ====== ======

In April 1999, the Company decided to further reduce the amount of space
it occupied in its Billerica, Massachusetts headquarters facility. The space
consolidation was completed in the second quarter of 1999 and the Company
increased the amount of space it was offering for sublease from 50,000 to 75,000
square feet. Accordingly, in June 1999, the Company recorded an additional
restructure accrual of $517,000 consisting primarily of the cost of lease
expenses and real estate commissions associated with the additional vacated
25,000 square feet net of estimated sublease income. The assumptions underlying
the charge for the newly vacated space and the space vacated in previous
quarters were modified from previous assumptions based on the progress in
marketing the vacated space and changes in market conditions. The estimated
sublease date was changed from December 1, 1999 to January 1, 2000. The assumed
sublease discount from the lease-related payments due under lease was lowered to
12%. The assumption regarding the discount period was changed to cover the
entire lease term. Finally, estimated construction costs and commissions were
also updated. The additional restructuring resulted in a quarterly reduction in
lease-related costs of approximately $87,000 beginning in the third quarter of
1999.

The total facilities related payments/reclassifications for the second
quarter of 1999 were as follows:

Rent levelization reclassification........... $ 296,000
Cincinnati settlement (facility portion)..... (136,000)
All other net payments....................... (55,000)
----------
Total........................................ $ 105,000
==========

The $738,000 facility related release in the second quarter of 1999 broke
down as follows:

Billerica related...... $ (502,000)
Cincinnati related..... (272,000)
Lisle related.......... 36,000
----------
Total.................. $ (738,000)
==========

Q2 1999
Balance Payments/ Q2 1999 Q2 1999 Balance
March 31, 1999 Reclassifications Accrual Release June 30, 1999
-------------- ----------------- ------- ------- -------------
(in thousands)

Provisions for severance and benefit payments to
terminated employees ........................... $ 615 $ (425) $ -- $ (75) $ 115
Provision related to closure of facilities and
reduction of occupied space .................... 1,783 105 517 (738) 1,667
------ ------ ------ ------ ------

Total .............................................. $2,398 $ (320) $ 517 $ (813) $1,782
====== ====== ====== ====== ======

The total facilities related restructuring payments/reclassifications for
the third quarter of 1999 broke down as follows:

Lisle settlement ........................................... $(116,000)
Billerica cash payment ..................................... (200,000)
Billerica security deposit ................................. (300,000)
Billerica stock issued (valued at 90% of closing price) ... (89,000)
Rent levelization reclassification ......................... 149,000
All other net payments ..................................... (30,000)
---------
Total ...................................................... $(586,000)
=========

The total payments/reclassifications related to write-off of fixed assets,
leasehold improvements, and telephone lease related items for the third quarter
of 1999 broke down as follows:

The $436,000 facility related release in the third quarter of 1999 broke
down as follows:

Billerica related....... $ (392,000)
Lisle related........... (44,000)
----------
Total................... $ (436,000)
==========

The Lisle related release resulted from the settlement of the Lisle
telephone system lease for less than the capitalized lease liability.

In total, the Company recorded a net favorable impact of $450,000
associated with restructuring to the results of operations for the three months
ended September 30, 1999.

Q3 1999
Balance Payments/ Q3 1999 Balance
June 30, 1999 Reclassifications Release September 30, 1999
------------- ----------------- ------- ------------------
(in thousands)

Provisions for severance and benefit payments
to terminated employees .......................... $ 115 $ (101) $ (14) $ --
Provision related to closure of facilities and
reduction of occupied space ...................... 1,667 (586) (436) 645
Write-off of fixed assets, leasehold improvements,
and telephone lease related items .................... -- (645) -- (645)
------- ------- ------- -------

Total ................................................ $ 1,782 $(1,332) $ (450) $ --
======= ======= ======= =======

Year Ended 1998

In March 1998, the Company announced its intention for a strategic
restructuring to refocus the Company's

investments and to reduce its operating expenses. The Company effected this
restructuring, which was finalized in the second quarter of 1998, and recorded a
total charge of $1,439,000. The charge included severance-related payments of
$947,000 associated with the termination of approximately 12% of the Company's
employees in April 1998 (48 employees). At June 30, 1998, all 48 employees had
been terminated with no further terminations remaining under the restructuring.
In addition, $165,000 of the total restructuring charge related to support costs
for a discontinued product. The final $327,000 of the restructuring charge
related to the closure of two research and development and outsourcing centers
(Westborough, Massachusetts, and Nashua, New Hampshire) consisting primarily of
accrual of lease costs, net of estimated sublease income. Under its plan, the
Company committed to vacate the majority of its Westborough facility effective
June 1998. The $162,000 accrued for Westborough was computed as 100% of the
lease-related payments for the period from June 1998 through the expiration of
the lease for only that portion of the facility which was vacated. The Company
estimated that it would be unable to sublease the space prior to the expiration
of lease in December 1998, primarily due to the short period of time for which
the space would be available to potential sublessees. The lease did expire in
December 1998 and was not renewed. The assumption underlying the $165,000 charge
recorded for the Nashua facility was that it would remain unoccupied for nine
months and that it would be subleased thereafter at a 20% discount from the
lease-related payments due under the Company's lease. Payments related to
terminated employees were completed in June 1998 for 45 employees and were
completed by September 1999 for the remaining 3 employees. Payments related to
the closure and reduction of facilities were originally expected to be complete
by April 2003. However, payments ended as of December 31, 1998, upon the
execution of a settlement agreement with the Company's Nashua landlord. The
restructuring resulted in a reduction of approximately $950,000 in salary and
related costs and $90,000 in facility-related costs on a quarterly basis
beginning in second quarter of 1998.

In September 1998, the Company announced its intention to restructure and
recorded a total restructuring charge of $3,372,000. The charge included
$1,909,000 for severance-related payments associated with the termination of
approximately 33% of the Company's employees at that time (89 employees). At
September 30, 1998, all 89 employees had been terminated with no further
terminations remaining under the restructuring. The charge also included
$1,463,000 related to the closure of two research and development centers
(Cincinnati, Ohio and Lisle, Illinois) and a 30,000 square foot reduction of
occupied space at the Company's headquarters facility in Billerica, MA. The
accrual consisted primarily of estimated lease costs, net of estimated sublease
income. The $837,000 charge associated with Billerica, assumed that the vacated
space would remain empty for nine months and would be subsequently subleased
thereafter at a 20% discount from the lease-related payments due under the
Company's lease for the following four years. Thereafter, for the last 2 and
one-half years of the lease, the Billerica sublease income was estimated to
equal the amounts due under the Company's lease. The assumption for the
Cincinnati charge of $442,000 and the Lisle charge of $184,000 was that space
would remain empty for six months and would be subsequently subleased thereafter
at a 20% discount from the lease-related payments due under the Company's lease
until lease termination. Payments related to terminated employees were completed
by December 1998 for 82 employees and were completed by September 1999 for the
remaining 7 employees. Payments related to the closure of facilities and
reduction of occupied space were originally expected to be completed by June
2003; however, payments ended as of September 30, 1999 upon the execution of a
settlement agreement with the Company's Billerica landlord. The restructuring
resulted in a reduction of approximately $1,900,000 in salary and related costs
and $250,000 in lease-related costs on a quarterly basis beginning in the fourth
quarter of 1998.

be complete by June 2003; however, payments ended as of September 30, 1999 upon
the execution of a settlement agreement with the Company's Billerica landlord.
The restructuring resulted in a reduction of approximately $950,000 in salary
and related costs and $70,000 in lease-related costs on a quarterly basis
beginning in the first quarter of 1999. In December of 1998, through its
marketing activity, the Company found a new tenant for its Nashua, New Hampshire
facility and executed a settlement agreement with its landlord rather than
entering into a sublease. The settlement resulted in a $58,000 release from the
restructuring accrual.

Balance Balance
December 1998 1998 Other December 31,
31, 1997 Accrual Charges Adjustments 1998
------- ------ ------- ----- ------
(in thousands)

Provision for severance and benefit payments to
Terminated employees ........................... $ -- $3,264 $(2,558) $(170) $ 536
Provisions related to closure of facilities and
reduction of occupied space .................... -- 2,698 (503) (51) 2,144
Support costs for discontinued product ............ -- 165 (165) -- --
------- ------ ------- ----- ------
Total ....................................... $ -- $6,127 $(3,226) $(221) $2,680
======= ====== ======= ===== ======

7. DISPOSITION OF MAJORITY-OWNED SUBSIDIARY

In July 1998, the Company divested 100% of its equity interest in its
majority-owned Spanish subsidiary, Persist, S. A. ("Persist"), to Persist for
cash proceeds totaling $470,000. Accordingly, the results of operations of
Persist subsequent to the date of disposition have been excluded from the
Company's consolidated results for the year ended December 31, 1998 and the
Company's consolidated December 31, 1998 balance sheet excludes Persist's assets
and liabilities. The gain on this transaction was determined as the excess of
cash proceeds received by the Company over the net assets of Persist at the date
of disposition and reflects the realization of the cumulative impact of foreign
exchange rate fluctuations on the balance sheet of Persist while a subsidiary of
the Company.

8. PROPERTY AND EQUIPMENT

Property and equipment consist of the following:

Estimated
Useful
Lives
(Years) December 31,
------- ---------------------------
1999 1998
----------- -----------

Equipment..................................................... 3-7 $ 1,734,000 $ 4,765,000
Furniture, fixtures and internal use software................. 5-7 1,040,000 1,936,000
Leasehold improvements........................................ 2-5 43,000 897,000
----------- -----------
2,817,000 7,598,000
Less: Accumulated depreciation and amortization............... 2,115,000 3,750,000
----------- -----------
$ 702,000 $ 3,848,000
=========== ===========

Equipment under capital leases at December 31, 1999 and 1998 was $53,000
and $471,000 with related accumulated depreciation of $15,000 and $52,000,
respectively. Amortization expense related to assets under capital leases was
$69,000, $48,000 and $116,000 for the years ended December 31, 1999, 1998 and
1997, respectively. Depreciation expense on all fixed assets amounted to
$1,166,000, $2,063,000 and $1,140,000 for the years ended December 31, 1999,
1998 and 1997, respectively.

9. INTANGIBLE AND OTHER ASSETS

Intangible and other assets consist of the following:

December 31,
---------------------------------
1999 1998
------------- ------------

Acquired technology....................... -- $ 289,000
Goodwill.................................. -- 235,000
Other..................................... 55,000 $ 435,000
------------- ------------
55,000 959,000
Less: Accumulated amortization............ -- 449,000
------------- ------------
$ 55,000 $ 510,000
============= ============

Amortization expense related to intangible assets was $276,000, $1,020,000
and $187,000 for the years ended December 31, 1999, 1998 and 1997, respectively.
At December 31, 1999, the $55,000 of other assets consisted entirely of facility
related security deposits.

During the quarter ended September 30, 1998, the Company recorded an
impairment charge totaling $4,294,000 which related to intangible assets. During
the quarter ended September 30, 1999, the Company recorded an impairment charge
totaling $63,000 which related to intangible assets for the remaining book value
of its patented technology. (Note 5)

10. OTHER ACCRUED EXPENSES AND CURRENT LIABILITIES

Other accrued expenses and current liabilities consist of the following:

December 31,
--------------------------
1999 1998
---------- ----------
Sales and use tax accrual .......... 484,000 185,000
Employee-related costs ............. 223,000 548,000
Professional costs ................. 168,000 342,000
Restructuring costs ................ -- $1,613,000
Accrual for services rendered by
American Financial Group ........... -- 432,000
Rent levelization accrual .......... -- 357,000
Miscellaneous accruals ............. 253,000 937,000
---------- ----------
$1,128,000 $4,414,000
========== ==========

Miscellaneous accruals include items such as income taxes owed, third
party commissions owed, property taxes owed, warranty costs exposure, and
accruals for expenses where no invoices have been received.

11. REVOLVING LINE OF CREDIT AND TERM LOAN PAYABLE

Borrowings outstanding under the Company's credit facilities are as
follows:

December 31,
---------------------
1999 1998
------- ---------

Term loan payable to bank in monthly principal installments of
$24,000 with interest at prime plus 1% (8.75% at December 31,
1998) through January 2000. Paid in full February 1999.............. -- $ 269,000
---------
269,000
Less--Current portion.................................................. -- 269,000
------- ---------
$ -- $ --
======= =========

In September 1996, the Company entered into a new revolving line of credit
facility (the "Revolver") with a bank which bore interest at the bank's prime
rate plus 0.5%. The maximum borrowings under the Revolver were $3,500,000 and
were limited to 75% of certain receivables plus 50% of costs and estimated
earnings in excess of billings as defined in the Revolver agreement. Borrowings
were collateralized by all of the assets of the Company. Interest was payable
monthly in arrears. The Revolver facility was not used and expired on June 30,
1998.

In September 1996, the Company also entered into an equipment financing
agreement (the "Equipment Line") with a bank to provide financing of up to
$1,500,000 for the purchase of certain equipment as defined in the Equipment
Line. Borrowings under the Equipment Line take a form of a term loan, the terms
of which are shown above. There were no borrowings outstanding under the
Equipment Line at December 31, 1999.

Both of these agreements required the Company to comply with certain
financial covenants and were secured by all of the assets of the Company. The
bank notified the Company in November 1998 that the Company was in default under
its line of credit facility and equipment financing agreement and required that
the Company provide cash collateral for the amount of equipment financing
outstanding, as well as a $300,000 standby letter of credit issued by the bank
on the Company's behalf. Accordingly, all borrowings outstanding at December 31,
1998 were classified as non-current. In addition, no amounts were available
under this arrangement at December 31, 1998 and the bank has indicated that it
will not renew or further extend the Company's revolving credit facility.

At December 31, 1998, $269,000 and $300,000 of cash was pledged as
collateral for all amounts outstanding under the equipment financing agreement
and the standby letter of credit, respectively. Accordingly, these amounts have
been classified as restricted cash on the accompanying consolidated balance
sheet.

Subsequent to December 31, 1998, amounts outstanding on the equipment
financing agreement were paid in full and the standby letter of credit was drawn
down by the lessor of a non-cancelable operating lease. The Company concluded an
accounts receivable purchase agreement with a lender to permit borrowing against
certain acceptable receivables at a rate of 80% of the face amount of such
receivables up to a maximum of $4 million. In exchange for such agreement, the
Company granted the lender a security interest in substantially all of its
assets. There can be no assurance that the Company will be able to successfully
borrow against such agreement, negotiate other borrowing arrangements or raise
additional funds through bank borrowings and/or debt and/or equity financings.

12. RELATED PARTY TRANSACTIONS

For the year ended December 31, 1997, the Company recorded revenue of
$3,319,000 related to outsourcing and license agreements with a significant
shareholder, Bull HN Information Systems Inc. ("Bull"). At December 31, 1997,
$289,000 was included in accounts receivable from related parties with respect
to this stockholder and $233,000 was included in costs and estimated earnings
in excess of billings on uncompleted contracts with related parties. During
1998, Bull sold substantially all of its remaining interest in the Company.

For the year ended December 31, 1998, the Company recorded revenue of
$204,000 and $255,000, respectively, related to software services and licensing
agreements with Great American Insurance Company ("GAI"), an affiliated company
of a significant shareholder, APU (Note 3). At December 31, 1998, $42,000 was
included in accounts receivable from related parties with respect to this
customer.

For the years ended December 31, 1998 and 1997, Persist recorded revenue
of $872,000 and $1,183,000, respectively, related to outsourcing services to a
corporation owning a majority of and 27% of the outstanding stock of Persist at
December 31, 1998 and 1997, respectively (Note 7).

For the year ended December 31, 1997, the Company recorded revenue of
$2,640,000 related to software services and licensing to a customer. An employee
and officer of the Company, hired in September 1996, was previously employed by
the customer as an employee and officer until August 1996.

For the year ended December 31, 1997, the Company recorded license and
other services revenue of $2,828,000 from a customer. An employee and officer of
the Company, hired in December 1996, was previously employed by the customer as
an employee and officer until December 1996.

13. INCOME TAXES

The components of loss before income taxes are as follows:

Year Ended December 31,
--------------------------------------------
1999 1998 1997
------------ ------------ ------------

Domestic .................................................... $ (2,222,000) $(26,393,000) $(67,323,000)
Foreign ..................................................... (359,000) (255,000) 97,000
------------ ------------ ------------
$ (2,581,000) $(26,648,000) $(67,226,000)
============ ============ ============

The provision (benefit) for income taxes consists of the following:

Year Ended December 31,
--------------------------------------------
1999 1998 1997
------------ ------------ ------------

Current:
Federal ............................................... $ $ $ 150,000
State ................................................. 53,000
Foreign ............................................... 2,000 25,000 57,000
------------ ------------ ------------
2,000 25,000 260,000
------------ ------------ ------------
Deferred:
Federal ............................................... (513,000) (9,546,000) (18,538,000)
State ................................................. 37,000 (1,902,000) (3,356,000)
------------ ------------ ------------
(476,000) (11,448,000) (21,894,000)
Change in deferred tax asset valuation
allowance ................................................ 476,000 11,448,000 21,894,000
------------ ------------ ------------

$ 2,000 $ 25,000 $ 260,000
============ ============ ============

No current federal or state income taxes were payable in the years ended
December 31, 1999, 1998 or 1997 as a result of taxable losses incurred.

The components of deferred tax assets and liabilities follow:

December 31,
-------------------------------
1999 1998
------------ ------------

Deferred tax assets:
Intangible asset amortization.................................... $ -- $ 23,347,000
Net operating loss carryforwards................................. 33,703,000 8,517,000
Tax credit carryforwards......................................... 778,000 1,301,000
Nondeductible accrued expenses and reserves...................... 525,000 2,057,000
Other deferred tax assets........................................ 1,106,000 676,000
------------ ------------
Gross deferred tax assets.............................................. 36,112,000 35,898,000
------------ ------------
Deferred tax liabilities:

December 31,
-------------------------------
1999 1998
------------ ------------

Estimated costs and earnings in excess of billings on
uncompleted contracts.......................................... (116,000) (342,000)

Other deferred tax liabilities................................... -- (36,000)
------------ ------------
Gross deferred tax liabilities................................... (116,000) (378,000)
------------ ------------
Net deferred tax (liabilities) assets.................................. 35,996,000 35,520,000
Deferred tax asset valuation allowance................................. (35,996,000) (35,520,000)
------------ ------------
$ -- $ --
============ ============

At December 31, 1999 and 1998, the Company has provided a valuation
allowance for the full amount of its net deferred tax assets since, based on the
weight of available evidence, management has concluded that it is more likely
than not (defined as a likelihood of slightly more than 50%) that these future
benefits will not be realized. If the Company achieves profitability, these net
deferred tax assets may be available to offset future income tax liabilities and
expense.

A reconciliation between the amount of reported income tax provision
(benefit) and the amount determined by applying the U.S. federal statutory rate
to the loss before income taxes and minority interest in majority-owned
subsidiary follows:

Year Ended December 31,
-----------------------------------------
1999 1998 1997
--------- ------------ ------------

Loss at statutory rate ................. $(903,000) $ (9,327,000) $(23,529,000)
Tax credit carryforwards ............... -- (655,000) (237,000)
Permanent differences and other, net ... 571,500 191,000 5,355,000
State tax benefit, net of federal effect (142,500) (1,632,000) (3,223,000)
Change in deferred tax asset valuation
Allowance ........................... 476,000 11,448,000 21,894,000
--------- ------------ ------------
$ 2,000 $ 25,000 $ 260,000
========= ============ ============

At December 31, 1999, the Company had available net operating loss
carryforwards of approximately $81.7 million and $82.6 million for federal and
state income tax reporting purposes, respectively. At December 31, 1999, the
Company had research and development credit carryforwards of $543,000 and
$235,000 available to offset future federal and state income tax, respectively.
These carryforwards and credits will expire at various times during the period
2001 through 2019 if not utilized.

In accordance with certain provisions of the Internal Revenue Code, a
change in ownership of greater than 50% within a three-year period places an
annual limitation on the Company's ability to utilize its existing net operating
loss and research and development tax credit carryforwards. As a result of the
$4 million investment by Rocket Software, Inc. on March 27, 2000, the limitation
was triggered.

14. COMMON STOCK

On July 8, 1997, the Company closed its initial public offering of
4,025,000 shares of common stock, 2,800,000 of which were sold by the Company
and the balance by selling stockholders, at a public offering price of $16 per
share. The proceeds to the Company from the offering, net of offering expenses,
were approximately $40,664,000.

In connection with closing the initial public offering, the Company
amended its Articles of Organization to authorize 50,000,000 shares of Common
Stock, $0.01 par value. Concurrently, all outstanding shares of Series A and B
preferred stock and Class B common stock automatically converted into an
aggregate of 3,822,903 shares of common stock, the Class A common stock was
redesignated as common stock, and the redeemable common stock

right automatically terminated.

15. STOCK PLANS

1992 Long-Term Incentive Plan and 1997 Stock Incentive Plan

In January 1992, the Board of Directors established the Long-Term
Incentive Plan (the "1992 Incentive Plan"). In May 1997, the Board of Directors
established the 1997 Stock Incentive Plan (the "1997 Incentive Plan") which
replaced the 1992 Incentive Plan. The 1992 Incentive Plan and the 1997 Incentive
Plan allow for the grant of awards in the form of incentive and nonqualified
stock options, restricted stock awards and other stock-based awards, including
the grant of shares based upon certain conditions, the grant of securities
convertible into common stock and the grant of stock appreciation rights
(collectively, the "Awards") to officers, employees, directors, consultants and
advisors of the Company. At December 31, 1999, 3,950,000 shares of common stock
were authorized under the 1997 Incentive Plan, and no further grants may be made
under the 1992 Incentive Plan. Incentive stock options are granted at an
exercise price equal to the fair market value of the Company's common stock at
the grant date (or no less than 110% of the fair market value in the case of
optionees holding more than 10% of the voting stock of the Company) and expire
10 years from the date of grant or upon termination of employment. Non-qualified
stock options are granted at an exercise price determined by the Board of
Directors and expire 10 years from the date of grant. Both the incentive and
non-qualified stock options are exercisable at various dates as determined by
the Board of Directors. Through December 31, 1999, no awards other than
incentive stock options and non-qualified stock options were issued under the
1992 Incentive and 1997 Incentive Plans.

1997 Director Stock Option Plan

The Company's 1997 Director Stock Option Plan (the "Director Plan") was
adopted by the Board of Directors and approved by the stockholders of the
Company in May 1997. Under the terms of the Director Plan, directors of the
Company who are not employees of the Company or any subsidiary of the Company
are eligible to receive nonstatutory options to purchase shares of Common Stock.
A total of 200,000 shares of Common Stock were initially available for issuance
upon exercise of options granted under the Director Plan. On March 24, 2000, the
Board of Directors amended the Director Plan to increase the number of shares
available for issuance thereunder to 600,000. The Director Plan was also amended
to provide (i) that commencing in 2001, options to purchase 25,000 shares on the
last trading day in April will be granted to each director serving on the Board
of Directors on such date who has been a director for the preceding year, (ii)
for an initial grant of options to purchase 25,000 shares to each new non-
employee director elected after April 1, 2000, and (iii) for a grant of options
to purchase 50,000 shares on first trading day in April 2000 for each director
serving on the Board of Directors on such date who has served as a director
since January 1, 2000.

Summary of Activity Under Stock Option Plans

At December 31, 1999, there were 1,633,680 options available for future
grant under the 1997 Incentive Plan and the Director Plan.

The following table summarizes stock option activity during the years
ended December 31, 1999, 1998 and 1997:

Year Ended December 31,
-------------------------------------------------------------------------------------
1999 1998 1997
------------------------ ------------------------ -------------------------
Weighted Weighted Weighted
-------- -------- --------
Average Average Average
-------- -------- --------
Exercise Exercise Exercise
-------- -------- --------
Shares Price Shares Price Shares Price
----------- -------- ----------- -------- --------- --------

Outstanding at beginning of year......... 4,331,572 $ 4.0008 4,160,967 $ 5.9797 2,944,930 $ 1.8814

Granted.................................. 1,823,500 0.2026 3,166,340 3.9877 1,513,350 12.9703
Exercised................................ (1,000) 0.0004 (883,185) 1.1507 (217,783) 0.3360
Forfeited................................ (3,312,236) 4.2350 (2,112,550) 9.0704 (79,530) 2.7027
----------- ---------- ---------
Outstanding at end of year............... 2,841,836 1.2921 4,331,572 4.0008 4,160,967 5.9797
=========== ========== =========
Options exercisable at end of year....... 1,475,706 1.4128 1,254,326 2.7785 1,454,261 1.3299
----------- ========== =========

The following summarizes information regarding stock options outstanding
and exercisable at December 31, 1999:

Options Outstanding Options Exercisable
-------------------------------------- --------------------------
Weighted
--------
Average Weighted Weighted
------- -------- --------
Remaining Average Average
--------- ------- -------
Number Contractual Exercise Number Exercise
----------- ------------- -------- ----------- --------
Range of Exercise Prices Outstanding Life (years) Price Outstanding Price
- ------------------------ ----------- ------------- -------- ----------- --------

$ 0.010--$ 0.100.............................. 154,375 3.2 $ 0.10 154,375 $ 0.10
$ 0.101--$ 0.250.............................. 1,696,000 9.4 $ 0.20 566,985 $ 0.20
$ 0.251--$ 1.000.............................. 508,125 7.9 $ 0.87 508,125 $ 0.87
$ 1.001--$ 2.000.............................. 17,000 5.1 $ 1.60 17,000 $ 1.60
$ 2.001--$ 5.000.............................. 292,116 7.7 $ 3.00 143,541 $ 2.88
$ 5.001--$10.000.............................. 98,720 7.4 $ 7.95 37,930 $ 8.66
$10.001--$15.000.............................. 20,000 7.5 $ 13.00 10,000 $ 13.00
$15.001--$20.000.............................. 55,500 5.6 $ 16.59 37,750 $ 16.22
--------- --- ------- --------- -------
2,841,836 8.5 $ 1.29 1,475,706 $ 1.41
========= =========

No compensation expense was recorded under APB No. 25 during the years
ended December 31, 1999, 1998 and 1997. Had compensation cost been determined
based upon the fair value of options at their grant dates as prescribed in SFAS
No. 123, the Company's net loss and basic and diluted net loss per share would
have been as follows:

Year Ended December 31,
-------------------------------------------------
1999 1998 1997
----------- ------------ ------------

Net loss:
As reported............................. $(2,583,000) $(26,673,000) $(67,490,000)
Pro forma............................... $(7,671,000) (36,204,000) (69,668,000)
Basic and diluted net loss per share:
As reported............................. $ (0.15) $ (1.65) $ (7.03)
Pro forma............................... $ (0.46) (2.24) (7.25)

Because the determination of the fair value of all options granted after
May 14, 1997, the date the Company filed its initial registration statement on
Form S-1 in connection with its initial public offering of common stock,
includes an expected volatility factor, additional option grants could be made
subsequent to December 31, 1999 and options vest over several years, the above
pro forma effects may not be indicative of pro forma effects in future years.

The fair value of options at the date of grant was estimated using the
Black-Scholes option pricing model with the following weighted average
assumptions:

Year Ended December 31,
--------------------------------
1999 1998 1997
-------- -------- --------

Expected life (years) ....................................... 2 5 5
Risk-free interest rate ..................................... 5.43% 5.02% 6.05%
Dividend yield .............................................. 0% 0% 0%
Fair value of option grants--exercise price equal to the fair
value of the related stock ............................... $ 0.17 $ 2.90 $ 7.79

The Company assumed an expected volatility factor of 198% and 90% for all
option grants made during 1999 and 1998, respectively. On May 14, 1997, the
Company filed its initial registration statement on Form S-1. Accordingly, the
Company assumed an expected volatility factor of 70% for all option grants made
from this date through December 31, 1997.

1997 Employee Stock Purchase Plan

In May 1997, the Board of Directors adopted the 1997 Employee Stock
Purchase Plan (the "Purchase Plan"). As amended, the Purchase Plan provides for
the issuance of up to 300,000 shares of the Company's common stock to
participating employees. All employees of the Company whose customary employment
is more than 20 hours per week and who own no more than 5% of the total combined
voting power or value of the stock of the Company are eligible to participate in
the Purchase Plan. Under the terms of the Purchase Plan, the option price is an
amount equal to 85% of the average market price per share of the common stock on
either the first day or the last day of the offering period, whichever is lower.
As amended, the Purchase Plan provides for four consecutive six-month offering
periods beginning with the six-month period extending from October 1, 1997
through March 31, 1998. A total of 50,000 and 50,000 shares were sold on April
1, 1998 and October 1, 1998, respectively, under the Purchase Plan. No awards
were made under the Purchase Plan in 1997. The Board of Directors terminated the
Purchase Plan on April 1, 1999.

16. DEFINED CONTRIBUTION PLAN

The Company maintains a defined contribution plan under Section 401(k) of
the Internal Revenue Code covering substantially all employees. Under the plan,
employees may contribute the lower of up to 20% of their salaries or a dollar
amount prescribed by the Internal Revenue Code. The Board of Directors may elect
to make a discretionary contribution to the plan. For the years ended December
31, 1999, 1998 and 1997, the Company contributed $89,000, $251,000 and $213,000
respectively, to the Plan.

17. SEGMENT, GEOGRAPHIC, AND PRODUCT INFORMATION

The Company operates in one reportable segment due to its centralized
structure and single industry segment: software maintenance, tools and services.
The Company currently derives its revenue from software maintenance outsourcing
services, software and methodology licensing and other services (including
direct delivery of year 2000 renovation services and renovation quality
evaluation ("RQE")) sold directly to end users or indirectly via value added
integrators. Information by geographic area at December 31, 1999, 1998 and 1997
and for the years then ended, is summarized below (in thousands):

Long-
-----
Lived
-----
Outsourcing Services License Revenue Other Services Revenue Assets
-------------------- --------------- ---------------------- ------
Unaffiliated Affiliated Unaffiliated Affiliated Unaffiliated Affiliated
------------ ---------- ------------ ---------- ------------ ----------

1999
United States ... $5,923 $ -- $ 2,087 $ -- $ 3,188 $ -- $ 668
Foreign ......... -- -- -- -- -- -- 34
------ ------- ------- ------- ------- ------ ------
$5,923 $ -- $ 2,087 $ -- $ 3,188 $ -- $ 702
====== ======= ======= ======= ======= ====== ======
1998
United States ... $8,802 $ -- $ 9,189 $ 255 $11,850 $ 204 $4,027
Foreign ......... 251 872 -- -- 109 -- 211
------ ------- ------- ------- ------- ------ ------
$9,053 $ 872 $ 9,189 $ 255 $11,959 $ 204 $4,238
====== ======= ======= ======= ======= ====== ======
1997
United States ... $6,644 $ 3,295 $21,149 $ -- $ 6,773 $ -- $9,468
Foreign ......... 325 1,183 106 -- 234 -- 118
------ ------- ------- ------- ------- ------ ------
$6,969 $ 4,478 $21,255 $ -- $ 7,007 $ -- $9,586
====== ======= ======= ======= ======= ====== ======

The geographic classification of revenue is determined based on the
country in which the legal entity providing the services is located. Revenue
from no single foreign country was greater than 10% of the consolidated revenues
of the Company in 1999, 1998 or 1997.

Significant Customers

For the year ended December 31, 1999, Bull and Compaq represented 22% and
12%, respectively, of the Company's total revenue. Revenue from two customers,
AT&T and Bull, accounted for 12% and 10%, respectively, of the Company's total
revenue for the year ended December 31, 1998. For the year ended December 31,
1997, no single customer accounted for more than 10% of the Company's total
revenue. At December 31, 1999, the Company had accounts receivable from Bull of
$236,000 for billed accounts receivable, $59,000 for costs and estimated
earnings in excess of billings on uncompleted contracts and $116,000 for
unbilled revenue. At December 31, 1999, the Company had no amounts receivable
from Compaq. At December 31, 1998, the Company had amounts receivable from Bull
of $164,000 for billed accounts receivable, $114,000 for costs and estimated
earnings in excess of billings on uncompleted contracts and $77,000 for unbilled
revenue.

18. COMMITMENTS

The Company leases its operating facilities and certain equipment under
non-cancelable operating and capital lease agreements. Rent expense for the
years ended December 31, 1999, 1998 and 1997 was $850,000, $2,244,000 and
$1,101,000, respectively. Future minimum lease payments under non-cancelable
leases as of December 31, 1999 are as follows:

Operating Capital
--------- -------
Year Ending December 31,: Leases Leases
------------------------- ------- ---------
2000 ...................................... 270,000 13,000
2001 ...................................... 270,000 13,000
2002 ...................................... -- 12,000
2003 ...................................... -- --
Thereafter ................................ -- --
------- ---------
540,000 38,000
Less--Amount representing interest ........ -- 1,000
------- ---------
Present value of minimum lease payments ... 540,000 37,000
======= =========

19. LEGAL PROCEEDINGS

On or about June 1, 1998, all of the named plaintiffs and additional
purported class members filed a motion for

the appointment of several of those individuals as lead plaintiffs, for
approval of lead and liaison plaintiffs' counsel and for consolidation of the
actions. The Court granted the motion on June 18, 1998.

In addition to the matters noted above, the Company is from time to time
subject to legal proceedings and claims which arise in the normal course of its
business. In the opinion of management, the amount of ultimate liability with
respect to these other actions, currently known, will not have a material
adverse effect on the Company's financial position or results of operations.

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

None.

PART III.

Item 10. Directors and Executive Officers of the Registrant

Directors and Executive Officers

For each member of the Board of Directors and each person serving as an
executive officer of the Company, there follows information given by each
concerning his principal occupation and business experience for the past five
years, the names of other publicly held companies of which such person serves as
a director and such person's age and length of service as a director of the
Company.

Dominic K. Chan, age 51, has served on the Board of Directors since July
1999. Dr. Chan also has served as a Director of the Company since its inception
until April 1999 and as Chairman of the Board from December 1996 to April 1999.
From November 1998 to April 1999, Dr. Chan served as the Company's President and
Chief Executive Officer. From October 1997 to November 1998, he served as the
Company's Chief Technology Officer. From December 1996 to October 1997, Dr. Chan
served as the Company's Chief Executive Officer. He co-founded the Company in
1991 and served as its President from inception until December 1996. Prior to
co-founding the Company, Dr. Chan held the position of Executive Vice President
of Research and Development for Bull HN Information Systems Inc., a manufacturer
of computer products.

Axel Leblois, age 51, has served on the Board of Directors of the Company
since February 1995. Since July 1997, he has served as President and Chief
Executive Officer of ExecuTrain Corp., a computer training company, and since
January 1996, Mr. Leblois has served as the Chairman of World Times Inc., a
publishing company. From May 1991 to December 1995, he served as President and
Chief Executive Officer of Bull HN Information Systems Inc. Mr. Leblois is a
director of IDG Books, Inc., an online book publisher. Mr. Leblois is a member
of the Audit Committee and Compensation Committee of the Board of Directors of
the Company.

Roland D. Pampel, age 65, has served on the Board of Directors of the
Company since November 1995. Mr. Pampel is retired. From March 1994 to January
1997, Mr. Pampel held the positions of President, Chief Executive Officer and
director of Microcom, Inc. ( "Microcom "), a manufacturer of computer equipment.
From October 1991 to September 1993, prior to joining Microcom, Mr. Pampel was
President and Chief Executive Officer of Nicolet Instrument Inc., a manufacturer
of medical instruments. He currently serves on the Board of Directors of
Infinium Software, Inc., a provider of client-server business software
applications. Mr. Pampel is a member of the Audit Committee and Compensation
Committee of the Board of Directors of the Company.

Andrea C. Campbell, age 48, co-founded the Company and since May 1999 has
served as its Vice President, Sales and Marketing. From June 1998 to May 1999,
she has served as its Vice President, Outsourcing Research and Development. She
served as the Company's Vice President, Outsourcing Operations from June 1996 to
June 1998 and as Vice President, Consulting and Technology Transfer Services
from September 1992 to June 1996. Ms. Campbell was previously employed as Human
Resources Director at Bull HN Information Systems Inc., a manufacturer of
computer products, from March 1990 to August 1992.

Eugene J. DiDonato, age 43, joined the Company in June 1997 and since
July 1997 has served as Vice President and General Counsel. Prior to joining the
Company, Mr. DiDonato was Vice President and General Counsel of Cayenne
Software, Inc. ("Cayenne") from November 1993 to June 1997, and General Counsel
of Cayenne from August 1993 to November 1993. Mr. DiDonato was employed as a
securities lawyer at Foley, Hoag & Eliot, a law firm in Boston, Massachusetts
from April 1986 to July 1993.

Ronald C. Garabedian, age 48, joined the Company in February 1999 and
has served as its Treasurer since April 1999. From 1995 to 1998, Mr. Garabedian
was the Treasurer and Controller of Japonica Partners, a private investment
company. From 1980 to 1994, he held various positions at Bull HN Information
Systems Inc., a manufacturer of computer products, where he most recently
served as Controller of Public Sector Operations.

John D. Giordano, age 43, has served as the Company's President and
Chief Executive Officer since April 1999. He joined the Company in September
1998 as Vice President, Finance and Chief Financial Officer and still holds
those offices. From March 1997 to December 1997, Mr. Giordano served on the
Board of Directors of the Company. Prior to joining the Company and since 1978,
Mr. Giordano held various positions at Bull HN Information Systems Inc., a
manufacturer of computer products, where he most recently served as Vice
President, Chief Financial Officer and Treasurer.

Patrick J. Manning, age 56, joined the Company in September 1999 and has
served as its Controller since March 2000. From 1996 to 1999, Mr. Manning was
the Corporate Controller of KAO Infosystems Company, a software manufacturing
and services company. From 1990 to 1995, he served as a Group Controller for
certain North American operations for Logica, a United Kingdom based software
company.

For Johan Magnussen and Andrew Youniss, there follows information given by
each concerning his principal occupation and business experience for the past
five years, the names of any publicly held companies of which such person serves
as a director and such person's age. It is expected that Messrs. Magnussen and
Youniss will join the Board of Directors of the Company pursuant to the terms of
Common Stock Purchase Agreement dated March 27, 2000.

Johan Magnussen, age 41, is the Chief Operating Officer and a member of
the Board of Directors of Rocket Software, Inc. ("Rocket"), a privately held
software company, and has served in those capacities since 1990. Mr. Magnusson
is also a general partner of The Fallen Angel Equity Fund, a hedge fund
specializing in public software company turnaround situations.

Andrew Youniss, age 38, is the President and Chief Executive Officer and a
member of the Board of Directors of Rocket and has served in that capacity since
1990. He is also a member of the Board of Directors of Rocket and prior to
founding Rocket, he was the Development Manager for DB View, Inc., a software
company specializing in DB2 database utilities.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"), requires the Company's directors, executive officers and
holders of more than 10% of the Company's Common Stock ("Reporting Persons") to
file with the Securities and Exchange Commission initial reports of ownership
and reports of changes in ownership of Common Stock and other equity securities
of the Company. Based solely on its review of copies of reports filed by
Reporting Persons with the Securities and Exchange Commission or written
representations from certain Reporting Persons that no Form 5 filing was
required for such person, the Company believes that, during 1999 all filings
required to be made by its Reporting Persons were timely made in accordance with
the requirements of the Exchange Act.

Item 11. Executive Compensation

Director Compensation

All directors are reimbursed for expenses incurred in connection with
their attendance at Board of Directors and committee meetings.

nonstatutory options to purchase shares of Common Stock. A total of 200,000
shares of Common Stock were initially available for issuance upon exercise of
options granted under the Director Plan. On March 24, 2000, the Board of
Directors amended the Director Plan to increase the number of shares available
for issuance thereunder to 600,000. The Director Plan was also amended to
provide (i) that commencing in 2001, options to purchase 25,000 shares on the
last trading day in April will be granted to each director serving on the Board
of Directors on such date who has been a director for the preceding year,
(ii) for an initial grant of options to purchase 25,000 shares to each new non-
employee director elected after April 1, 2000, and (iii) for a grant of options
to purchase 50,000 shares on first trading day in April 2000 for each director
serving on the Board of Directors on such date who has served as a director
since January 1, 2000.

On July 2, 1997, each of Messrs. Leblois and Pampel received an option to
purchase 15,000 shares of the Company's Common Stock at an exercise price of
$16.00 per share. On June 10, 1998, each of Messrs. Leblois and Pampel received
an option to purchase 3,000 share of the Company's Common Stock at an exercise
price of $4.19 per share. The exercise price per share of such options will be
the closing price of a share of Common Stock on the date of the grant. On
July 1, 1999, Mr. Chan received an option to purchase 15,000 shares of the
Company's Common Stock at an exercise price of $0.17 per share. All options
granted under the Director Plan vest at a rate of one-third of the shares per
year over a period of three years from the date of grant so long as the optionee
remains a director of the Company.

Executive Compensation

The following table sets forth the total compensation paid or accrued for
the three years ended December 31, 1999 for the two individuals who served as
the Company's Chief Executive Officer during 1999 and the Company's three other
most highly compensated executive officers in 1999 (such Chief Executive
Officers and such other executive officers are hereinafter referred to as the
"Named Executive Officers"):

Summary Compensation Table

Long-term
---------
Compensation
Annual Compensation(1) Awards
---------------------- ------

Securities
----------
Underlying All Other
---------- ---------
Name and Principal Position(2) Year Salary Bonus(3) Options(4) Compensation(5)
------------------------------ ---- ------ --------- ----------- ---------------

Dominic K. Chan (6) ..................... 1999 $ 65,154 -- 15,000 $ 323
Chairman of the Board, President, 1998 277,000 -- -- 1,072
and Chief Executive Officer 1997 241,577 $ 35,000 -- 1,736
John D. Giordano (6) .................... 1999 195,000 250,000 300,000 --
President, Chief Executive Officer 1998 56,250 125,000 220,000 --
and Chief Financial Officer
Eugene J. DiDonato ...................... 1999 160,000 64,000 150,000 1,083
Vice President and General Counsel 1998 156,423 -- 144,000 2,137
1997 75,750 15,000 20,000 --
Andrea C. Campbell ...................... 1999 166,000 -- 150,000 2,423
Vice President, Sales & Marketing 1998 166,500 -- 100,000 4,000
1997 147,676 35,000 50,000 1,841
Ronald C. Garabedian .................... 1999 107,308 27,500 150,000 841
Treasurer and Director of Finance

(1) Excludes perquisites and other personal benefits because the aggregate
amount of such compensation was in all cases less than the lesser of
$50,000 or 10% of the total of annual salary and bonus for the Named
Executive Officer.
(2) Unless otherwise noted, lists principal position with the Company as of
December 31, 1999.
(3) Amounts in this column represent bonuses earned under the Company's
executive compensation, retention or other bonus programs during 1997,
1998 and 1999.
(4) Reflects the grant of options to purchase Common Stock. The Company has
never granted stock appreciation rights.
(5) Consists of the Company's matching contributions to the Company's 401(k)
Plan.
(6) Mr. Chan became the President and Chief Executive Officer on November 5,
1998 and resigned as an officer and Director on April 1,1999. Mr. Chan was
subsequently elected to the Board of Directors on July 1, 1999. Mr.
Giordano was elected President and Chief Executive Officer on April 1,
1999.

The following table sets forth certain information concerning grants of
stock options to each of the Named Executive Officers during the year ended
December 31, 1999:

Option Grants, Exercises and Year-End Values

Option Grants in Last Fiscal Year

Individual Grants
----------------------------------------------------------------------------------------
Potential
Realizable Value
Number of Percent of at Assumed
Securities Total Options Annual Rates of
Underlying Granted to Exercise of Stock Price
Options Employees in Base Price Expiration Appreciation for
Name Granted(1) Fiscal Year Per Share(2) Date Option Term(3)
- ---- ---------- ----------- ------------ ---- --------------

5% 10%
------- ------

Dominic K. Chan........... 15,000 0.82% $0.1719 07/01/09 $ 1,622 $4,110
John D. Giordano.......... 300,000 16.45 0.2031 08/19/09 38,318 97,106
Eugene J. DiDonato...... 150,000 8.22 0.2031 08/19/09 19,159 48,553
Andrea C. Campbell...... 150,000 8.22 0.2031 08/19/09 19,159 48,553
Ronald C. Garabedian.... 150,000 8.22 0.2031 08/19/09 19,159 48,553

(1) With the exception of options granted to Mr. Chan, all options were
granted pursuant to the 1997 Plan and, unless otherwise noted, grant a
right to purchase shares of Common Stock. Mr. Chan's options vest in three
equal annual installments beginning one year after the date of grant. All
other options vest in three equal installments on each of December 31,
1999, March 31, 2000 and June 30, 2000.

(2) Represents the per share fair market value of the Common Stock, as
determined by the Board of Directors, on the date of grant.

(3) Amounts reported in these columns represent amounts that may be realized
upon exercise of the options immediately prior to the expiration of their
term assuming the specified compound rates of appreciation (5% and 10%) on
the market value of the Common Stock on the date of option grant over the
term of the options. These numbers are calculated based on rules
promulgated by the Securities and Exchange Commission and do

not reflect the Company's estimate of future stock price growth. Actual
gains, if any, on stock option exercises and Common Stock holdings are
dependent on the timing of such exercise and the future performance of the
Common Stock. There can be no assurance that the rates of appreciation
assumed in this table can be achieved or that the amounts reflected will
be received by the individuals. No gain to the optionees is possible
without an appreciation in stock price, which will benefit all
stockholders commensurately. A zero percent stock price appreciation will
result in zero gain for the optionee.

The following table sets forth certain information concerning stock
options exercised during 1999 and stock options held by each of the Named
Executive Officers on December 31, 1999:

Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option
Values

Shares Number of Shares
Acquired Underlying Unexercised Value of Unexercised
On Value Options at Fiscal In-the-Money Options
Name Exercise Realized(1) Year-End at Fiscal Year-End(2)
---- ----------- -------- ---------------------
Exercisable/Unexercisable Exercisable/Unexercisable
------------------------- -------------------------

Dominic K. Chan ............. 0 $ 0 0 / 15,000 $0 / $0
John D. Giordano ............ 0 0 230,000 / 290,000 0 / 0
Eugene J. DiDonato .......... 0 0 171,000 / 143,000 0 / 0
Andrea C. Campbell .......... 0 0 349,880 / 129,272 0 / 0
Ronald C. Garabedian ........ 0 0 50,000 / 100,000 0 / 0

(1) Value represents the difference between the exercise price and the fair
market value of the Common Stock on the date of exercise, as determined by
the Board of Directors of the Company.
(2) Value based on the closing sales price per share ($0.0781) of the
Company's Common Stock on December 31, 1999, as reported on the Over the
Counter Bulletin Board, less the exercise price.

Employment Agreements

On March 15, 1996, the Company entered into a Non-Competition Agreement
with Dominic K. Chan (the "Chan Agreement") which terminates on the first
anniversary of the date on which Mr. Chan's employment with the Company
terminates. The Chan Agreement provided for severance payments to Mr. Chan in
quarterly installments over a one-year period following termination, in an
aggregate amount not to exceed the amount paid to Mr. Chan by the Company in
combined salary and bonus for the 12-month period immediately preceding the date
of termination. The Company's obligation to pay such severance was conditional
upon Mr. Chan's continued compliance with the terms of the Chan Agreement. The
Chan Agreement prohibits Mr. Chan, during the term thereof, from engaging in any
business activity that is directly or indirectly competitive in the United
States with any of the products or services being developed or otherwise
provided by the Company at the date of his termination. Mr. Chan terminated his
employment with the Company on April 1, 1999. He was elected as a Director of
the Company on July 1, 1999.

On August 13, 1998, the Company entered into an employment agreement with
John D. Giordano that was subsequently amended on September 9, 1999, October 5,
1998, April 9, 1999 and January 21, 2000 (the "Giordano Employment Agreement").
The term of the Giordano Employment Agreement expires on January 21, 2003 unless
earlier terminated thereunder. The Giordano Employment Agreement (i) is
terminable by either party without cause upon 30 days' prior notice, (ii)
terminates upon a change of control of the Company, (iii) is terminable by
either party pursuant to a breach of the Giordano Employment Agreement by the
other party and failure to remedy the breach by such party upon 30 days' prior
notice, (iv) is terminable immediately by the Company with cause (as defined),
or (v) terminates upon the death or disability of the employee. The employment
agreement provides for an annual base salary of $195,000 as well as bonus
compensation to be determined in accordance with the Company's policies, with a
minimum bonus of $25,000 for 1998. If Mr. Giordano's employment is terminated by
the Company without cause (as defined) or terminates upon a change of control of
the Company, he will be entitled to receive (i)a

severance payment equal to his base compensation for one year, and (ii) benefits
in accordance with the Company's then current policies until the earlier of the
date of one year following the termination date or the date Mr. Giordano
commences employment or consulting with a third party. The Giordano Employment
Agreement also provides for the vesting of all of Mr. Giordano's unvested
options and for the extension of the date to exercise those options for up to
one year after termination of his employment if his employment is terminated by
the Company without cause or terminates upon a change of control of the Company.
The Giordano Employment Agreement contains a non-solicitation covenant and a
non-competition covenant pursuant to which Mr. Giordano, during the term of his
employment, is prohibited from engaging in any business activity that would
compete directly or indirectly with products or services of the kind or type
developed by the Company. The non-competition and non solicitation covenants
extend for a one-year period after termination. The Giordano Employment
Agreement provided for retention payments of $60,000, $40,000, $30,000 and
$30,000 on December 1, 1998, January 1, 1999, February 1, 1999 and March 1,
1999, respectively, together with a payment of $280,000 minus the foregoing
payments, if made, in the event of a change in control of the Company. The
Giordano Employment Agreement provided for the payment of a retention bonus of
$120,000 on September 30,1999. The foregoing retention bonus was in place of the
change in control payment referenced above. The Giordano Employment Agreement
provided for a retention payment of $70,000 on January 1, 2000. The Employment
Agreement also provides for retention payments of $60,000 and $100,000 on April
1, 2000 and July 1, 2000, respectively, which payments are immediately payable
upon the termination of Mr. Giordano's employment by the Company without cause
or the merger, liquidation, consolidation, sale of substantially all of the
assets, bankruptcy, reorganization or receivership of the Company.

Item 12. Security Ownership of Certain Beneficial Owners and Management

Voting Securities and Principal Holders Hereof

The following table sets forth certain information as of March 17, 2000
(unless otherwise specified) with respect to the beneficial ownership of shares
of Common Stock by (i) each person or entity known to the Company to own
beneficially more than 5% of the outstanding shares of Common Stock, (ii) the
directors and director nominees of the Company, (iii) each Named Executive
Officer and (iv) all directors and executive officers of the Company as a group.

Number of Shares Percentage of
of Common Stock Common Stock
Beneficial Owner Beneficially Owned(1) Outstanding(2)
- ---------------- --------------------- --------------

Rocket Software, Inc.(3) 10,000,000 36.7%
One Innovation Drive
Natick, MA 01760
American Premier Underwriters, Inc.(4) 2,367,620 8.7%
One East Fourth Street
Cincinnati, OH 45202
Dominic K. Chan(5) 2,108,363 7.7%
2 Gilboa Lane
Nashua, NH 03060
Andrea C. Campbell(6) 399,880 1.4%
John D. Giordano(7) 330,000 1.2%
Eugene J. DiDonato(8) 223,500 *
Ronald C. Garabedian(9) 100,000 *
Roland D. Pampel(10) 67,000 *

Number of Shares Percentage of
of Common Stock Common Stock
Beneficial Owner Beneficially Owned(1) Outstanding(2)
- ---------------- --------------------- --------------

Axel Leblois(11) 31,500 *
All executive officers and directors, as a group (8
persons) (12) 3,280,243 11.6%

* Less than 1% of outstanding Common Stock.

(1) The number of shares beneficially owned by each stockholder is determined
under rules promulgated by the Securities and Exchange Commission, and the
information is not necessarily indicative of beneficial ownership for any
other purpose. Share ownership is based upon information as of March 17,
2000 provided by EquiServe, the Company's transfer agent. Under such
rules, beneficial ownership includes any shares as to which the individual
has sole or shared voting power or investment power and also any shares
which the individual has the right to acquire within 60 days of March 17,
2000 through the exercise of any stock option, warrant or other right. The
inclusion herein of such shares, however, does not constitute an admission
that the named stockholder is a direct or indirect beneficial owner of
such shares.

(2) Number of shares of Common Stock deemed outstanding represents 17,239,971
shares issued and outstanding as of March 17, 2000, 10,000,000 shares
issued to Rocket Software, Inc. ("Rocket") on March 27, 2000 plus any
shares subject to options held by the referenced beneficial owner(s).

(3) Rocket acquired 10,000,000 shares of Common Stock on March 27, 2000
pursuant to a Common Stock Purchase Agreement dated as of March 27, 2000.
Johan Magnussen, Andrew Youniss and Matthew Kelley beneficially own all of
the outstanding capital stock of Rocket. Through their ownership of common
stock of Rocket and their positions as directors and officers of Rocket,
they may be deemed controlling persons with respect to Rocket.

(4) Includes 2,067,620 shares held by American Premier Underwriters, Inc.
("APU") and 300,000 shares held by American Financial Group ("AFG"). APU
is an indirect wholly-owned subsidiary of AFG. Carl H. Lindner, Carl H.
Lindner III, S. Craig Lindner and Keith E. Lindner (collectively, the
"Lindner Family") beneficially own approximately 32% of the outstanding
common stock of AFG at December 31,1999. Through their ownership of common
stock of AFG and their positions as directors and officers of AFG and APU,
the members of the Lindner Family may be deemed controlling persons with
respect to AFG and APU.

(5) Represents 2,108,363 shares of Common Stock held jointly with his wife,
Marsha C. Chan within 60 days of March 17, 2000.

(6) Includes 399,880 shares of Common Stock subject to outstanding stock
options which are exercisable within 60 days of March 17, 2000.

(7) Includes 330,000 shares of Common Stock subject to outstanding stock
options which are exercisable within 60 days of March 17, 2000.

(8) Includes 223,500 shares of Common Stock subject to outstanding stock
options which are exercisable within 60 days of March 17, 2000.

(9) Includes 100,000 shares of Common Stock subject to outstanding stock
options which are exercisable within 60 days of March 17, 2000.

(10) Includes 48,500 shares of Common Stock subject to outstanding stock
options which are exercisable within 60 days of March 17, 2000. Also
includes 1,200 shares of Common Stock held by four trusts of which Carol
P. Pampel, Mr. Pampel's wife, is sole trustee, as to which shares Mr.
Pampel disclaims beneficial ownership.

(11) Includes 23,500 shares of Common Stock subject to outstanding stock
options which are exercisable within 60 days of March 17, 2000.

(12) Includes an aggregate of 1,145,380 shares of Common Stock subject to
outstanding options which are exercisable within 60 days of March 17,
2000.

Item 13. Certain Relationships and Related Transactions

Certain Relationships and Related Transactions

On March 27, 2000, Rocket, a privately held company, invested $4 million
in the Company in exchange for 10,000,000 shares of Common Stock of the Company.
The Company granted certain registration rights to Rocket with respect to such
shares. Pursuant to the terms of Common Stock Purchase Agreement dated March 27,
2000, Rocket may nominate two persons to serve on the Company's Board of
Directors and the Company will use its best efforts to elect such nominees and
to fix the number of the members of the Board of Directors at not more than six.

In June 1999, the Company reached a settlement agreement with American
Financial Group, Inc. ("AFG") and its subsidiaries and affiliates including
American Premier Underwriters, Inc. ("APU") for release from its real estate
lease in Cincinnati, Ohio and certain other obligations. Under the settlement,
the Company paid $200,000 in cash and issued 300,000 shares of Common Stock to
AFG in exchange for the release of the Company's real estate lease in
Cincinnati, Ohio and net claims for other services and disputes.

Peter A. Espinosa, the Company's former Vice President of Worldwide Sales,
issued an unsecured promissory note dated May 29,1998 in the amount of $150,000
payable to the Company. The note incurred interest at 6% per annum and was
payable in two equal annual installments of $75,000 together with accrued
interest. Pursuant to a separation agreement and release dated March 30, 1999
between Mr. Espinosa and the Company, Mr. Espinosa's

employment with the Company was terminated and the Company forgave all principal
and interest payments totaling $157,500 due under such note.

For a description of certain employment and other arrangements between the
Company and its executive officers and directors, see "Item 11- Executive
Compensation, Employment Agreements."

The Company has adopted a policy providing that all material transactions
between the Company and its officers, directors and other affiliates must (i) be
approved by a majority of the members of the Company's Board of Directors and by
a majority of the disinterested members of the Company's Board of Directors and
(ii) be on terms no less favorable to the Company than could be obtained from
unaffiliated third parties.

PART IV.

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

(A)(1) Financial Statements

The financial statements filed as part of this report are listed on the
Index to Consolidated Financial Statements on Page 50 and incorporated herein by
reference.

(2) Financial Statement Schedules

Schedule II: Valuation and Qualifying Accounts All other Schedules are
omitted because they are not applicable or the required information is shown in
the consolidated financial statements or notes thereto.

(3) Exhibits

Documents listed immediately following the signature page to this Annual
Report on Form 10-K, except for documents identified by footnotes, are being
filed as exhibits herewith. Documents identified by footnotes are not being
filed herewith and, pursuant to Rule 12b-32 of the General Rules and Regulations
promulgated by the Commission under the Securities Exchange Act of 1934 (the
"Act") reference is made to such documents as previously filed as exhibits filed
with the Commission. The Company's file number under the Act is 000-22647.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

PERITUS SOFTWARE SERVICES, INC.

By: /s/ JOHN GIORDANO
-------------------------------------
John Giordano
President, Chief Executive Officer and
Chief Financial Officer (Principal
Executive Officer)

March 30, 2000
(Date)

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

By: /s/ JOHN GIORDANO
-------------------------------------
John Giordano
President, Chief Executive Officer and
Chief Financial Officer (Principal
Financial Officer)

March 30, 2000
(Date)

By: /s/ PATRICK MANNING
-------------------------------------
Patrick Manning,
Corporate Controller, (Principal
Accounting Officer)

March 30, 2000
(Date)

By: /s/ AXEL LEBLOIS
-------------------------------------
Axel Leblois,
Director

March 30, 2000
(Date)

By: /s/ ROLAND PAMPEL
-------------------------------------
Roland Pampel,
Director

March 30, 2000
(Date)

By: /s/ DOMINIC K. CHAN
-------------------------------------
Dominic K.Chan,
Director

March 30, 2000
(Date)

SCHEDULE II

PERITUS SOFTWARE SERVICES, INC.

VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)

Balance Charged to Charged Balance
Beginning Costs and to Other End of
For The Year Ended Classification of Year Expenses Accounts Deductions Year
- ------------------ ---------------- ------- -------- -------- ---------- --------

December 31, 1997...... Allowance for doubtful accounts $ 30 $ 65 $ -- $ -- $ 95
December 31, 1998...... Allowance for doubtful accounts $ 95 $ 1,481 $ (850) $ -- $ 726
December 31, 1999...... Allowance for doubtful accounts $ 726 $ (321) $ (380) $ -- $ 25

December 31, 1997...... Net deferred tax assets valuation allowance $ 2,178 $ -- $ 21,894 $ -- $ 24,072
December 31, 1998...... Net deferred tax assets valuation allowance $ 24,072 $ -- $ 11,448 $ -- $ 35,520
December 31, 1999...... Net deferred tax assets valuation allowance $ 35,520 $ -- $ 476 $ -- $ 35,996

Exhibit
No. Description

3.1(1) Restated Articles of Organization of the Registrant.

3.2(1) Amended and Restated By-Laws of the Registrant.

4(1) Specimen Certificate for shares of Common Stock.

*10.1(1) Long-Term Incentive Plan (1992).

*10.2(1) 1997 Stock Incentive Plan.

*10.3(1) 1997 Director Stock Option Plan.

*10.4(1) 1997 Employee Stock Purchase Plan.

10.5(1) Common Stock Purchase Agreement dated May 29, 1992 between the
Registrant and Bull HN Information Systems, Inc.

10.6(1) Agreement of Amendment dated as of March 15, 1996 between the
Registrant and Bull HN Information Systems, Inc.

10.7(1) Registration Rights Agreement dated as of March 15, 1996, as
amended, among the Registrant and the stockholders listed on
the signature pages thereto.

*10.8(1) Non-Competition Agreement dated as of March 15, 1996 between
the Registrant and Dominic K. Chan.

10.9(1) Master Software Services Agreement dated as of February 3,
1992 between the Registrant and Bull HN Information Systems,
Inc.

10.11(1) License Agreement dated as of July 29, 1996 between the
Registrant and Bull HN Information Inc., as amended.

10.12(1) Master License Agreement dated as of October 21, 1996, as
amended, between the Registrant and Merrill Lynch, Pierce,
Fenner & Smith Incorporated.

10.13(1) License and Alliance Agreement dated as of May 1, 1996, as
amended, between the Registrant and CSC Consulting, Inc., as
amended.

10.14(1) Agreement and Plan of Merger among the Registrant, Vista
Technologies Incorporated and its stockholders, dated January
29, 1996.

10.15(2) Asset Purchase Agreement dated October 22, 1997 by and among
the Registrant and Twoquay, Inc. and Millennium Dynamics, Inc.
("MDI") and American Premier Underwriters ("APU").

10.16(2) Registration Rights Agreement dated December 1, 1997 by and
among the Registrant and APU.

10.17(3) License Agreement dated October 25, 1997 between MDI and
Chiquita Brands International, Inc.

10.18(3) License Agreement dated December 31, 1996 between MDI and
Windsor Group.

10.19(3) License Agreement dated March 17, 1997 between MDI and
Provident Bank.

10.20(3) License Agreement dated November 11, 1997 between MDI and
Great American Insurance Company.

10.21(4) Service Agreement dated as of November 18, 1997 by and between
the Company and Great American Insurance Company.

*10.22(5) Employment Agreement dated August 13, 1998 between the Company
and John Giordano.

10.23(5) Share Purchase Agreement dated July 20, 1998 between the
Company and Persist S.A.

*10.24(6) Addendum to Employment Agreement dated October 5, 1998 between
the Company and John Giordano.

*10.25(6) Letter Agreement dated April 9, 1999 between the Company and
John Giordano.

10.26(7) Settlement Agreement and Release dated July 29, 1999 by and
among the Company, American Financial Group, Inc. ("AFG") and
affiliates of AFG.

10.27(8) Settlement Agreement dated September 15, 1999 by and between
the Company and BCIA New England Holdings LLC.

10.28(8) Agreement for Termination of Lease dated August 12, 1999
between the Company and The Prudential Insurance Company of
America.

*10.29(8) Amended Employment Agreement between the Company and John
Giordano dated as of September 9, 1999.

*10.30(8) Addendum to Employment Agreement between the Company and John
Giordano dated as of September 9, 1999.

10.31(8) Letter Agreement dated September 30, 1999 between the Company
and Siemens Credit Corporation.

10.32(8) Lease dated February 2, 1999, as amended, between the Company
and OTR.

*10.33 Addendum to Employment Agreement between the Company and John
Giordano dated January 21, 2000.

*10.34 Amended Employment Agreement between the Company and John
Giordano dated January 21, 2000.

10.35 Asset Purchase Agreement dated as of January 31,2000, as
amended, by and among Peritus Software Services (India)
Private Limited, LTP (India) Pvt. Ltd. and Lisle Technology
Partners L.L.C.

10.36 Accounts Receivable Purchase Agreement dated as of
November 19, 1999 by and between the Company and Silicon
Valley Bank.

10.37 Intellectual Property Security Agreement dated as of
November 19, 1999 by and between the Company and Silicon
Valley Bank.

10.38 Common Stock Purchase Agreement dated as of March 27, 2000 by
and between the Company and Rocket Software, Inc.

10.39 Registration Rights Agreement dated as of March 27, 2000 by
and between the Company ahd Rocket Software, Inc.

21 Subsidiaries of the Registrant.

23 Consent of PricewaterhouseCoopers LLP.

27 Financial Data Schedule for the year ended December 31, 1999.

- ----------

(1) Incorporated by reference to Registrant's Registration Statement on Form
S-1, Commission file number 333-27087.

(2) Incorporated by reference to Registrant's Current Report on Form 8-K dated
December 16, 1997.

(3) Incorporated by reference to Registrant's Annual Report on Form 10-K dated
March 31, 1998.

(4) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q
dated August 14, 1998.

(5) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q
dated December 14, 1998.

(6) Incorporated by reference to Registrant's Annual Report on Form 10-K dated
April 14, 1999.

(7) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q
dated August 11, 1999.

(8) Incorporated by reference to Registrant's Quarterly Report on Form 10-Q
dated November 12, 1999.

*Management Contract or compensatory plan or arrangement filed in response to
Item 14(a)(3) of the instructions to the Annual Report on Form 10-K.