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UNITED STATES

FORM 10-Q

Commission File Number: 0-26880

VERITY, INC.

894 Ross Drive

     Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x     No o

      The number of shares outstanding of the Registrant’s Common Stock, $0.001 par value, was 34,697,117 as of September 30, 2002.

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VERITY, INC.

FORM 10-Q

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

VERITY, INC.

ASSETS

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

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VERITY, INC.

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

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VERITY, INC.

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

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VERITY, INC.

1. Interim Financial Data (Unaudited)

      The unaudited condensed consolidated financial statements for Verity, Inc. (the “Company” or “Verity”) as of August 31, 2002 and for the three months ended August 31, 2002 and 2001 have been prepared on the same basis as the Company’s audited financial statements and, in the opinion of management, include all material adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the financial position and results of operations in accordance with generally accepted accounting principles. Although certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission, the Company believes the disclosures made are adequate to make the information presented not misleading. The accompanying financial statements should be read in conjunction with the Company’s annual financial statements contained in the Company’s Annual Report on Form 10-K for the year ended May 31, 2002.

      The Company’s balance sheet as of May 31, 2002 was derived from the Company’s audited financial statements, but does not include all disclosures necessary for the presentation to be in accordance with generally accepted accounting principles.

2. Computation of Net Income (Loss) and Net Income (Loss) Per Share

      Basic earnings per share are computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed using the weighted average number of common and common equivalent shares outstanding during the period. Dilutive common equivalent shares consist of “in-the-money” stock options. “In-the-money” options are those where the exercise price is lower than the average market price being used to determine the value. Verity’s average market price for the first quarter in fiscal year 2003 was $10.5363. All common equivalent shares have been excluded from the computation of diluted net loss per share for the three months ended August 31, 2001 because the effect would be anti-dilutive.

      Basic and diluted net income (loss) per share are calculated as follows for the three months ended August 31, 2002 and 2001 (in thousands, except per share data):

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      As of August 31, 2002 and August 31, 2001, zero and 10,710,540 anti-dilutive shares have been excluded from the dilutive effect of common stock equivalent shares.

3. Investments

      As of August 31, 2002, available-for-sale securities consist of the following (in thousands):

      At August 31, 2002, scheduled maturities of investments classified as available-for-sale are as follows (in thousands):

      As of May 31, 2002, available-for-sale securities consist of the following (in thousands):

4. Comprehensive Income (Loss)

      Comprehensive income (loss) is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. The following are the components of comprehensive income (loss) (in thousands):

5. Business Segment

      The Company has sales and marketing operations located outside the United States in the Netherlands, the United Kingdom, France, Germany, South Africa, Mexico, Australia, a joint investment partnership in Brazil and a development and technical support operation in Canada. Foreign branch and subsidiary revenues

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consist primarily of maintenance and consulting services and are being allocated based on foreign branch and subsidiary location.

      Transfers between geographic areas are recorded at amounts generally above cost and in accordance with the rules and regulations of the respective governing tax authorities. Long-lived assets of geographic areas are those assets used in the Company’s operations in each area.

      No single customer accounted for more than 10% of the Company’s total revenues for the three months ended August 31, 2002 and 2001. Revenues derived from sales to the United States government and its agencies were 9.1% and 6.4% of the Company’s total revenues for the three months ended August 31, 2002 and 2001, respectively.

6. Contingencies

      On June 7, 2001, Verity filed a complaint in federal district court in the Northern District of California, San Jose Division, against BroadVision, Inc. (Case No. C01-20501-PVT-ADR). BroadVision is a software company that Verity in the past has licensed to distribute Verity’s copyrighted software known as the Verity Developer Kit (“VDK”). Verity alleges in its complaint that under the terms of the parties’ licenses, BroadVision was authorized to distribute certain limited portions of VDK as an embedded component of specified software applications of BroadVision. Verity further alleges that BroadVision has distributed portions of VDK that it was not authorized to distribute, failed to prevent end users from accessing unlicensed functions and encouraged end users to make use of unlicensed functions of VDK. Verity further alleges that it terminated its license with BroadVision on April 24, 2001 and that BroadVision no longer has any right to distribute any portion of VDK.

      Based on the foregoing allegations, Verity has asserted claims against BroadVision for copyright infringement, declaratory relief, unfair competition, interference with economic advantage, breach of contract, and breach of the implied covenant of good faith and fair dealing. Verity seeks by its complaint, among other things, an injunction to prohibit BroadVision from further distribution of VDK, damages, including statutory damages, according to proof based on BroadVision’s unauthorized distribution of VDK and attorneys’ fees.

      BroadVision answered Verity’s complaint on June 28, 2001 and denied the material allegations of the Complaint and asserted affirmative defenses to Verity’s claims. BroadVision also asserted a counterclaim alleging that Verity had breached the parties’ license and the implied covenant of good faith and fair dealing

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contained therein (1) by failing to pay BroadVision referral fees that it claims Verity owes to BroadVision for BroadVision’s efforts in securing the sale of Verity Advanced K-2 Search Modules; and (2) by failing to provide support to BroadVision for VDK after Verity terminated the parties’ license. BroadVision seeks by its counterclaim, among other things, damages according to proof, a declaration that BroadVision has not breached the parties’ license and attorneys’ fees.

      Verity answered BroadVision’s counterclaim on July 23, 2001 and denied the material allegations of the counterclaim and asserted various affirmative defenses to BroadVision’s claims. On August 8, 2002, Verity filed a first amended complaint against BroadVision which, among other things, added a claim for contributory copyright infringement against BroadVision based on allegations that BroadVision knowingly facilitated the use by end users of unlicensed functionality of VDK. BroadVision answered Verity’s amended complaint on August 29, 2002 and denied the material allegations of the Complaint and asserted affirmative defenses to Verity’s claims. BroadVision reasserted its counterclaim described above. Verity answered the counterclaim on September 23, 2002 and denied the material allegations of the counterclaim and asserted various affirmative defenses to BroadVision’s claims.

      The action is currently in the discovery phase. The trial date has been set for July 14, 2003.

      The Company intends to defend all of these actions vigorously. However, there can be no assurance that any of the complaints discussed above will be resolved without costly litigation, or in a manner that is not materially adverse to Verity’s financial position, results of operations or cash flows. No estimate can be made of the possible loss or possible range of loss, if any, associated with the resolution of these contingencies and accordingly, the Company has not recorded a liability.

7. Stock Repurchase Program

      On June 20, 2002, Verity announced an extension of the stock repurchase program it initiated on September 12, 2001. The program calls for the repurchase of outstanding shares of Verity’s common stock up to an aggregate value of $50.0 million. Through August 31, 2002, Verity repurchased and retired 2,132,200 shares of its common stock through open market transactions, valued at approximately $26.5 million. The program will terminate at the end of the current fiscal year ending May 31, 2003 unless extended or shortened by the Board of Directors.

8. Recent Accounting Pronouncements

      In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 141 (“SFAS No. 141”), “Business Combinations.” This standard eliminates the pooling-of-interests method of accounting for business combinations, except for qualifying business combinations that were initiated prior to July 1, 2001, and applies to all business combinations accounted for under the purchase method that are completed after June 30, 2001.

      In June 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets.” This standard eliminates the amortization of goodwill and requires goodwill to be reviewed at least annually for impairment, the useful lives of previously recognized intangible assets to be reassessed and the remaining amortization periods to be adjusted accordingly. This standard is effective for Verity’s fiscal year beginning on June 1, 2002. The adoption of SFAS No. 142 had no impact on the Company’s financial position or results of operations.

      In October 2001, the FASB issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 supersedes “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (SFAS No. 121), however it retains the fundamental provisions of SFAS No. 121 for (1) the recognition and measurement of the impairment of long-lived assets to be held and

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used and (2) the measurement of long-lived assets to be disposed of by sale. SFAS No. 144 develops a single accounting model for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired assets and consequently amends Accounting Principles Board Opinion No. 30, “Reporting Results of Operations — Reporting the Effects of Disposal of a Division of a Business.” Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. The adoption of SFAS No. 144 did not have a significant impact on the Company’s financial position or results of operations.

      In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 nullifies the guidance of the Emerging Issues Task Force (EITF) in 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).” Under EITF Issue No. 94-3, an entity recognized a liability for an exit cost on the date that the entity committed itself to an exit plan. In SFAS 146, the Board acknowledges that an entity’s commitment to a plan does not, by itself, create a present obligation to other parties that meets the definition of a liability and requires that a liability for a cost that is associated with an exit or disposal activity be recognized when the liability is incurred. It also establishes that fair value is the objective for the initial measurement of the liability. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002. Verity does not expect an impact on its financial position and results of operations from the adoption of SFAS 146.

9. Subsequent Event

      On September 18, 2002, the Company announced the elimination of about 50 positions within the Company, or about a 12 percent reduction. The move was made in order to reduce operating expenses and to position the Company to achieve its goal of continued profitability. The Company expects to record a charge related to severance and other payments of approximately $0.9 million in the quarter ending November 30, 2002. The employees affected by this staffing reduction were located in the United States and Canada.

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      The following discussion should be read in conjunction with the consolidated financial statements and related notes, which appear in our Annual Report on Form 10-K for the fiscal year ended May 31, 2002. The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly under the heading “— Risk Factors” below.

Overview

      We offer solutions and technology that address the business portal market. The business portal market includes corporate portals used for sharing information within an enterprise, e-commerce portals for online selling and market exchange portals for business-to-business activities. Business portals provide personalized information to employees, partners, customers and suppliers. We expect that for the foreseeable future we will continue to derive the largest portion of our revenues from licensing our technology for enterprise applications and business portal solutions.

Results of Operations

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

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Revenues

      The increase in our total revenues for the three month period ended August 31, 2002, compared with the same period a year ago, was primarily due to an increase in license sales, particularly our K2 Enterprise application, partially offset by a modest decrease in service and other revenues.

      Revenues derived from foreign operations accounted for 16.5% and 14.5% of total revenues for the three month periods ended August 31, 2002 and 2001, respectively. Our export sales consist primarily of products licensed for delivery outside of the United States. For the three month periods ended August 31, 2002 and 2001, export sales accounted for 19.4% and 21.6% of total revenues, respectively.

      No single customer accounted for more than 10% of our total revenues for the three month periods ended August 31, 2002 and 2001. Revenues derived from sales to the United States government and its agencies were 9.1% and 6.4% of our total revenues for the three month periods ended August 31, 2002 and 2001, respectively.

      We saw an increase in demand for our software products in the three month period ended August 31, 2002, compared with the same period a year ago. This increase in software product revenues was principally due to increased revenue from sales of our K2 Enterprise application.

      Our service and other revenues consist primarily of fees for software maintenance, consulting and training. The slight decrease in service and other revenues for the three month period ended August 31, 2002, compared with the same period a year ago, was related to a decrease in maintenance revenue resulting from normal recognition of maintenance revenue derived from a lower level of license revenues in the same period of the prior year. We recognize revenues associated with maintenance fees ratably over the period of the maintenance contract, which is typically twelve months. Revenues associated with fees for consulting and training remained flat.

Costs of Revenues

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      Costs of our software products consists primarily of product media, duplication, manuals, packaging materials, shipping expenses, and in certain instances, royalties for licensing of third-party software incorporated in our products. The decrease in costs of software products in absolute dollars and as a percentage of software product revenues for the three month period ended August 31, 2002, compared with the same period a year ago, was primarily attributable to decreased costs of third party software components and to decreased costs for manuals and other shipping expenses. In addition, during fiscal years 2002 and 2003, we did not capitalize any software development costs as these costs were not material.

      Costs of service and other revenues consist of costs incurred in providing consulting services, customer training, telephone support and product upgrades to customers. The decrease in absolute dollars and as a percentage of costs of service and other revenues for the three month period ended August 31, 2002 was primarily due to reduced compensation and other employee related expenses associated with the reduction in staffing in our professional services organization during the quarter ended November 30, 2001.

Operating Expenses

      Research and development expenses consist primarily of employee compensation and benefits, payments to outside contractors, depreciation on equipment used for development and corporate overhead allocations. We anticipate that research and development expenditures will continue to comprise a significant percentage of total revenues, because in our judgment, they are essential to maintaining our competitive position. We believe that research and development expenses will decrease in absolute dollars as a result of the workforce reduction discussed in note 9 of the Notes to Condensed Consolidated Financial Statements in Item 1 of Part I of this Quarterly Report on Form 10-Q.

      Research and development expenses in absolute dollars for the three month period ended August 31, 2002 were flat with the comparable prior period. Employee compensation and benefits expenses increased modestly during the three month period ended August 31, 2002 and were offset entirely by decreased payments to outside contractors. The decrease in research and development expenses as a percentage of total revenues for the three month period ended August 31, 2002 was due to the increase in total revenues for the period.

      Marketing and sales expenses consist primarily of employee compensation and benefits, tradeshows, outbound marketing and other lead generation activities, public relations, travel expenses associated with our sales staff and corporate overhead allocations. We anticipate that we will continue to make significant

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      The decrease in marketing and sales expenses in absolute dollars for the three months ended August 31, 2002, compared with the same period a year ago, was primarily due to a $3.7 million decrease in compensation and other employee related expenses associated with the reduction in staffing in our marketing and sales organization during the quarter ended November 30, 2001 and to a $0.3 million decrease in overall marketing program spending. The decrease in marketing and sales expenses as a percentage of total revenues for the three months ended August 31, 2002 was due to the decrease in absolute costs combined with the increase in total revenues for the period.

      General and administrative expenses consist primarily of personnel costs for finance, legal, human resources and general management, provisions for doubtful accounts, insurance, fees for external professional advisors and corporate overhead allocations. We believe that general and administrative expenses will remain relatively flat in absolute dollars for the foreseeable future.

      The decrease in general and administrative expenses in absolute dollars for the three month period ended August 31, 2002, compared with the same period a year ago, was primarily related to decreased expenses for outside professional services including various tax studies. The decrease as a percentage of total revenues for the three month period ended August 31, 2002 was primarily due to the decrease in absolute costs combined with the increase in total revenues.

      Other income consists primarily of interest income and realized gains from our investments in marketable securities.

      The decrease in other income in absolute dollars for the three month period ended August 31, 2002, compared with the same period a year ago, was primarily due to decreasing overall yields on our portfolio of marketable securities caused by the decreasing interest rate environment, partially offset by a slightly higher balance of marketable securities. The decrease in other income as a percentage of total revenues for the three month period ended August 31, 2002 was due to the decrease in absolute dollars combined with the increase in total revenues.

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      Income tax provision (benefit) includes U.S. and foreign income taxes, as well as the provision for U.S. taxes on undistributed earnings of international subsidiaries. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of this difference is reported as deferred income taxes.

      We expect the tax savings for fiscal 2003 due to research and development tax credits to result in a marginally lower effective tax rate and accordingly applied an effective tax rate of 38.0% to the results of our quarter ended August 31, 2002. We will continue to reassess the impact of our research and development expenses on our effective tax rate in future periods.

Liquidity and Capital Resources

      As of August 31, 2002, we had $242.9 million in cash and cash equivalents and available-for-sale securities compared to $245.4 million at May 31, 2002. At August 31, 2002, our principal sources of liquidity were our cash and cash equivalents and short-term investments of $134.3 million. As of August 31, 2002, we had no outstanding debt obligations.

      Cash provided by operating activities for the three month period ended August 31, 2002 was primarily due to a $4.0 million decrease in accounts receivable, net income of $1.4 million plus depreciation expense of $0.9 million, and a $0.8 million decrease in prepaid and other current assets, partially offset by a $2.8 million decrease in deferred revenue, a $1.0 million decrease is accrued compensation and other accrued liabilities and a $1.0 million decrease in accounts payable. Cash provided by operating activities for the three month period ended August 31, 2001 was primarily due to a $15.2 million decrease in accounts receivable, partially offset by a loss from operations of $2.5 million, a $5.2 million decrease in accrued compensation and a $3.0 million decrease in deferred revenue.

      Cash used in investing activities for the three month period ended August 31, 2002 and 2001 was the result of capital expenditures of $0.4 million and $2.0 million in the respective periods and net purchases of marketable securities. For the three month period ended August 31, 2002 and 2001, the capital expenditures consisted primarily of purchases for computer hardware and software.

      Cash used by financing activities for the three month period ended August 31, 2002 consisted of $6.6 million in repurchases of our common stock through our stock repurchase program, partially offset by $0.5 million in proceeds from the sale of common stock as a result of stock option exercises. Cash provided by financing activities for the three month period ended August 31, 2001 was from the sale of common stock as a result of stock option exercises.

      Our principal commitments as of August 31, 2002 consist of obligations under operating leases, totaling $11.0 million over the life of these leases.

      On June 20, 2002, we announced an extension of the stock repurchase program we initiated on September 12, 2001. The program calls for the repurchase of outstanding shares of our common stock up to an aggregate value of $50.0 million. Through August 31, 2002, we repurchased and retired 2,132,200 shares of our common stock through open market transactions, valued at approximately $26.5 million. The program will terminate at the end of the current fiscal year ending May 31, 2003 unless extended or shortened by the Board of Directors.

      We believe that our current cash and cash equivalents, interest income and cash generated from operations, if any, will provide adequate liquidity to meet our working capital and operating resource

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Recent Accounting Pronouncements

      In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 141 (“SFAS No. 141”), “Business Combinations.” This standard eliminates the pooling-of-interests method of accounting for business combinations, except for qualifying business combinations that were initiated prior to July 1, 2001, and applies to all business combinations accounted for under the purchase method that are completed after June 30, 2001.

      In June 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets.” This standard eliminates the amortization of goodwill and requires goodwill to be reviewed at least annually for impairment, the useful lives of previously recognized intangible assets to be reassessed and the remaining amortization periods to be adjusted accordingly. This standard is effective for our fiscal year beginning on June 1, 2002. The adoption of SFAS No. 142 did not have a significant impact on our financial position or results of operations.

      In October 2001, the FASB issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 supersedes “Accounting for the Impairment of Long- Lived Assets and for Long-Lived Assets to Be Disposed Of” (SFAS No. 121), however it retains the fundamental provisions of SFAS No. 121 for (1) the recognition and measurement of the impairment of long-lived assets to be held and used and (2) the measurement of long-lived assets to be disposed of by sale. SFAS No. 144 develops a single accounting model for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired assets and consequently amends Accounting Principles Board Opinion No. 30, “Reporting Results of Operations — Reporting the Effects of Disposal of a Division of a Business.” Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. The adoption of SFAS No. 144 did not have a significant impact on our financial position or results of operations.

      In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 nullifies the guidance of the Emerging Issues Task Force (EITF) in 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).” Under EITF Issue No. 94-3, an entity recognized a liability for an exit cost on the date that the entity committed itself to an exit plan. In SFAS 146, the Board acknowledges that an entity’s commitment to a plan does not, by itself, create a present obligation to other parties that meets the definition of a liability and requires that a liability for a cost that is associated with an exit or disposal activity be recognized when the liability is incurred. It also establishes that fair value is the objective for the initial measurement of the liability. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002. We do not expect an impact on our financial position and results of operations from the adoption of SFAS 146.

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RISK FACTORS

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

Risks Related to Our Business

      We have incurred net losses in the past and, although we reported net income in fiscal year 2002 and the first quarter of fiscal year 2003, we may not be able to maintain profitability. In the future, our revenues may decline, remain flat, or grow at a rate slower than was experienced in the quarter ended August 31, 2002, especially in light of the current economic environment. To achieve revenue growth and maintain fiscal year profitability, we must:

	•	increase market acceptance of our products;
	•	respond effectively to competitive developments;
	•	execute sales despite the recent economic slowdown and resulting decrease in our customers’ capital spending;
	•	attract, retain and motivate qualified personnel; and
	•	upgrade our technologies and commercialize our products and services incorporating these technologies.

      We cannot assure you that we will be successful in achieving any of these goals or that we will experience increased revenues, positive cash flows, or achieve long-term profitability.

      The results of operations for any quarter are not necessarily indicative of results to be expected in future periods. We expect our stock price to vary with our operating results and, consequently, any adverse fluctuations in our operating results could have an adverse effect on our stock price. Our operating results have in the past been, and will continue to be, subject to quarterly fluctuations as a result of a number of factors. These factors include:

	•	the downturn in capital spending by customers as a result of the current economic slowdown;
	•	the size and timing of orders;
	•	changes in the budget or purchasing patterns of corporations and government agencies, foreign country exchange rates, or pricing pressures from competitors;
	•	increased competition in the software and Internet industries;
	•	the introduction and market acceptance of new technologies and standards in search and retrieval, Internet, document management, database, networking, and communications technology;
	•	variations in sales channels, product costs, the mix of products sold, or the success of quality control measures;

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	•	the integration of people, operations, and products from acquired businesses and technologies;
	•	changes in operating expenses and personnel;
	•	changes in accounting principals, such as a requirement that stock options be included in compensation, as is currently being considered by Congress and, which if adopted, would increase our compensation expenses and have a negative effect on our earnings;
	•	the overall trend toward industry consolidation; and
	•	changes in general economic and geo-political conditions and specific economic conditions in the computer and software industries.

      Any of the factors, some of which are discussed in more detail below, could materially and adversely impact our operations and financial results, and consequently our stock price.

      The size and timing of individual orders may cause our operating results to fluctuate significantly. Our operating results for a quarter could be materially and adversely affected if one or more large orders are either not received or are delayed or deferred by customers. A significant portion of our revenues in recent quarters has been derived from these relatively large sales to a limited number of customers, and we currently anticipate that future quarters will continue to reflect this trend. Sales cycles for these customers can be up to six months or longer. In addition, customer order deferrals in anticipation of new products may cause our operating results to fluctuate. Like many software companies, we have generally recognized a substantial portion of our revenues in the last month of each quarter, with these revenues concentrated in the last weeks of the quarter. Accordingly, the cancellation or deferral of even a small number of purchases of our products could harm our business in any particular quarter. In addition, to the extent that the significant sales occur earlier than expected, operating results for subsequent quarters may fail to keep pace or even decline.

      Any delay in sales of our products and services could cause our quarterly revenue and operating results to fluctuate. The typical sales cycle of our products is lengthy, generally between six to twelve months, unpredictable, and involves significant investment decisions by prospective customers, as well as our education of potential customers regarding the use and benefits of our products. Our customers spend a substantial amount of time before purchasing our products in performing internal reviews and obtaining capital expenditure approvals. Our sales cycle has lengthened in 2002 and we cannot be certain that this cycle will not lengthen in the future.

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

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      In the past, securities class action litigation has often been brought against a company following a decline in the market price of its securities. For example, in December 1999 our stock price dramatically declined and a number of lawsuits were filed against us. Because we expect our stock price to continue to fluctuate significantly, we may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert management’s attention and resources, and could seriously harm our business.

      During the past few years, management and other personnel have focused on modifying and enhancing our core technology to support a broader set of search and retrieval solutions for use on enterprise-wide systems, over online services, over the Internet and on CD-ROM. In order for our strategy to succeed and to remain competitive, we must leverage our core technology to develop new product offerings by us and by our original equipment manufacturer, or OEM, customers that address the needs of these new markets. These development efforts are expensive. If these products do not generate substantial revenues, our business and results of operations will be adversely affected. We cannot assure you that any of these products will be successfully developed and completed on a timely basis or at all, will achieve market acceptance or will generate significant revenues.

      Our future operating results will depend upon our ability to increase the installed base of our information retrieval technology and to generate significant product revenues from our core products. Our future operating results will also depend upon our ability to successfully market our technology to online and Internet publishers who use this technology to index their published information in our format. To the extent that customers do not adopt our technology for indexing their published information, users will be unable to search their information using our search and retrieval products, which in turn will limit the demand for our products.

      The business portal software market is intensely competitive and we cannot assure you that we will maintain our current position of market share. A number of companies offer competitive products addressing this market. We compete with Alta Vista, Autonomy, Convera, Epicentric, FAST, Google, Hummingbird/ PC Docs/ Fulcrum, Inktomi, Infoseek, Lotus, Mercado, Microsoft, Thunderstone and Viador, among others. We also compete indirectly with database vendors, such as Oracle, that offer information search and retrieval capabilities with their core database products and web platform companies, such as Netscape.

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

      Regent Pacific Management Corporation, a management firm of which Gary J. Sbona, our chairman of the board and chief executive officer, is chief executive officer, provides management services for our company under a management services agreement. The management services provided under our agreement with Regent Pacific include the services of Regent Pacific personnel as part of Verity’s management team. The agreement terminates on August 31, 2003, but provides us with an option to further extend the term of this agreement through February 2004. This agreement may be cancelled at the option of the board after February

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      Historically, our foreign operations and export sales account for a significant portion of our annual revenues. Our international business activities are subject to a number of risks, each of which could impose unexpected costs on us that would have an adverse effect on our operating results. These risks include:

	•	difficulties in complying with regulatory requirements and standards;
	•	tariffs and other trade barriers;
	•	costs and risks of localizing products for foreign countries;
	•	reliance on third parties to distribute our products;
	•	longer accounts receivable payment cycles;
	•	potentially adverse tax consequences;
	•	limits on repatriation of earnings; and
	•	burdens of complying with a wide variety of foreign laws.

      We currently engage in only limited hedging activities to protect against the risk of currency fluctuations. Fluctuations in currency exchange rates could cause sales denominated in U.S. dollars to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. Also, these fluctuations could cause sales denominated in foreign currencies to affect a reduction in the current U.S. dollar revenues derived from sales in a particular country. Furthermore, future international activity may result in increased foreign currency denominated sales and, in this event, gains and losses on the conversion to U.S. dollars of accounts receivable and accounts payable arising from international operations may contribute significantly to fluctuations in our results of operations. The financial stability of foreign markets could also affect our international sales. In addition, revenues earned in various countries where we do business may be subject to taxation by more than one jurisdiction, thereby adversely affecting our earnings. We cannot assure you that any of these factors will not have an adverse effect on the revenues from our future international sales and, consequently, our results of operations.

      Service and other revenues derived from foreign operations accounted for 16.5%, 13.9%, 6.3% and 6.7% of total revenues for the three month period ended August 31, 2002, and fiscal years 2002, 2001, and 2000, respectively. Our export sales consist primarily of products licensed for delivery outside of the United States. For the three months ended August 31, 2002 and fiscal years 2002, 2001 and 2000, export sales accounted for 19.4%, 21.8%, 26.0% and 19.0% of total revenues, respectively. We expect that revenues derived from foreign operations and export sales will continue to account for a significant percentage of our revenues for the foreseeable future. These revenues may fluctuate significantly as a percentage of revenues from period to period. In addition, a portion of these revenues was derived from sales to foreign government agencies, which may be subject to risks similar to those described immediately below.

      Revenues derived from sales to the federal and state governments and their agencies were 9.1%, 6.1%, 7.4% and 7.8% of total revenues for the three months ended August 31, 2002 and fiscal years 2002, 2001 and 2000, respectively. Future reductions in government spending on information technologies could harm our operating results. In recent years, budgets of many government agencies have been reduced, causing certain

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

      The computer software industry is subject to rapid technological change, changing customer requirements, frequent new product introductions, and evolving industry standards that may render existing products and services obsolete. As a result, our position in our existing markets or other markets that we may enter could be eroded rapidly by product advancements by competitors. If we are unable to develop and introduce products in a timely manner in response to changing market conditions or customer requirements, our financial condition and results of operations would be materially and adversely affected.

      The life cycles of our products are difficult to estimate. Our future success will depend upon our ability to keep pace with technological developments, conform to evolving industry standards, particularly client/ server and Internet communication and security protocols, as well as publishing formats such as HTML and XML, and address increasingly sophisticated customer needs. We cannot assure you that we will not experience difficulties that could delay or prevent the successful development, introduction and marketing of new products, or that new products and product enhancements will meet the requirements of the marketplace and achieve market acceptance.

      We strive to achieve compatibility between our products and the text publication formats we believe are or will become popular and widely adopted. We invest substantial resources in development efforts aimed at achieving compatibility. Any failure by us to anticipate or respond adequately to technology or market developments could result in a loss of competitiveness or revenue. For instance, to date we have focused our efforts on integration with the Adobe PDF and Lotus Notes environments and, more recently, the Microsoft Exchange environment. Should any of these products or technologies lose or fail to achieve acceptance in the marketplace or be replaced by other products or technologies, our business could be materially and adversely affected.

      We embed our basic search engine in key OEM application products and, therefore, our sales of information retrieval products depend on our ability to maintain compatibility with these OEM applications. We cannot assure you that we will be able to maintain compatibility with these vendors’ products or continue to be the search technology of choice for OEMs. The failure to maintain compatibility with or be selected by OEMs would materially and adversely affect our sales. Further, the failure of the products of our key OEM partners to achieve market acceptance could harm our results of operations.

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

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

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

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

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

      Third parties may assert that our products infringe their proprietary rights, or may assert claims for indemnification resulting from infringement claims against us. Any such claims may cause us to delay or cancel shipment of our products, which could harm our business. In addition, irrespective of the validity or the successful assertion of claims, we could incur significant costs in defending against claims. To date, we have not incurred any such claims.

      Some of the technology used by our products is licensed from third parties, generally on a nonexclusive basis. We believe that there are alternative sources for each of the material components of technology we license from third parties. However, the termination of any of these licenses, or the failure of the third-party licensors to adequately maintain or update their products, could result in delay in our ability to ship these products while we seek to implement technology offered by alternative sources. Any required replacement licenses could prove costly. Also, any delay, to the extent it becomes extended or occurs at or near the end of a fiscal quarter, could harm our quarterly results of operations. While it may be necessary or desirable in the

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      Our business is highly competitive and our growth is dependent upon market growth and our ability to enhance our existing products and introduce new products on a timely basis. One of the ways we may address the need to develop new products is through acquisitions of complementary businesses and technologies. From time to time, we consider and evaluate potential business combinations both involving our acquisition of another company and transactions involving the sale of Verity through, among other things, a possible merger or consolidation of our business into that of another entity. Acquisitions involve numerous risks, including the following:

	•	difficulties in integration of the operations, technologies, and products of the acquired companies;
	•	the risk of diverting management’s attention from normal daily operations of the business;
	•	accounting consequences, including changes in purchased research and development expenses, resulting in variability in our quarterly earnings;
	•	potential difficulties in completing projects associated with purchased in-process research and development;
	•	risks of entering markets in which we have no or limited direct prior experience and where competitors in these markets have stronger market positions;
	•	the potential loss of key employees of the acquired company; and
	•	the assumption of unforeseen liabilities of the acquired company.

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

Risks Related to Our Industry

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

      The business of most of our customers would be seriously harmed if:

	•	use of the Internet, the Web and other online services does not continue to increase or increases more slowly than expected;
	•	the infrastructure for the Internet, the Web and other online services does not effectively support expansion that may occur; or

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

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

	•	potentially inadequate development of the necessary communication and network infrastructure, particularly if rapid growth of the Internet continues;
	•	delayed development of enabling technologies and performance improvements;
	•	delays in the development or adoption of new standards and protocols; and
	•	increased governmental regulation.

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

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