FORM 10-Q

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Item 1. Financial Statements 

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BORLAND SOFTWARE CORPORATION

Notes to Condensed Consolidated Financial Statements (unaudited)

NOTE 1—BASIS OF PRESENTATION  

           The accompanying Borland Software Corporation, or Borland, condensed consolidated financial statements at September 30, 2003 and December 31, 2002 and for the three and nine months ended September 30, 2003 and 2002 are unaudited and have been prepared in accordance with generally accepted accounting principles for interim financial information and Rule 10-01 of Regulation S-X. Accordingly, they do not include all financial information and disclosures required by generally accepted accounting principles for complete financial statements and certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly Borland’s financial position at September 30, 2003 and December 31, 2002, and its results of operations and cash flows for the three and nine months ended September 30, 2003 and 2002. Certain amounts in the September 30, 2002 and December 31, 2002 information have been reclassified in order to be consistent with current financial statement presentation. The preparation of condensed consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. Actual results could differ from those estimates. The results of operations for interim periods are not necessarily indicative of the results to be expected for any subsequent quarter or for the full year. The condensed consolidated financial statements and notes should be read in conjunction with our audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2002 as filed with the Securities and Exchange Commission, or the SEC, on March 28, 2003.

NOTE 2—STOCK BASED COMPENSATION  

Stock-Based Compensation Plans

           We account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25, and related interpretations. Under APB 25, compensation expense is measured as the excess, if any, of the closing market price of our stock at the date of grant over the exercise price of the option granted. We recognize compensation cost for stock options, if any, ratably over the vesting period. Generally, we grant options with an exercise price equal to the closing market price of our stock on the grant date. We provide additional pro forma disclosures as required under Statement of Financial Accounting Standards, or SFAS, No. 123, “Accounting for Stock-Based Compensation,” or SFAS 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure an amendment of FASB Statement No. 123,” or SFAS 148.

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Pro Forma Net Loss and Net Loss Per Share

           Compensation expense (included in pro forma net income (loss) and net income (loss) per share amounts) is recognized for the fair value of the awards granted under our stock option and stock purchase plans using the Black-Scholes option pricing model. The Black-Scholes model, as well as other currently accepted option valuation models, was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from our stock option and stock purchase plan awards. These models also require highly subjective assumptions including future stock price volatility and expected time until exercise, which greatly affect the calculated fair value on the grant date. The fair value of each stock option award is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

           The weighted average fair value of the stock options granted under our employee stock option plans and the stock awarded under our employee stock purchase plan (as defined by SFAS 123) was $5.76 and $5.19 for the three months ended September 30, 2003 and 2002, respectively, and $7.47 and $7.01 for the nine months ended September 30, 2003 and 2002, respectively.

           Had we recorded compensation expenses based on the estimated fair value at grant date for awards granted under our stock option and stock purchase plans (as defined by SFAS 123), our pro forma net loss and net loss per share for the three and nine months ended September 30, 2003 and 2002 would have been as follows (amounts in thousands, except per share data):

           The pro forma amounts include compensation expenses related to stock option grants and stock purchase rights for the three and nine months ended September 30, 2003 and 2002. In future periods, the pro forma compensation expense may increase as a result of the fair value of stock options and stock purchase rights granted in those future periods.

           We account for stock options issued to non-employees, excluding non-employee directors, under SFAS 123 and Emerging Issues Task Force, or EITF, Issue No. 96-18, “Accounting for Equity Instruments with Variable Terms that are Issued for Consideration Other Than Employee Services under SFAS 123,” or EITF 96-18. We record the expense of such services based upon the estimated fair value of the equity instrument using the Black-Scholes option pricing model. During the three and nine months ended September 30, 2003 and 2002, there was no expense recorded for options issued to non-employees.

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NOTE 3—NET INCOME (LOSS) PER SHARE

           We compute net income (loss) per share in accordance with SFAS No. 128, “Earnings per Share,” or SFAS 128. Under the provisions of SFAS 128, basic net income (loss) per share is computed by dividing the net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common and potentially diluted shares outstanding during the period. Potentially dilutive shares, which consist of incremental shares issuable upon exercise of stock options and warrants, are included in diluted net income per share to the extent such shares are dilutive.

           The following table sets forth the computation of basic and diluted net income (loss) per share for the three and nine months ended September 30, 2003 and 2002 (in thousands, except per share amounts):

           The diluted earnings per share calculation for the three and nine months ended September 30, 2003 and 2002 excludes options to purchase approximately 13.5 million and 6.9 million shares, respectively, because their effect would have been antidilutive.

NOTE 4—ACQUISITIONS

TogetherSoft Corporation

           On January 14, 2003, we completed the acquisition of TogetherSoft Corporation, or TogetherSoft, which was a privately-held corporation. TogetherSoft was a provider of platform-neutral, design-driven development solutions designed to accelerate the software development process. The consideration consisted of approximately $82.5 million in cash, 9,050,000 shares of Borland common stock and the assumption of certain liabilities and obligations of TogetherSoft, including those arising under its stock option plans. The consideration paid was reduced for certain legal expenses paid by TogetherSoft. Approximately $22.8 million of the total consideration is being held in escrow to indemnify us against, and reimburse us for, certain events and cover certain liabilities and transaction costs. Unused funds will be released from escrow at specified times between 2004 and 2007. We recorded $151.3 million in goodwill for the excess of the purchase price over the net assets acquired and $37.2 million for acquired technology.

           Of the purchase price of TogetherSoft, $4.6 million represented acquired in-process research and development, or IPRD, that had not yet reached technological feasibility and has no alternative future use. Accordingly, these amounts were immediately charged to expense upon consummation of the acquisition. Independent third-party sources calculated the value of IPRD by estimating the expected cash flows from the projects once commercially viable, discounting the net cash flows back to their present value and then applying a percentage of completion. In determining the value ultimately assigned to IPRD, we considered the stage of completion, complexity of work to date, difficulty of completing the remaining development, costs already incurred and the expected cost to complete the project. Subsequent to the acquisition of TogetherSoft, there have been no significant developments related to the current status of the IPRD that would result in material changes to the assumptions.

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           During the three and nine months ended September 30, 2003, we recorded approximately $4.1 million and $11.8 million, respectively, in acquisition-related costs associated with the amortization of purchased intangibles from the acquisition of TogetherSoft.

           The following table summarizes the short-term portion of our restructuring activity related to the TogetherSoft acquisition, accounted for according to EITF Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination,” or EITF 95-3, for the nine months ended September 30, 2003 (in thousands):

           Our 2003 restructuring accrual included $3.2 million resulting from headcount reductions of 76 employees, including 71 in sales, general and administrative and five in research and development and $3.1 million resulting from reduction of certain facilities leases. In addition, we recorded a charge of $0.5 million for lease termination costs and other costs related to facilities in France and Germany. Due to the timing of payments under lease agreements, we have recorded a portion of these costs as part of long-term restructuring.

Starbase Corporation

           On October 8, 2002, we signed a merger agreement to purchase all of the outstanding shares of Starbase Corporation, or Starbase, for an aggregate consideration of approximately $24.0 million in cash and $2.0 million in bridge financing that was forgiven upon the consummation of the transaction. We recorded $31.7 million in goodwill for the excess of the purchase price over the net assets acquired and $12.0 million for acquired technology. Starbase is a provider of end-to-end enterprise software lifecycle solutions covering requirements definition and management, code and content development, and change and configuration management.

           Pursuant to the merger agreement, on October 11, 2002, we commenced an all-cash tender offer to acquire all outstanding shares of Starbase at a price of $2.75 per share. In the initial tender offer, which expired on November 22, 2002, we purchased approximately 78.9% of the outstanding shares of Starbase. Upon the completion of the initial tender, we began consolidating the operating results of Starbase. The initial tender offer was followed by the merger on January 7, 2003 of Starbase with Galaxy Acquisition Corp., a wholly-owned subsidiary of Borland formed for the purposed of making the acquisition. In the merger, holders of the remaining outstanding shares of Starbase common stock at the time of the merger received the same $2.75 cash price per share paid in the tender offer. As a result of the merger, Starbase is now a wholly-owned subsidiary of Borland. Accordingly, with the payment to the remaining stockholders, we eliminated the minority interest in the consolidated subsidiary during the three months ended March 31, 2003.

           During the three and nine months ended September 30, 2003, we recorded approximately $1.5 million and $4.6 million, respectively, in acquisition-related costs associated with the amortization of purchased intangibles from the acquisition of Starbase.

           The following table summarizes our restructuring activity related to the Starbase acquisition accounted for according to EITF 95-3 for the nine months ended September 30, 2003 (in thousands):

           Our 2003 restructuring accrual included $0.3 million resulting from headcount reductions.

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           Supplemental pro forma information reflecting the acquisitions of TogetherSoft and Starbase as if they occurred on December 31, 2001 is as follows for the three and nine months ended September 30, 2003 and 2002 (in thousands, unaudited):

           Such information is not necessarily representative of the actual results that would have occurred for those periods.

VMGear

           On January 18, 2002, we completed our acquisition of Redline Software, Inc., or VMGear, which was a provider of performance assurance and testing solutions for Java developers. The transaction was accounted for as a purchase. Total fixed consideration of $2.0 million was paid upon the close of the transaction and acquisition-related costs were $0.2 million. Additional contingent consideration related to the transaction includes retention payments of $6.0 million to be earned through the continued employment of certain individuals and additional earnout payments of up to $10.0 million contingent upon future revenues derived from the sale of VMGear products. Contingent consideration, if any, will be earned and paid over a three-year period. We recorded this earnout as a component of restructuring, amortization of intangibles and acquisition-related expenses based upon our estimate of the total earnout on a straight-line basis. The results of operations for this acquisition were not material to our financial statements and, accordingly, pro forma results have not been presented.

           In accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets,” or SFAS 142, we did not amortize the excess of the purchase price over net assets acquired. The contingent consideration will be expensed when it is deemed probable that such payments will be made. For the three and nine months ended September 30, 2003, we expensed $3.3 million and $7.8 million, respectively, in contingent consideration related to the VMGear acquisition.

NOTE 5—GOODWILL AND INTANGIBLE ASSETS

           The changes in the carrying amount of goodwill for the nine months ended September 30, 2003 are as follows (in thousands):

           We performed a transitional impairment test of our goodwill and intangible assets as of January 1, 2002. At the time of the test, no impairment of our goodwill or intangible assets was noted. We performed our annual assessment of goodwill in September 2003 and concluded that there was no additional impairment. Due to the adoption of SFAS 142 on January 1, 2002, we ceased amortizing goodwill.

           The following tables summarize our intangible assets, net (in thousands):

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           The intangible assets are all amortizable and have original estimated useful lives as follows: acquired technology – 2 to 3 years; maintenance contracts — 1 year; trademarks, trade names and service marks —3 years; other—1 to 3 years. Based on the current amount of intangibles subject to amortization, the estimated amortization expense for the remainder of 2003 and the succeeding four years is as follows: remainder of 2003: $5.9 million; 2004: $14.2 million; 2005: $12.1 million; 2006: $0.1 million; and 2007: $0 million.

NOTE 6—RESTRUCTURING

           Prior to January 1, 2003, we accounted for our restructuring and acquisition-related activity according to EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring),” or EITF 94-3. The following table summarizes our short-term restructuring and acquisition-related activity accounted for according to EITF 94-3 and SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” or SFAS 146, for the nine months ended September 30, 2003 (amounts in thousands):

           Our March 2003 restructuring accrual included $1.0 million resulting from headcount reductions of 28 employees, including 19 in sales and general and administrative and 9 in research and development, and $2.0 million resulting from reduction of certain facilities leases. This amount represents our remaining lease payments less anticipated sublease income plus the write-off of leasehold improvements and is recorded in current liabilities.

           Our September 2003 restructuring accrual included $2.4 million resulting from headcount reductions of 110 employees, including 75 in sales and general and administrative and 35 in research and development, and $1.1 million resulting from reduction of certain facilities leases. This amount represents our remaining lease payments less anticipated sublease income plus the write-off of leasehold improvements and is recorded in current liabilities.

           In addition, we recorded a charge of $2.4 million during the nine months ended September 30, 2003 for a change in estimated lease termination costs related to two facilities in the United Kingdom. Due to the timing of payments under the lease agreements, we have recorded these costs as a part of long-term restructuring. The total long-term lease termination obligation as of September 30, 2003 was $3.9 million.

NOTE 7—LEASES

           We lease certain of our office and operating facilities and certain furniture and equipment under various operating leases. Remaining lease terms range from one to ten years.

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           Minimum annual lease commitments at September 30, 2003 is as follows, amounts in thousands:

           Rent expense for all operating leases were approximately $3.0 million and $2.0 million for the three months ended September 30, 2003 and 2002, respectively, and $9.2 million and $5.7 million for the nine months ended September 30, 2003 and 2002, respectively.

NOTE 8—INCOME TAXES 

           For the three months ended September 30, 2003 and 2002, we recorded an income tax expense of $1.3 million and $1.4 million, respectively. For the nine months ended September 30, 2003 and 2002, we recorded an income tax expense of $4.0 million and $4.0 million, respectively. Our tax provisions for the three-month and nine-month periods ended September 30, 2003 were not based on our expected annual rate, as we incurred non-U.S. withholding taxes in a number of foreign jurisdictions, regardless of our profitability, as well as non-U.S. income taxes for certain profitable foreign operations. As these tax liabilities were incurred in foreign jurisdictions, they were not offset by the benefits of prior U.S. net operating loss and tax credit carryforwards.

NOTE 9—REPURCHASES OF COMMON STOCK

           In September 2001, our Board of Directors authorized repurchases of up to $30.0 million of our outstanding common stock. In August 2003, our Board of Directors authorized an additional repurchase of up to $15.0 million in Borland common stock. As a part of this program, we repurchased 616,305 shares of our common stock for an average price of $9.24 per share for a total consideration of $5.7 million during the three months ended September 30, 2003. We repurchased 1,311,305 shares of our common stock for an average price of $9.53 per share for a total consideration of $12.5 million during the nine months ended September 30, 2003. We repurchased 462,000 shares of our common stock for an average price of $8.45 per share for a total consideration of $3.9 million during the three months ended September 30, 2002. We repurchased 821,700 shares of our common stock for an average price of $8.94 per share for a total consideration of $7.3 million during the nine months ended September 30, 2002. This authorization is still in effect, and $22.0 million remains authorized for future repurchases. We expect to continue to repurchase shares under our repurchase program from time to time depending on market conditions, share price and availability, and other factors at our discretion.

NOTE 10—LITIGATION  

           On November 27, 2002, a stockholder class action and derivative lawsuit, Dieterich v. Harrer, et al., Case No. 02CC00350, was filed against Starbase Corporation and five former directors of Starbase in the Superior Court of the State of California for Orange County, claiming that the former directors had breached fiduciary duties owed to Starbase and stockholders of Starbase. Borland is paying the costs of defending this litigation pursuant to indemnification obligations under the merger agreement relating to the acquisition of Starbase by Borland. Following a series of motions, the case was dismissed without prejudice on August 20, 2003. We previously reported these legal proceedings in our Annual Report on Form 10-K for the fiscal year ended December 31, 2002 and our Quarterly Report on Form 10-Q for the quarterly periods ended March 31 and June 30, 2003. On October 28, 2003, a stockholder class action, Dieterich v. Harrer, et al, Case No. 024-N, was filed against the former directors of Starbase in Chancery Court of the State of Delaware, alleging breach of fiduciary duties by the former directors of Starbase, Borland, Dale L. Fuller, Keith E. Gottfried, Frederick A. Ball, and Doug Barre. The company is currently reviewing the case and intends to defend itself vigorously. There is no indication at present whether the lawsuit will have a material effect on Borland’s financial condition, results of operations or liquidity.

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           In the ordinary course of business, we are involved in other lawsuits, claims, investigations, proceedings, and threats of litigation consisting of intellectual property, commercial, employment and other matters. In accordance with SFAS No. 5, “Accounting for Contingencies,” we make a provision for a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case. Litigation is inherently unpredictable. However, we believe that we have valid defenses with respect to the legal matters pending against us, as well as adequate provisions for any probable and estimable losses. If an unfavorable ruling were to occur in any specific period, there exists the possibility of a material adverse impact on the results of operations for that period. We believe that, given our current liquidity and cash and investment balances, even were we to receive an adverse judgment with respect to litigation that we are currently a party to, it is likely that such a judgment would not have a material impact on our financial condition, results of operations or liquidity.

NOTE 11—LOAN RECEIVABLE WRITE-OFF 

           At December 31, 2002, we had a loan receivable with a book value of $2.2 million related to a loan to AltoWeb, Inc., or AltoWeb, a provider of J2EE applications. In April 2003, AltoWeb informed us that it had ceased substantially all of its operations. We recorded the write-off of this loan receivable of $2.2 million during the three months ended March 31, 2003. Since our investment in AltoWeb was related to AltoWeb’s attempt to extend their product development efforts for the Borland platform, we have included these expenses in research and development. This charge is reflected in the nine-month period ended September 30, 2003.

           In July 2003, we recovered $0.5 million from AppForge, Inc. in consideration for a loan receivable. Due to concerns about collectibility of the loan receivable, we had written off the loan in 2002. We recorded a gain of $0.5 million in interest income, net and other for the three months ended September 30, 2003.

NOTE 12—INDEMNIFICATIONS AND GUARANTEES 

           As permitted under our Restated Certificate of Incorporation, Amended and Restated Bylaws and the Delaware General Corporation Law, we have entered into agreements whereby we indemnify our officers, directors and certain employees for certain events or occurrences while the officer, director or employee is, or was, serving at our request in such capacity.

           We have entered into an agreement for the outsourcing of our order fulfillment. As a component of this agreement, we guarantee that in the event we terminate the fulfillment agreement, we will purchase all inventory held by the vendor at the time of termination. We estimate and accrue reserves for excess inventory held by the fulfillment vendor. As of September 30, 2003, we had inventory in excess of the reserves of approximately $0.5 million, which represents the potential obligation relating to this guarantee.

           From time to time, we engage various professional service firms that require as a condition to their engagement that we undertake to indemnify them for all claims and damages arising out of their engagement. In the recent past, we have not been subject to any significant claims for such losses and have not incurred any material costs in defending or settling claims related to these indemnification obligations. Accordingly, we believe the estimated fair value of these obligations is not material.

           We undertake indemnification obligations in our ordinary course of business in connection with, among other things, the licensing of our products and the provision by us of consulting services. Pursuant to these agreements, we may indemnify the other party for certain losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with various types of claims, which may include, without limitation, claims of intellectual property infringement, certain tax liabilities, negligence and intentional acts in the performance of services and violations of laws. The term of these indemnification obligations is generally perpetual. In general, we attempt to limit the maximum potential amount of future payments we could be required to make under these indemnification obligations to the purchase price paid, but in some cases the obligation may not be so limited. In addition, we may, in certain situations, warrant that, for a certain period of time from the date of delivery, our software products will be free from defects in media or workmanship. From time to time, we may also warrant that our professional services will be performed in a good and workmanlike manner. In addition, it is our standard policy to seek to disclaim most warranties, including any implied or statutory warranties such as warranties of merchantability, fitness for a particular purpose, quality and non-infringement, as well as any liability with respect to incidental, consequential, special, exemplary, punitive or similar damages. In some states, such disclaimers may not be enforceable. If necessary, we would provide for the estimated cost of product and service

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warranties based on specific warranty claims and claim history. In the recent past, we have not been subject to any significant claims for such losses and have not incurred any material costs in defending or settling claims related to these indemnification obligations. Accordingly, we believe the estimated fair value of these agreements is not material.

           During the nine months ended September 30, 2003, we entered into an operating lease for our U.S. regional sales headquarters in Cupertino, California. In the event that we do not exercise our option to extend the term of the lease, we guarantee certain costs to restore the property to certain conditions in place at the time the lease commenced. We are accruing the estimated lease restoration costs over the lease term.

NOTE 13—RECENT ACCOUNTING PRONOUNCEMENTS

           In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” or SFAS 150. SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires an issuer to classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of SFAS 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. We do not expect the adoption of SFAS 150 to have a material impact upon our financial condition, cash flows or results of operations.

           In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” or SFAS 149, which amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” or SFAS 133, for certain decisions made by the FASB Derivatives Implementation Group. In particular, SFAS 149 (1) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, (2) clarifies when a derivative contains a financing component, (3) amends the definition of “an underlying” to conform it to language used in term because it is within the scope of FASB Interpretation, or FIN, No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” or FIN 45, and (4) amends certain other existing pronouncements. SFAS 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. In addition, most provisions of SFAS 149 are to be applied prospectively. We do not expect the adoption of SFAS 149 to have a material impact upon our financial condition, cash flows or results of operations.

           In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities,” or FIN 46. Until this interpretation, a company generally included another entity in its consolidated financial statements only if it controlled the entity through voting interests. FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns. FIN 46 is effective for interests held by public entities in variable interest entities or potential variable interest entities created before February 1, 2003 for financial statement periods ending after December 15, 2003, and otherwise is effective after June 15, 2003. We do not expect the adoption of FIN 46 to have a material impact upon our financial condition, cash flows or results of operations.

           In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables,” or EITF 00-21. EITF 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF 00-21 apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We do not believe the adoption of EITF 00-21 will have a material impact on our financial condition or results of operations.

           In November 2002, the FASB issued FIN 45. FIN 45 elaborates on the existing disclosure requirements for most guarantees, including loan guarantees. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under that guarantee. However, the provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations does not apply to product warranties or to guarantees accounted for as derivatives. The initial recognition and initial measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002.

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

Forward-Looking Statements

           The statements made throughout this Quarterly Report on Form 10-Q that are not historical facts are forward-looking statements and, accordingly, involve estimates, projections, goals, forecasts, assumptions and uncertainties that could cause actual results or outcomes to differ materially from those expressed or implied in the forward-looking statements.

           These forward-looking statements may relate to, without limitation, future capital expenditures, acquisitions, timing of the integration of acquired businesses, the ultimate cost of acquired businesses, revenue “pipeline,” revenues, including revenues from recently acquired businesses, cash flows, earnings, margins, costs, strategy, demand for our products, market and technological trends in the software industry, effective tax rates, interest rates, foreign currency exchange rates and inflation and various economic and business trends. Generally, you can identify forward-looking statements by the use of words such as “expect,” “estimate,” “project,” “budget,” “forecast,” “anticipate,” “goal,” “intend,” “plan,” “may,” “will,” “could,” “should,” “believes,” “predicts,” “potential,” “continue” and similar expressions or the negative or other variations thereof. These forward-looking statements involve substantial risks and uncertainties. Examples of such risks and uncertainties are described under “Factors That May Affect Future Results and Market Price of Stock” and elsewhere in this report, as well as in our other filings with the SEC or in materials incorporated by reference herein or therein. You should be aware that the occurrence of any of these risks and uncertainties may cause our actual results to differ materially from those anticipated in our forward-looking statements and have a material and adverse effect on our business, results of operations and financial condition. New factors may emerge from time to time, and it is not possible for us to predict new factors, nor can we assess the potential effect of any new factors on us.

           These forward-looking statements are found at various places throughout this Form 10-Q. We caution you not to place undue reliance on these forward-looking statements, which, unless otherwise indicated, speak only as of the date they were made. We do not undertake any obligation to update or release publicly any revisions to these forward-looking statements to reflect events or circumstances after the date of this Form 10-Q, except as required by law.

General

           We are a leading provider of software development and deployment solutions. We provide our customers with comprehensive solutions designed to improve software quality, accelerate the delivery of software, lower the cost of ownership and reduce the risk of errors by offering products that address the definition, design, development, testing and deployment phases of the application development lifecycle and products that help customers manage software development projects from beginning to end. We also provide training, consulting and support services through our dedicated professional services organization.

            Recently, we have begun transforming the company from one focused on selling individual development tools to one focused on selling multi-product enterprise solutions that span the full software application development lifecycle. As part of this transformation, we recently acquired two companies and certain other technologies to fill out our product portfolio, and are currently in the process of integrating and bundling our products into solution suites, upgrading our marketing and selling efforts to address enterprise opportunities, and realigning our management and organization to support the strategic direction of the company. In addition, we have also restructured many of our operations and conducted reductions in force in an effort to improve organizational efficiencies, control our expense structure and drive to a more profitable long-term financial model. We expect to continue all of these activities over the next several quarters, and doing so may put pressure on our financial results and operations as we go through this transformation.

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Overview of the Consolidated Statements of Operations

           The following table presents our Consolidated Statements of Operations data and the related percentage of revenues for the three and nine months ended September 30, 2003 and 2002 (in thousands):

Overview of the Results of Operations for the Three and Nine Months ended September 30, 2003

           During the three months and nine months ended September 30, 2003, we continued to focus on transforming our operations to sell our application lifecycle management, or ALM, solutions to enterprise customers, improving our sales execution, and improving our operating model. As a result of these efforts and the addition of Starbase and TogetherSoft to our operations, we achieved the following financial results during the three and nine months ended September 30, 2003:

For the three months ended September 30, 2003, net revenues grew 16% to $70.6 million, including $17.1 million in revenue associated with the operations we assumed in our acquisitions of Starbase and TogetherSoft, from $60.7 million for the three months ended September 30, 2002. For the nine months ended September 30, 2003, net revenues grew 25% to $221.2 million, including $54.3 million in revenues associated with the operations we assumed in our acquisitions of Starbase and TogetherSoft, from $177.5 million for the nine months ended September 30, 2002.

Licenses and other revenues increased 2% to $51.5 million for the three months ended September 30, 2003 from $50.3 million for the three months ended September 30, 2002. Licenses and other revenues increased 11% to $165.0 million for the nine months ended September 30, 2003 from $148.1 million for the nine months ended September 30, 2002.

Service revenues increased 83% from $10.4 to $19.0 million and 91% from $29.5 million to $56.3 million for the three and nine months ended September 30, 2003, respectively, over the same periods in 2002.

Gross margins increased to 85% for the three months ended September 30, 2003 from 84% for the three months ended September 30, 2002. Gross margins increased to 86% for the nine months ended September 30, 2003 from 85% for the nine months ended September 30, 2002.

Operating expenses increased 53% to $71.9 million for the three months ended September 30, 2003 from $46.8 million for the three months ended September 30, 2002. Operating expenses increased 63% to $224.6 million for the nine months ended September 30, 2003 from $137.7 million for the nine months ended September 30, 2002.

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We had a net loss of $12.2 million for the three months ended September 30, 2003, compared to net income of $5.0 million for the three months ended September 30, 2002. We had a net loss of $34.9 million for the nine months ended September 30, 2003, compared to net income of $14.2 million for the nine months ended September 30, 2002.

Expenses from the amortization of intangible assets increased to $5.8 million and $17.0 million for the three and nine months ended September 30, 2003, respectively, from $0.2 million and $0.7 million for the three and nine months ended September 30, 2002, respectively.

Cash, cash equivalents and short-term investments decreased $88.9 million to $207.2 million as of September 30, 2003 from $296.2 million as of December 31, 2002. The decrease is primarily attributable to cash expended in connection with the acquisitions of Starbase and TogetherSoft.

During the three months ended September 30, 2003, we had 87 customers with cumulative sales of $100,000 or more, which was down from 102 such customers during the three months ended June 30, 2003. In addition, 40 of these customers purchased multiple products during the three months ended September 30, 2003.

We repurchased 616,000 shares of our stock under our stock repurchase program for a total cost of $5.6 million during the three months ended September 30, 2003. This brings the total purchased under our stock repurchase program during the nine months ended September 30, 2003 to 1.3 million shares for a total cost of $12.5 million.

           For a more in-depth discussion of our business, including a discussion of our critical accounting policies and estimates, please read our Annual Report on Form 10-K for the year ended December 31, 2002 as filed with the SEC on March 28, 2003.

Net Revenues

           We derive revenue from licenses of our software and the sale of related services, which include assistance in implementation and integration, post-contract customer support, training and consulting.

           We recognize license fees on contracts that do not involve significant implementation or integration essential to functionality of our products upon delivery when there is persuasive evidence of an arrangement, the fee is fixed or determinable and collection of the receivable is probable. We recognized license and service revenues associated with contracts involving significant implementation or integration only as the services are completed, either on a percentage of completion basis or a completed contract basis depending on whether or not we can obtain reliable estimates of the costs to complete the work. For arrangements with multiple elements, we determine the value for the different elements based upon vendor specific objective evidence, or VSOE, and recognize revenue when we have established the VSOE of all undelivered elements and as the elements are delivered. Other service revenues from consulting and training services are recognized as such services are performed. Service revenues from post-contract customer support are recognized ratably over the support period, generally one year.

           We recognize revenues from reseller arrangements upon shipment to the reseller, with allowances for estimated future returns and exchanges provided based upon our return history. We maintain allowances for product returns from customers based upon historical return rates of end user customers, current economic trends, changes in customer demand and acceptance of our products and the type and quantity of inventory held by channel customers. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and rebate reserves in any accounting period. Material differences may have resulted in the amount and timing of our revenues for any period if management made different judgments or utilized different estimates.

           The following table presents our net revenues for the three and nine months ended September 30, 2003 and 2002 (in thousands):

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           Licenses and Other Revenues 

           With the integration of the acquisitions of TogetherSoft and Starbase, we have aligned our presentation of licenses and other revenues to better reflect our ALM strategy. Specifically, we see three major product categories: Design, Develop and Deploy. Design includes the products from our recent acquisitions of TogetherSoft and Starbase: StarTeam, CaliberRM, Together and other related design and management products. Develop includes two major categories: Java, which includes JBuilder, Java Studio and Optimizeit, and .NET, which includes Delphi, C#Builder, C++Builder, Kylix and C++ Mobile Edition. Deploy is comprised of our Borland Enterprise Server products, InterBase, Janeva and other enterprise products.

           Compared to our reporting prior to the second quarter of 2003, Design is a new category, Develop encompasses our former Java and RAD product lines, and Deploy encompasses the products that we previously described as the Enterprise product group. We have sought to provide comparability between historic product groups while updating our nomenclature to reflect new platforms and our emphasis on the application development lifecycle.

           Licenses and other revenues represent amounts for license fees and royalties earned for granting customers the right to use our software products. Licenses and other revenues were $51.5 million and $50.3 million for the three months ended September 30, 2003 and 2002, respectively, and represented 73% and 83% of net revenues for the three months ended September 30, 2003 and 2002, respectively. Licenses and other revenues were $165.0 million and $148.1 million for the nine months ended September 30, 2003 and 2002, respectively, and represented 75% and 83% of net revenues for the nine months ended September 30, 2003 and 2002, respectively.

           The following table presents our licenses and other revenues by product category for the three and nine months ended September 30, 2003 and 2002 (in thousands):

           Design.  Licenses and other revenues from our Design product group for the three and nine months ended September 30, 2003 consisted of approximately $11.4 million and $37.6 million, respectively. There were no licenses and other revenues from our Design product group in the three or nine months ended September 30, 2002, as we completed the acquisitions of TogetherSoft and Starbase and began consolidating their results in January 2003 and December 2002, respectively.

           Develop.  Licenses and other revenues from our Develop product group included licenses and other revenues of $17.0 million and $21.2 million in the three months ended September 30, 2003 and 2002, respectively, from our Java product lines. Licenses and other revenues from our Develop product group included licenses and other revenues of $60.2 million and $68.5 million in the nine months ended September 30, 2003 and 2002, respectively, from our Java product lines. The decrease in licenses and other revenues in our Java product lines during the three and nine months ended September 30, 2003 was due to lower revenues from our JBuilder product line partially offset by growth in our Optimizeit product line. We believe the growth of the market for Java development tools has slowed and consequently our sales of JBuilder have slowed. Additionally, as more of our customers purchase maintenance contracts that provide them with upgrades, and as the product matures, the incentives to upgrade to the next release decrease. Therefore, we believe that the growth in licenses and other revenues from JBuilder will continue to slow. Licenses and other revenues from our Develop products group included licenses and other revenues of $11.1 million and $18.9 million in the three months ended September 30, 2003 and 2002, respectively, from our .NET product lines. This decrease was primarily due to lower licenses and other revenues generated from our RAD products. Licenses and other revenues from our Develop products group included licenses and other revenues of $35.7 million and $46.8 million in the nine months ended September 30, 2003 and 2002, respectively, from our .NET product lines. This decrease during the three and nine months ended September 30, 2003 was primarily attributable to the lack of a major product version release during the nine months ended September 30, 2003 compared to the three and nine months ended September 30, 2002, which included the releases of Delphi 7 in the third quarter of 2002 and C++Builder 6 in the first quarter of 2002.  

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           Deploy.  Licenses and other revenues from our Deploy product group were $11.9 million and $10.2 million in the three months ended September 30, 2003 and 2002, respectively. Licenses and other revenues from our Deploy product group were $31.2 million and $32.8 million in the nine months ended September 30, 2003 and 2002, respectively. The increase for the three months ended September 30, 2003 as compared with September 30, 2002 was due to higher revenue from our VisiBroker and application server products, particularly in our Asia Pacific region. The decrease in licenses and other revenues for the nine months ended September 30, 2003 as compared with the same period in 2002 was due to lower revenues generated from our VisiBroker and application server products, due primarily to a lower volume of sales in the Americas. We believe that this reduction in licenses and other revenues from our Deploy products was a result of general economic weakness and geopolitical uncertainty. Revenue growth from our Deploy products category will depend upon the recovery in corporate spending for deployment solutions, our ability to provide compelling technical solutions for software deployment to differentiate ourselves from our competitors and our ability to integrate our Deploy products with our Design and Develop products.

           Service Revenues  

           Service revenues represent amounts earned for technical support, consulting and training services for our software products. Net service revenues were $19.0 million and $10.4 million for the three months ended September 30, 2003 and 2002, respectively, representing 27% and 17% of net revenues for those periods, respectively. Service revenues increased $8.6 million in the three months ended September 30, 2003 from the three months ended September 30, 2002 primarily as a result of an increase in technical support revenues and, to a lesser extent, an increase in consulting revenue. Technical support revenues were $13.2 million and $6.3 million in the three months ended September 30, 2003 and 2002, respectively, representing 70% and 60% of total service revenues in the three months ended September 30, 2003 and 2002, respectively. The growth in the technical support revenues in the three months ended September 30, 2003 from the three months ended September 30, 2002 was due to the increase in support revenues associated with our assumption of the support obligations from the acquisitions of TogetherSoft and Starbase. Consulting revenues were $4.2 million and $2.8 million in the three months ended September 30, 2003 and 2002, respectively, representing 22% and 27% of total service revenues in the three months ended September 30, 2003 and 2002, respectively. The increase in the consulting revenue for the three months ended September 30, 2003 when compared with the same period in the prior year was due to an increased emphasis on products with a greater process focus (our Design products) and approximately $1.2 million in consulting revenue recognized from large development projects with two technology partners. Based upon our progress to date on these projects, we expect consulting revenues from the development projects to remain consistent in the fourth quarter and decrease to substantially lower levels in following quarters.

           Net service revenues were $56.3 million and $29.5 million for the nine months ended September 30, 2003 and 2002, respectively, representing 25% and 17% of net revenues for those periods, respectively. Service revenues increased $26.8 million in the nine months ended September 30, 2003 from the nine months ended September 30, 2002 primarily as a result of an increase in technical support revenues and, to a lesser extent, an increase in consulting revenues. Technical support revenues were $38.1 million and $18.7 million in the nine months ended September 30, 2003 and 2002, respectively, representing 68% and 64% of total service revenues in the nine months ended September 30, 2003 and 2002, respectively. The growth in the technical support revenues in the nine months ended September 30, 2003 from the nine months ended September 30, 2002 was due to the increase in support revenues associated with our assumption of the support obligations from the acquisitions of TogetherSoft and Starbase. Consulting revenues increased from $6.7 million for the nine months ended September 30, 2002 to $13.3 million for the nine months ended September 30, 2003. The increase in the consulting revenues for the nine months ended September 30, 2003 when compared with the same period in the prior year was due to an increased emphasis on products with a greater process focus (our Design products) and approximately $5.2 million in consulting revenue recognized from large development projects with three technology partners. Over the longer term, we expect growth, if any, in our support revenues and our consulting revenues to depend on our success in selling our solutions into larger enterprises with greater frequency. Our service revenues may also grow as our new enterprise solution offerings increase in complexity and include more services as a component of larger sales contracts. We may experience decreases in our consulting revenue on a quarter-to-quarter basis as we complete large consulting engagements if we are unsuccessful in expanding or finding new engagements.

           International Net Revenues  

           Revenues from sources outside the United States, or non-U.S. revenues, represented approximately 57% and 66% of net revenues for the three months ended September 30, 2003 and 2002, respectively. Non-U.S. revenues

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represented approximately 56% and 64% of net revenues for the nine months ended September 30, 2003 and 2002, respectively. The decrease in the percentage of non-U.S. revenues for the three and nine months ended September 30, 2003, as compared to the same periods in 2002, was principally due to net revenues generated from our newly-acquired Design products in 2003, which generate more sales in the U.S. than internationally. We expect non-U.S. revenues to continue to be a significant portion of our net revenues in future periods, though the U.S. percentage is expected to be higher in 2003 as compared with 2002 due to the acquisitions of Starbase and TogetherSoft, each of which had sales channels with a greater U.S. focus.

           Fluctuations in foreign currency exchange rates did not have a material impact on our net revenues or operating results for the three or nine months period ended September 30, 2003 and 2002. However, our non-U.S. revenues would be harmed if the U.S. dollar were to strengthen against major foreign currencies, including the Japanese Yen, Euro and United Kingdom Pound Sterling. The following table presents our net revenues by region (in thousands):

Cost of Revenues

           Cost of Licenses and Other Revenues 

           Cost of licenses and other revenues consists primarily of production costs, product packaging costs and royalties paid to third-party vendors. Cost of licenses and other revenues were $3.4 million and $4.2 million for the three months ended September 30, 2003 and 2002, respectively, representing 7% and 8% of total licenses and other revenues in the three months ended September 30, 2003 and 2002, respectively. Cost of licenses and other revenues were $9.5 million and $11.3 million for the nine months ended September 30, 2003 and 2002, respectively, representing 6% and 8% of total licenses and other revenues in the nine months ended September 30, 2003 and 2002, respectively. The reduction in the cost of licenses and other revenues was principally attributable to a reduction in direct production costs as we had a larger percentage of our licenses and other revenues generated from large corporate contracts. Typically, large enterprise and corporate licenses are delivered electronically or represent additional licenses of software that have already been delivered. This has the impact of reducing our overall production costs. Royalty costs were 2% and 3% of licenses and other revenues for the three months ended September 30, 2003 and 2002, respectively. Royalty costs were 2% of licenses and other revenues for the nine months ended September 30, 2003 and 2002. The level of royalty costs in future periods will depend on our ability to obtain favorable licensing terms for our products that include third-party technology and the extent to which we include such third-party technology in our product offerings.

           Cost of Service Revenues 

           Cost of service revenues consists primarily of salaries and benefits, third-party contractor costs and related expenses incurred in providing customer support, consulting and training. Cost of service revenues were $7.0 million and $5.2 million for the three months ended September 30, 2003 and 2002, respectively, representing 37% and 50% of service revenues in the three months ended September 30, 2003 and 2002, respectively. Cost of technical support revenues represented 22% and 27% of the cost of service revenues for the three months ended September 30, 2003 and 2002, respectively, while cost of consulting and training revenues represented 78% and 73%, respectively, of the cost of service revenues for the same periods. Service revenues gross margins were 63% and 50% in the three months ended September 30, 2003 and 2002, respectively. Cost of service revenues were $20.9 million and $15.6 million for the nine months ended September 30, 2003 and 2002, respectively, representing 37% and 53% of service revenues in the nine months ended September 30, 2003 and 2002, respectively. Cost of technical support revenues represented 24% and 29% of the cost of service revenues for the nine months ended September 30, 2003 and 2002, respectively, while cost of consulting and training revenues represented 76% and 71%, respectively, of the cost of service revenues for the same periods. Service revenues gross margins were 63% and 47% in the nine months ended September 30, 2003 and 2002, respectively. The increase in gross margins for the three and nine month periods ended September 30, 2003 when compared with the three and nine month periods ended September 30, 2002 was due to an increase in support revenues resulting from the assumed support obligations from the

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acquisitions of TogetherSoft and Starbase. In future periods, we expect increases in our cost of service revenues as our service revenues grow and the consulting and training revenues become a larger component of service revenues.

Operating Expenses

           Research and Development 

           Research and development expenses for the three months ended September 30, 2003 and 2002 were $15.6 million and $12.7 million, respectively, representing 22% and 21% of net revenues for the three months ended September 30, 2003 and 2002, respectively. Research and development expenses for the nine months ended September 30, 2003 and 2002 were $49.0 million and $37.4 million, respectively, representing 22% and 21% of net revenues for the nine months ended September 30, 2003 and 2002, respectively. The increase in research and development expenses was principally attributable to an increase in our research and development employee-related expenses of 29% and 34% for the three and nine months ended September 30, 2003, respectively, as compared with the same periods in 2002, primarily as a result of an increase in our research and development headcount of approximately 215 employees at September 30, 2003 when compared to September 30, 2002 following the acquisitions of TogetherSoft and Starbase. In addition, we recorded research and development charges of $2.2 million during the nine months ended September 30, 2003, resulting from the write-off of the loan receivable from AltoWeb. There were no comparable charges during the three months ended September 30, 2003 or for the three and nine months ended September 30, 2002.

           Selling, General and Administrative 

           Selling, general and administrative expenses were $43.4 million and $32.7 million for the three months ended September 30, 2003 and 2002, respectively, representing 62% and 54% of net revenues for the three months ended September 30, 2003 and 2002, respectively. Selling, general and administrative expenses were $136.3 million and $95.8 million for the nine months ended September 30, 2003 and 2002, respectively, representing 62% and 54% of net revenues for the nine months ended September 30, 2003 and 2002, respectively. The increase in selling, general and administrative expenses was principally attributable to an increase in our employee-related expenses of 36% and 44% for the three and nine months ended September 30, 2003, respectively, as compared with the same periods in 2002. This was primarily due to an increase in headcount of approximately 220 employees at September 30, 2003 when compared to September 30, 2002, which was mostly a result of the acquisitions of TogetherSoft and Starbase. In addition, our facilities cost increased 44% for the three-month period ended September 30, 2003 and 43% for the nine-month period ended September 30, 2003 as compared with the same periods in 2002 as we assumed the lease obligations of TogetherSoft and Starbase.

           Restructuring, Amortization of Intangibles, Acquisition-Related Expenses and Other Charges 

           The following table summarizes our restructuring, amortization of intangibles, acquisition-related expenses and in-process research and development activity for the three and nine months ended September 30, 2003 and 2002 (in thousands):

                      During the three months ended September 30, 2003, we recorded $5.8 million in amortization from purchased intangibles from the TogetherSoft, Starbase, VMGear, Bedouin, Boldsoft and Highlander acquisitions, and $3.4 million in acquisition-related expenses, which is principally associated with the earn-out provision of the VMGear acquisition. During the nine months ended September 30, 2003, we recorded $9.0 million in restructuring costs from redundancies as a result of the TogetherSoft and Starbase acquisitions and excess facilities in the United Kingdom, $17.0 million in amortization from purchased intangibles from the TogetherSoft, Starbase, VMGear, Bedouin, Boldsoft and Highlander acquisitions, $8.7 million in acquisition-related expenses, which is principally

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associated with the earn-out provision of the VMGear acquisition, and a $4.6 million charge for in-process research and development from the TogetherSoft acquisition.

           During the three months ended September 30, 2002, we recorded restructuring, amortization of intangibles and acquisition-related expenses in the amount of $1.4 million, which consisted primarily of $1.1 million in acquisition-related expense associated with an earn-out provision in the VMGear acquisition. During the nine months ended September 30, 2002, we recorded restructuring, amortization of intangibles and acquisition-related expenses in the amount of $4.5 million, which consisted primarily of $3.4 million in acquisition-related expense associated with an earn-out provision in the VMGear acquisition.

           The following table summarizes our restructuring activity under EITF 94-3 and SFAS 146 for the nine months ended September 30, 2003 (in thousands):