10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE THREE MONTHS ENDED DECEMBER 31, 2004

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

Commission File Number

1-15681

webMethods, Inc.

(Exact name of Registrant as Specified in its Charter)

Delaware (State or Other Jurisdiction of Incorporation or Organization)	54-1807654 (I.R.S. Employer Identification No.)
3930 Pender Drive, Fairfax, Virginia (Address of Principal Executive Offices)	22030 (Zip Code)

Registrant’s telephone number, including area code:  (703) 460-2500

Securities registered pursuant to Section 12(b) of the Act: None

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

Preferred Stock Purchase Rights

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

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

      As of February 10, 2005, there were outstanding 53,317,777 shares of the registrant’s Common Stock.

*  The registrant’s Form 10-Q for the quarter ended September 30, 2004 will be filed promptly following the filing of this report.

WEBMETHODS, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE MONTHS ENDED DECEMBER 31, 2004

TABLE OF CONTENTS

Part I	Financial Information
Item 1	Financial Statements	1
	Condensed Consolidated Financial Statements	1
	Condensed Consolidated Balance Sheets (unaudited) as of December 31, 2004 and March 31, 2004	1
	Condensed Consolidated Statements of Operations and Comprehensive Loss (unaudited) — Three and nine months ended December 31, 2004 and 2003	2
	Condensed Consolidated Statements of Cash Flows (unaudited) — Nine months ended December 31, 2004 and 2003	3
	Notes to Condensed Consolidated Financial Statements (unaudited)	4
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10
Item 3	Quantitative and Qualitative Disclosures About Market Risk	29
Item 4	Controls and Procedures	29
Part II	Other Information
Item 1	Legal Proceedings	32
Item 5	Other Information	32
Item 6	Exhibits	33

PART I

FINANCIAL INFORMATION

Item 1:     FINANCIAL STATEMENTS

WEBMETHODS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

			December 31,			March 31,
			2004			2004
						As restated
			(In thousands)
ASSETS
Current assets:
	Cash and cash equivalents		$	69,196		$	75,462
	Marketable securities available for sale			56,523			44,328
	Accounts receivable, net of allowance of $1,903 and $2,103			51,827			46,741
	Prepaid expenses and other current assets			6,610			6,235
		Total current assets		184,156			172,766
Marketable securities available for sale				20,206			36,157
Property and equipment, net				7,170			8,106
Goodwill				46,704			46,704
Intangible assets, net				8,990			10,787
Other assets				6,766			9,130
		Total assets	$	273,992		$	283,650
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	11,516		$	10,919
	Accrued expenses			12,908			17,084
	Accrued salaries and commissions			12,996			11,560
	Deferred revenue			40,397			36,018
	Short-term borrowings			—			2,584
	Current portion of capital lease obligations			479			909
		Total current liabilities		78,296			79,074
	Capital lease obligations, net of current portion			99			373
	Other long term liabilities			690			1,000
	Long term deferred revenue			6,533			6,066
		Total liabilities		85,618			86,513
Commitments and contingencies
Stockholders’ equity:
	Common stock, $0.01 par value; 500,000,000 shares authorized; 53,311,282 and 52,746,722 shares issued and outstanding			533			527
	Additional paid-in capital			524,381			521,455
	Deferred stock compensation and warrant charge			(3,641	)		(5,625	)
	Accumulated deficit			(336,368	)		(321,473	)
	Accumulated other comprehensive income			3,469			2,253
		Total stockholders’ equity		188,374			197,137
		Total liabilities and stockholders’ equity	$	273,992		$	283,650

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

1

WEBMETHODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(Unaudited)

				Three Months Ended						Nine Months Ended
				December 31,						December 31,
				2004			2003			2004			2003
							As restated						As restated
				(In thousands, except per share amounts)
Revenue:
	License			$	25,953		$	25,037		$	64,610		$	67,061
	Professional services				11,854			11,210			36,455			30,543
	Maintenance				17,156			13,785			46,601			39,101
			Total revenue		54,963			50,032			147,666			136,705
Cost of revenue:
	Amortization of intangibles				599			599			1,797			599
	License				252			601			1,117			1,622
	Professional services and maintenance:
		Stock based compensation			—			12			—			57
		Other professional services and maintenance			13,764			13,614			42,317			37,676
			Total cost of revenue		14,615			14,826			45,231			39,954
Gross profit					40,348			35,206			102,435			96,751
Operating expenses:
	Sales and marketing:
		Stock based compensation and warrant charge			661			689			1,983			2,106
		Other sales and marketing costs			22,103			24,617			63,143			68,534
	Research and development:
		Stock based compensation			—			5			—			15
		Other research and development costs			10,877			11,446			32,747			33,503
	General and administrative:
		Stock based compensation			—			1			—			7
		Other general and administrative costs			7,093			4,333			17,034			13,282
	Restructuring and related charges				—			1,315			2,756			1,315
	In process research and development				—			4,284			—			4,284
			Total operating expenses		40,734			46,690			117,663			123,046
Operating loss					(386	)		(11,484	)		(15,228	)		(26,295	)
Interest income					615			549			1,700			2,277
Interest expense					(28	)		(56	)		(84	)		(162	)
Other expense					(27	)		(196	)		(31	)		(171	)
Impairment of equity investment in private company					—			—			(1,057	)		—
	Income (loss) before income taxes				174			(11,187	)		(14,700	)		(24,351	)
Provision for income taxes					126			—			195			—
	Net income (loss)			$	48		$	(11,187	)	$	(14,895	)	$	(24,351	)
Net income (loss) per share:
	Basic			$	0.00		$	(0.21	)	$	(0.28	)	$	(0.47	)
	Dilutive			$	0.00		$	(0.21	)	$	(0.28	)	$	(0.47	)
Shares used in per share calculation:
	Basic				53,155,607			52,101,406			53,024,466			51,982,122
	Dilutive				53,651,756			52,101,406			53,024,466			51,982,122
Comprehensive income (loss):
	Net income (loss)			$	48		$	(11,187	)	$	(14,895	)	$	(24,351	)
	Other comprehensive income (loss):
		Unrealized income (loss) on securities available for sale			(70	)		(164	)		(388	)		(254	)
		Foreign currency cumulative translation adjustment			1,880			1,242			1,604			2,186
			Total comprehensive income (loss)	$	1,858		$	(10,109	)	$	(13,679	)	$	(22,419	)

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

2

WEBMETHODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

			Nine Months Ended
			December 31,
			2004			2003
						As restated
			(In thousands)
Cash flows from operating activities:
	Net loss		$	(14,895	)	$	(24,351	)
	Adjustments to reconcile net loss to net cash used in operating activities:
		Depreciation and amortization		4,725			6,416
		Provision for doubtful accounts		241			17
		Amortization of deferred stock compensation related to employee and non-employee stock options and non-employee stock warrants		1,984			2,185
		Amortization of acquired intangibles		1,798			599
		Write off of in-process research and development		—			4,284
		Impairment of equity investment in private company		1,057			—
		Conversion of interest income into equity in private company		—			(257	)
		Non cash restructuring and related costs, and other		—			54
	Increase (decrease) in cash resulting from changes in assets and liabilities:
		Accounts receivable		(4,131	)		8,075
		Prepaid expenses and other current assets		(258	)		1,320
		Other assets		1,400			31
		Accounts payable		267			253
		Accrued expenses and other liabilities		(4,512	)		(2,516	)
		Accrued salaries and commissions		1,132			(2,211	)
		Deferred revenue		3,786			(6,632	)
Net cash used in operating activities				(7,406	)		(12,733	)
Cash flows from investing activities:
	Acquisitions of businesses and technology, net of cash acquired			—			(32,360	)
	Purchases of property and equipment			(3,851	)		(1,989	)
	Net maturities of marketable securities available for sale			3,366			26,926
	Repayment of investment in private company			—			1,000
Net cash used in investing activities				(485	)		(6,423	)
Cash flows from financing activities:
	Short-term borrowings			3,533			3,348
	Payments on short-term borrowings			(6,080	)		(3,397	)
	Payments on capital leases			(747	)		(2,789	)
	Proceeds from exercise of stock options and stock issued under the ESPP			2,932			3,312
Net cash provided by/(used in) financing activities				(362	)		474
Effect of exchange rate on cash and cash equivalents				1,987			2,876
Net decrease in cash and cash equivalents				(6,266	)		(15,806	)
Cash and cash equivalents at beginning of period				75,462			79,702
Cash and cash equivalents at end of period			$	69,196		$	63,896

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

3

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

      The accompanying consolidated financial statements of webMethods, Inc. and its subsidiaries (collectively, the “Company”) have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). This Quarterly Report on Form 10-Q should be read in conjunction with the Company’s Amendment No. 2 to Form 10-K for the year ended March 31, 2004. Certain information and footnote disclosures which are normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to SEC rules and regulations. The information reflects all normal and recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the financial position of the Company, and its results of operations for the interim periods set forth herein. The results for the three months and nine months ended December 31, 2004 are not necessarily indicative of the results to be expected for the full year or any future period. Certain amounts previously reported have been reclassified to conform with current year presentation.

2. Restatements

      On February 3, 2005, the Company issued a press release and thereafter filed a Form 8-K announcing that the Company was restating its financial statements for fiscal year 2004 (ended March 31, 2004), as well as quarterly financial statements for each of the three interim quarterly reports in that fiscal year and for the three months ended June 30, 2004. That announcement related primarily to the recently completed independent investigation conducted by the Company’s Audit Committee into certain transactions of the Company’s Japanese subsidiary.

      As a result of the investigation, the Company’s Audit Committee concluded that improper activities of certain employees of the Japanese subsidiary caused the Company to misstate revenue and expenses for the year ended March 31, 2004 and certain quarters therein and the three months ended June 30, 2004, as well as misstate accounts receivable, deferred revenue, debt and certain other items attributable to the operations of the Japanese subsidiary. The Audit Committee’s investigation found that the improper activities included, among other things, engaging in improper licensing and professional services transactions and misrepresenting the transactions to the Company’s management; causing the Japanese subsidiary to engage in undisclosed and unauthorized borrowings; failing to record expenses and recording improper expenses; and creating false documents in support of improper transactions. The Audit Committee also determined that those employees of the Japanese subsidiary acted to conceal their improper activities from webMethods’ management.

      The adjustments to the Company’s financial statements in the restatements fall into five general categories: (i) adjustments to license, professional services and maintenance revenue relating to improper activities of certain employees of the Japanese subsidiary; (ii) adjustments to deferred revenue with respect to certain of those revenue items that should have been deferred and recognized as revenue in subsequent periods; (iii) adjustments to properly record expenses of the Japanese subsidiary in the appropriate period; (iv) adjustments to debt (excluding the reclassification of interest expense, which was nominal) and accounts receivable as a result of certain unauthorized borrowings by the Japanese subsidiary that were improperly recorded by it as collections of receivables; and (v) elimination of a provision for tax expense based upon estimates of the taxable income of the Company’s Japanese subsidiary.

      As a result of the foregoing, the Company’s consolidated financial statements for the three- and nine-month periods ended December 31, 2003 and the Company’s Consolidated Balance Sheet at March 31, 2004 have been restated from amounts previously reported. The accompanying consolidated financial data presents the Company’s restated Condensed Consolidated Statements of Operations for the three and nine

4

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

2.     Restatements — (Continued)

months ended December 31, 2003 and the restated balance sheet items as of March 31, 2004 on a comparative basis showing the amounts as originally reported and as restated.

Summary of the Significant Effects of the Restatement on the Consolidated Statements of Operations

			Three Months Ended December 31, 2003									Nine Months Ended December 31, 2003
			As previously									As previously
			reported			Adjustments			As restated			reported			Adjustments			As restated
			(In thousands, except per share amounts)
Revenue:
	License		$	25,037		$	—		$	25,037		$	68,863		$	(1,802	)	$	67,061
	Professional services			11,210			—			11,210			30,661			(118	)		30,543
	Maintenance			13,851			(66	)		13,785			39,188			(87	)		39,101
		Total revenue		50,098			(66	)		50,032			138,712			(2,007	)		136,705
Cost of revenue				14,826			—			14,826			39,954			—			39,954
Gross profit				35,272			(66	)		35,206			98,758			(2,007	)		96,751
Operating expenses				46,690			—			46,690			123,046			—			123,046
Operating loss				(11,418	)		(66	)		(11,484	)		(24,288	)		(2,007	)		(26,295	)
Interest and other income, net				295			2			297			1,929			15			1,944
Net loss			$	(11,123	)	$	(64	)	$	(11,187	)	$	(22,359	)	$	(1,992	)	$	(24,351	)
Basic and diluted net loss per share			$	(0.21	)	$	(0.00	)	$	(0.21	)	$	(0.43	)	$	(0.04	)	$	(0.47	)

Summary of the Significant Effects of the Restatement on the Consolidated Balance Sheet

	March 31, 2004
	As previously
	reported			Adjustments			As restated
	(In thousands)
Accounts receivable, net	$	47,050		$	(309	)	$	46,741
Prepaid expenses and other current assets		6,398			(163	)		6,235
Total current assets		173,238			(472	)		172,766
Total assets		284,122			(472	)		283,650
Short-term borrowings		—			2,584			2,584
Accounts payable		11,055			(136	)		10,919
Deferred revenue		36,785			(767	)		36,018
Long term deferred revenue		2,802			3,264			6,066
Total liabilities		81,568			4,945			86,513
Accumulated deficit		(316,360	)		(5,113	)		(321,473	)
Accumulated other comprehensive income		2,557			(304	)		2,253

5

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

2.     Restatements — (Continued)

      Consequently, the effects of the restatements have been reflected in Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-Q.

3. Pro Forma Stock Based Compensation

      The Company measures compensation expense for its employee stock-based compensation using the intrinsic value method and provides pro forma disclosures of net loss as if the fair value method had been applied in measuring compensation expense. Under the intrinsic value method of accounting for stock based compensation, when the exercise price of options granted to employees is less than the fair value of the underlying stock on the grant date, compensation expense is recognized over the applicable vesting period.

      The following table summarizes the Company’s results on a pro forma basis as if it had recorded compensation expense based upon the fair value at the grant date for awards consistent with the methodology prescribed in SFAS 123, “Accounting for Stock-Based Compensation,” for the three and nine months ended December 31, 2004 and 2003:

		Three Months Ended						Nine Months Ended
		December 31,						December 31,
		2004			2003			2004			2003
					As restated						As restated
		(In thousands, except per share amounts)
Net income (loss), as reported		$	48		$	(11,187	)	$	(14,895	)	$	(24,351	)
	Add: Stock-based compensation expense determined under the intrinsic value method		—			46			—			201
	Less: Stock-based compensation expense determined under fair value method		(6,349	)		(10,526	)		(25,964	)		(37,353	)
Net income (loss), pro forma		$	(6,301	)	$	(21,667	)	$	(40,859	)	$	(61,503	)
Basic and diluted net loss per common share, as reported		$	0.00		$	(0.21	)	$	(0.28	)	$	(0.47	)
Basic and diluted net loss per common share, pro forma		$	(0.12	)	$	(0.42	)	$	(0.77	)	$	(1.18	)

4. Computation of Net Loss Per Share

      The calculation of the Company’s net loss per share on a basic and diluted basis is based on the weighted average number of common shares outstanding. There are no reconciling items in the numerator and denominator of the Company’s net loss per share calculation. Employee stock options and a non-employee warrant exercisable for 496,149 and 871,056 shares for the quarters ended December 31, 2004 and 2003, respectively, have been excluded from the net loss per share calculation because their effect would be anti-dilutive. Employee stock options and a non-employee warrant exercisable for 480,765 and 829,031 shares for the nine months ended December 31, 2004 and 2003, respectively, have been excluded from the net loss per share calculation because their effect would be anti-dilutive.

6

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

5. Supplemental Disclosures of Cash Flow Information

		Nine Months Ended
		December 31,
		2004			2003
					As restated
		(In thousands)
Cash paid during the period for interest		$	102		$	161
Non-cash investing and financing activities:
	Equipment purchased under capital lease	$	43		$	1,454
	Conversion of interest income into equity in private company	$	—		$	1,257
	Change in net unrealized loss on marketable securities	$	(388	)	$	(254	)

7

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

6. Segment Information

      The Company conducts operations worldwide and is primarily managed on a geographic basis with those geographic regions being the Americas, Europe, Japan and Asia Pacific region. Revenue is primarily attributable to the region in which the contract is signed and the product is deployed. Information regarding geographic areas is as follows:

		Three Months Ended				Nine Months Ended
		December 31,				December 31,
		2004		2003		2004		2003
				As restated				As restated
		(In thousands)
Revenue
Americas		$	31,290	$	28,956	$	89,379	$	80,370
Europe			16,965		10,652		35,250		33,313
Japan			2,173		5,693		11,838		12,492
Asia Pacific			4,535		4,731		11,199		10,530
	Total	$	54,963	$	50,032	$	147,666	$	136,705

		As of		As of
		December 31,		March 31,
		2004		2004
		(In thousands)
Long Lived Assets
Americas		$	65,501	$	70,497
Europe			1,923		2,189
Japan			1,632		1,681
Asia Pacific			573		360
	Total	$	69,629	$	74,727

7. Restructuring and Related Charges

      The Company has recorded restructuring and related charges to align its cost structure with changing market conditions. During the nine months ended December 31, 2004, the Company recorded a restructuring charge of $3.0 million due to a reduction in headcount and a $256,000 adjustment to previously recorded restructuring charges due to a revision in estimated severance and related benefits, resulting in a net restructuring charge of $2.8 million.

      The Company has previously recorded restructuring and related charges due to reductions in headcount and consolidation of offices. The cumulative amount of restructuring and related charges for the period September 30, 2001 through March 31, 2004, was $13.3 million.

      As of December 31, 2004 and March 31, 2004, respectively, $2.0 million and $3.1 million of restructuring and related charges remained unpaid. The December 31, 2004, balance includes $1.7 million relating to rent on excess facilities that is to be paid over the remaining rental periods and $220,000 relating to severance and other related benefits that is to be paid out according to the severance agreements.

8

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Unaudited)

7.  Restructuring and Related Charges — (Continued)

      The following table sets forth a summary of total restructuring and related charges, payments made against those charges and the remaining liabilities as of December 31, 2004:

	Excess			Severance and
	Facilities			Related Benefits			Total
	(In thousands)
Balance at March 31, 2004	$	2,360		$	749		$	3,109
Charges recorded during the nine months ended December 31, 2004		—			3,012			3,012
Adjustment due to revision in estimated severance and related benefits		—			(256	)		(256	)
Cash payments made during the nine months ended December 31, 2004		(613	)		(3,285	)		(3,898	)
Balance at December 31, 2004	$	1,747		$	220		$	1,967

8. Investment in Private Company

      In April 2000, the Company made an investment in a third party totaling $2,000,000 of which $1,000,000 was equity and $1,000,000 was convertible debt. The Company and this third party share a common Board member. In March 2002, the Company recorded an other-than-temporary decline in value of $200,000 in this equity investment. In June 2003, the Company received $1,000,000 as repayment of the convertible debt and converted $257,000 of interest income into additional equity. In September 2004, the Company recorded an other-than-temporary decline in value of $1,057,000 in this equity investment. The third party has been a business partner of the Company. As of December 31, 2004 and March 31, 2004, the carrying value of the investment in this third party was $0 and $1,057,000, respectively.

9. Borrowings

      The Company has a line of credit agreement with a bank to borrow up to a maximum principal amount of $20,000,000 with a maturity date of April 30, 2005. Borrowings under this note are limited to 80% of eligible accounts receivable. Interest is payable on any unpaid principal balance at the bank’s prime rate. The agreement includes restrictive covenants which require the Company to maintain, among other things, a ratio of quick assets to current liabilities, excluding deferred revenue of at least 1.5 to 1.0 and a quarterly revenue covenant such that total revenue for each fiscal quarter must be the greater of $35,000,000 or 85% of the average total revenue for the immediately preceding four fiscal quarters. As of December 31, 2004, the Company had not borrowed against this line of credit. In connection with the line of credit agreement, the Company has obtained letters of credit totaling approximately $1.1 million related to office leases.

      In March 2004, the Japanese subsidiary borrowed $2.6 million from a reseller, which was repaid in May 2004. The Company’s Japanese subsidiary had no borrowings outstanding as of December 31, 2004.

9

Item 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

      This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Examples of forward-looking statements include, but are not limited to, (i) projections of financial performance or financial results, including items such as revenue, costs or expense, cost savings, margins, revenue from specific geographic regions income or loss, earnings or loss per share, return to profitability on a pro-forma or GAAP basis, capital expenditures, costs of investigations, legal compliance efforts and modification, testing and remediation of internal controls, cash requirements or other financial items or metrics, the impact of expenses on levels of cash and marketable securities, sufficiency of working capital and projections regarding the market for the Company’s current and anticipated software offerings, (ii) statements of the plans or objectives of the Company or its management, including the development or enhancement of software, dates of availability of new products and new releases of existing products, competitive strategies and the impact of competition, development and continuation of strategic partnerships and alliances, contributions to future financial performance of any of our new or existing products, technologies or businesses, contribution to our financial performance by business partners or specific geographic regions, implementation and effect of sales and marketing initiatives by the Company, strength of results from geographic or specific vertical markets and allocation of resources to those markets, predictions of the timing and type of customer or market reaction to those initiatives or our product offerings, the ability to control expenses or achieve projected expense levels, future hiring, the Company’s business strategy and the execution on it and actions by customers and competitors, (iii) statements of future economic performance, economic conditions or the impact of recent changes in accounting standards and (iv) assumptions underlying any of the foregoing. In some instances, forward-looking statements can be identified by the use of the words “believes,” “anticipates,” “plans,” “expects,” “intends,” “may,” “will,” “should,” “estimates,” “predicts,” “continue”, the negatives thereof or similar expressions. Although we believe that the expectations reflected in the forward-looking statements are reasonable, our expectations or the forward-looking statements could prove to be incorrect, and actual results could differ materially from those indicated by the forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to risks and uncertainties, including (but not limited to) those discussed in Item 1 of our Amendment No. 2 Form 10-K for the year ended March 31, 2004 under the caption “Factors That May Affect Future Operating Results” and under this Item under the caption “Factors That May Affect Future Operating Results”. Achieving the future results or accomplishments described or projected in forward-looking statements depends upon events or developments that are often beyond our ability to control. All forward-looking statements and all reasons why actual results may differ that are included in this report are made as of the date of this report, and webMethods disclaims any obligation to publicly update or revise such forward-looking statements or reasons why actual results may differ.

RECENT DEVELOPMENTS

Restatement

      On February 3, 2005, the Company issued a press release and thereafter filed a Form 8-K announcing that the Company was restating its financial statements for fiscal year 2004 (ended March 31, 2004), as well as quarterly financial statements for each of the three interim quarterly reports in that fiscal year and for the three months ended June 30, 2004. That announcement related primarily to the recently completed independent investigation conducted by the Company’s Audit Committee into certain transactions of the Company’s Japanese subsidiary.

      As a result of the investigation, the Company’s Audit Committee concluded that improper activities of certain employees of the Japanese subsidiary caused the Company to misstate revenue and expenses for the year ended March 31, 2004 and certain quarters therein and the three months ended June 30, 2004, as well as misstate accounts receivable, deferred revenue, debt and certain other items attributable to the operations of the Japanese subsidiary. The Audit Committee’s investigation found that the improper

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activities included, among other things, engaging in improper licensing and professional services transactions and misrepresenting the transactions to the Company’s management; causing the Japanese subsidiary to engage in undisclosed and unauthorized borrowings; failing to record expenses and recording improper expenses; and creating false documents in support of improper transactions. The Audit Committee also determined that those employees of the Japanese subsidiary acted to conceal their improper activities from webMethods’ management.

      The adjustments to the Company’s financial statements in the restatements fall into five general categories: (i) adjustments to license, professional services and maintenance revenue relating to improper activities of certain employees of the Japanese subsidiary; (ii) adjustments to deferred revenue with respect to certain of those revenue items that should have been deferred and recognized as revenue in subsequent periods; (iii) adjustments to properly record expenses of the Japanese subsidiary in the appropriate period; (iv) adjustments to debt (excluding the reclassification of interest expense, which was nominal) and accounts receivable as a result of certain unauthorized borrowings by the Japanese subsidiary that were improperly recorded by it as collections of receivables; and (v) elimination of a provision for tax expense based upon estimates of the taxable income of the Company’s Japanese subsidiary.

      As a result of the foregoing, the Company’s consolidated financial statements for the three- and nine-month periods ended December 31, 2003 and the Company’s Consolidated Balance Sheet at March 31, 2004 have been restated from amounts previously reported. None of the adjustments described above have any impact on cash balances for any period. However, our consolidated statements of cash flows for the nine-months ended December 31, 2003 have been restated to reflect the restated net loss and revisions to certain balance sheet accounts.

      Consequently, the effects of the restatements have been reflected in Management’s Discussion and Analysis of Financial Condition and Results of Operations in this Form 10-Q.

OVERVIEW

Background

      We are a leading provider of business integration software enabling customers to integrate, assemble and optimize their available information technology assets to drive business process productivity. Our software products and related services give organizations the ability, seamlessly and in real-time, to integrate disparate information resources to create a unified, homogenous view of those resources. By effectively eliminating the disparity between the underlying systems, our customers are better able to connect their customers, vendors and business partners with our customer’s organization and their employees. The result is streamlined operational systems, increased visibility into critical data and business processes, and better connectivity to the information technology assets of our customers’ organizations, both internally and externally. Our customers’ organizations benefit by increasing the value from their information technology assets, by improving their ability to quickly respond to external business drivers, and by establishing the proper levels of control and governance over critical business processes.

      We license our software and provide services to Global 2000 customers through our direct sales force augmented by system integrators, application software partners and distributors. In Japan and the Asia Pacific region and, to a lesser extent, in Europe and the Americas, we also license our software through resellers. We license our software to customers primarily on a perpetual basis. As of December 31, 2004, we had over 1,250 customers, compared to approximately 1,000 customers as of December 31, 2003.

      We believe our strong focus and track record of ensuring that our software is successfully put into production (“production event”) is a strong competitive advantage and differentiator. During the third quarter of our fiscal year 2005, our global customer services group reported and documented approximately 165 separate production events as compared to over 130 such events reported and documented during the quarter ended December 31, 2003. Ensuring that our customers successfully implement our software in a timely manner enables them to achieve a greater return on their investment and, in many cases,

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encourages them to purchase additional software for other business integration projects and serve as a reference customer for us in our future sales efforts.

      In October 2003, the Company completed the business and asset acquisitions of The Mind Electric, Inc. (“TME”), The Dante Group and the portal solution previously known as DataChannel. TME was a leading provider of software for the service-oriented architectures and The Dante Group, Inc. was a provider of business activity monitoring software. The aggregate purchase price for these three acquisitions was approximately $32.4 million in cash.

Critical Accounting Policies and Estimates

      Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures. We evaluate our estimates, on an on-going basis, including those related to allowances for bad debts, investments, intangible assets, income taxes, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

      We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our condensed consolidated financial statements.

Revenue Recognition

      We enter into arrangements, which may include the sale of licenses of our software, professional services and maintenance or various combinations of each element. We recognize revenue based on Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended, and modified by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.” SOP 98-9 modified SOP 97-2 by requiring revenue to be recognized using the “residual method” if certain conditions are met. Revenue is recognized based on the residual method when an agreement has been signed by both parties, the fees are fixed or determinable, collection of the fees is probable, delivery of the product has occurred, vendor specific objective evidence of fair value exists for any undelivered element, and no other significant obligations remain. Revenue allocated to the undelivered elements is deferred using vendor-specific objective evidence of fair value of the elements and the remaining portion of the fee is allocated to the delivered elements (generally the software license). See Note 3 of the Consolidated Financial Statements included in the Company’s Amendment No. 2 to Form 10-K for the year ended March 31, 2004 for a more comprehensive discussion of our revenue recognition policies. Judgments we make regarding these items, including collection risk, can materially impact the timing of recognition of license revenue.

      Policies related to revenue recognition require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. These sources may publish new authoritative guidance which might impact current revenue recognition policies. We continue to evaluate our revenue recognition policies as new authoritative interpretations and guidance are published, and where appropriate, may modify our revenue recognition policies. Application of our revenue recognition policy requires a review of our license and professional services agreements with customers and may require management to exercise judgment in evaluating whether delivery has occurred, payments are fixed and determinable, collection is probable, and where applicable, if vendor-specific objective evidence of fair value exists for undelivered elements of the contract. In the event judgment in the application of our revenue recognition policies is incorrect, the revenue recognized by us could be impacted.

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Allowance for Doubtful Accounts

      We maintain allowances for doubtful accounts for estimated losses which may result from the inability of our customers to make required payments to us. These allowances are established through analysis of the credit-worthiness of each customer with a receivable balance, determined by credit reports from third parties, published or publicly available financial information, customer’s specific experience including payment practices and history, inquiries, and other financial information from our customers. The use of different estimates or assumptions could produce materially different allowance balances. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Goodwill and Intangibles Assets

      We record goodwill and intangible assets when we acquire other businesses. The allocation of acquisition cost to intangible assets and goodwill involves the extensive use of management’s estimates and assumptions, and the result of the allocation process can have a significant impact on our future operating results. Financial Accounting Standards Board No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), which was issued during fiscal year 2002 and adopted by us on April 1, 2002, eliminated the amortization of goodwill and indefinite lived intangible assets. Intangible assets with finite lives are amortized over their useful lives while goodwill and indefinite lived assets are not amortized under SFAS 142, but are periodically tested for impairment. In accordance with SFAS 142, all of our goodwill is associated with our corporate reporting unit, as we do not have multiple reporting units. On an annual basis, or as events occur or circumstances change, we will evaluate whether an impairment of the goodwill may exist. Goodwill is tested for impairment using a two-step process. The first step is to identify a potential impairment and the second step measures the amount of the impairment loss, if any. Goodwill is deemed to be impaired if the carrying amount of the asset exceeds its estimated fair value.

Acquired In-process Research and Development

      Costs to acquire in-process research and development technologies which have no alternative future use and which have not reached technological feasibility at the date of acquisition are expensed as incurred (see Note 13 in the Consolidated Financial Statements included in the Company’s Amendment No. 2 to Form 10-K for the year ended March 31, 2004 for more comprehensive information).

Foreign Currency Effects

      The functional currency for our foreign operations is the local currency. The financial statements of foreign subsidiaries have been translated into United States dollars. Asset and liability accounts have been translated using the exchange rate in effect at the balance sheet date. Revenue and expense accounts have been translated using the average exchange rate for the period. The gains and losses associated with the translation of the financial statements resulting from the changes in exchange rates from period to period have been reported in other comprehensive income or loss. To the extent assets and liabilities of the foreign operations are realized or the foreign operations are expected to pay back the intercompany debt in the foreseeable future, amounts previously reported in other comprehensive income or loss would be included in net income or loss in the period in which the transaction occurs. Transaction gains or losses are included in net income or loss in the period in which they occur.

Accounting for Income Taxes

      We have recorded a tax valuation allowance to reduce our deferred tax assets to the amount that is expected to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset

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in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

Restructuring and Related Charges

      We have recorded restructuring costs to align our cost structure with changing market conditions. These restructuring plans resulted in a reduction in headcount and consolidation of facilities through the closing of excess offices. Our restructuring costs included accruals for the estimated loss on facilities that we intend to sublease based on estimates of the timing and amount of sublease income. We reassess this liability each period based on market conditions. Revisions to our estimates of this liability could materially impact our operating results and financial position in future periods if anticipated events and key assumptions, such as the timing and amounts of sublease rental income, either change or do not materialize.

Litigation and Contingencies

      We are subject to the possibility of various loss contingencies arising in the ordinary course of business. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted.

RESULTS OF OPERATIONS

      The following table summarizes the results of our operations for the three and nine months ended December 31, 2004 and 2003 (all percentages are calculated using the underlying data in thousands):

	Three Months Ended December 31,									Nine Months Ended December 31,
							Percentage									Percentage
	2004			2003			Change			2004			2003			Change
				As restated									As restated
	($ in thousands)
Total revenue	$	54,963		$	50,032			10	%	$	147,666		$	136,705			8	%
Gross profit		40,348			35,206			15	%		102,435			96,751			6	%
% of total revenue		73	%		70	%					69	%		71	%
Total operating expenses		40,734			46,690			(13	)%		117,663			123,046			(4	)%
% of total revenue		74	%		93	%					80	%		90	%
Operating loss		(386	)		(11,484	)		(97	)%		(15,228	)		(26,295	)		(42	)%
% of total revenue		(1	)%		(23	)%					(10	)%		(19	)%
Net income (loss)	$	48		$	(11,187	)		(100	)%	$	(14,895	)	$	(24,351	)		(39	)%
% of total revenue		0	%		(22	)%					(10	)%		(18	)%

      Our net income for the three months ended December 31, 2004 was $48,000 as compared to a net loss of $11.2 million for the three months ended December 31, 2003. This improvement was due primarily to a $4.9 million increase in total revenue and a $6.0 million decrease in total operating expenses in the three months ended December 31, 2004 compared to the same period in the prior year. The decrease in total operating expenses was due primarily to a $4.3 million in process research and development charge and a $1.3 million restructuring charge included in the three months ended December 31, 2003.

      Our net loss of $14.9 million for the nine months ended December 31, 2004 decreased by approximately $9.5 million from a net loss of approximately $24.4 million in the nine months ended December 31, 2003. The decrease in net loss was due primarily to the following changes in the nine months ended December 31, 2004 as compared to the prior year period: an $11.0 million increase in total revenue and a $5.4 million decrease in total operating expenses which was offset by a $5.3 million increase

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in total cost of revenue and a $1.1 million impairment of an equity investment in a private company equity.

Revenue

      The following table summarizes our revenue for the three and nine months ended December 31, 2004 and 2003:

	Three Months Ended December 31,							Nine Months Ended December 31,
			Percentage							Percentage
	2004		Change			2003		2004		Change			2003
						As restated							As restated
	($ in thousands)
License	$	25,953		4	%	$	25,037	$	64,610		(4	)%	$	67,061
Professional services		11,854		6	%		11,210		36,455		19	%		30,543
Maintenance		17,156		24	%		13,785		46,601		19	%		39,101
Total revenue	$	54,963		10	%	$	50,032	$	147,666		8	%	$	136,705

      The following table summarizes our net revenue by geographic region for the three and nine months ended December 31, 2004 and 2003:

	Three Months Ended December 31,							Nine Months Ended December 31,
			Percentage							Percentage
	2004		Change			2003		2004		Change			2003
						As restated							As restated
	($ in thousands)
Americas	$	31,290		8	%	$	28,956	$	89,379		11	%	$	80,370
Europe		16,965		59	%		10,652		35,250		6	%		33,313
Japan		2,173		(62	)%		5,693		11,838		(5	)%		12,492
Asia Pacific		4,535		(4	)%		4,731		11,199		6	%		10,530
Total revenue	$	54,963		10	%	$	50,032	$	147,666		8	%	$	136,705

      Total revenue for the three months ended December 31, 2004 increased by 10% compared to the same period in the prior year due to increases in license, professional services and maintenance revenue. Total revenue for the nine months ended December 31, 2004 increased by 8% due to increases in professional services and maintenance revenue, offset by a decrease in license revenue.

      License revenue for the three months ended December 31, 2004 increased by 4% as compared to the same period in the prior year despite our having fewer quota bearing sales representatives during the three months ended December 31, 2004 as compared to the same period in the prior year. This 4% increase in license revenue was due to our broader suite of software products available for sale (due to our October 2003 acquisitions of The Mind Electric, Inc., The Dante Group, Inc. and DataChannel), as well as improved sales force productivity and execution resulting from improved sales processes.

      The 4% decrease in license revenue for the nine months ended December 31, 2004 was due primarily to unexpectedly low license revenue in the three month period ended June 30, 2004. During that period, we did not close a number of expected opportunities we were working on near the end of that quarter and experienced lower closure rates of large transactions across almost every geographical region. We believe that prospective customers exhibited an unexpected degree of cautiousness during the June 2004 quarter, with greater involvement of their procurement departments and greater demands for various contractual contingencies unacceptable to us, which extended or delayed anticipated closure of license transactions. We also had occasional sales execution or forecasting issues that contributed to license transactions not closing in the June 2004 quarter as we anticipated.

      Professional services revenue for the three and nine month periods ended December 31, 2004 increased by 6% and 19%, respectively as compared to the same periods in the prior year. These increases

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in professional services revenue levels are due primarily to an increase in billable hours recorded by our professional services staff and/or subcontractors, which is due partially to the increased demand for our professional services from our customer base.

      Maintenance revenue for the three and nine month periods ended December 31, 2004 increased by 24% and 19%, respectively as compared to the respective periods in the prior year due primarily to the increase in the number of copies of our software licensed by our customers and the cumulative effect of initial or renewed post-contract maintenance and support agreements, which are recognized ratably over the term of the agreement.

Cost of Revenue and Gross Margin

      The following table summarizes our gross margin by type of revenue, excluding stock based compensation, for the three and nine months ended December 31, 2004 and 2003:

	Three Months						Nine Months
	Ended						Ended
	December 31,						December 31,
	2004			2003			2004			2003
				As restated						As restated
License margin		97	%		95	%		95	%		97	%
Professional services and maintenance margin		53	%		45	%		49	%		46	%
Gross margin		73	%		70	%		69	%		71	%

      Total gross margin, license margin, and professional services and maintenance margin for the three months ended December 31, 2004 improved as compared to the prior year period. Gross margin for the nine months ended December 31, 2004, decreased to 69% compared to 71% in the prior year period due primarily to the decrease in license revenue as a percentage of total revenue and the increase in cost of license revenue due to the amortization of intangibles for technology acquired in October 2003, which was partially offset by an improvement in professional services and maintenance margins.

      Our cost of license revenue consists primarily of royalties for products embedded in our software which we license from third parties, and amortization of intangible related to certain technology we acquired in October 2003. The improvement of our license margin to 97% for the three months ended December 31, 2004 is due to a reduction in royalties related to a product previously embedded in our software, which we licensed from a third party, and which we have replaced with internally developed software.

      The decrease in our license margin to 95% for the nine months ended December 31, 2004 is due to the full period effect of the amortization of intangibles related to certain technology we acquired in October 2003, partially offset by a reduction in royalties related to a product previously embedded in our software, which we licensed from a third party, and which we have replaced with internally developed software.

      Our cost of professional services and maintenance revenue consists of costs related to our professional services and support personnel, as well as subcontractors we hire to provide implementation and support services. Our gross margin on professional services and maintenance revenue was 53% and 45% for each of the three months ended December 31, 2004 and 2003, respectively, and 49% and 46% for the nine months ended December 31, 2004 and 2003, respectively. These margin improvements are due primarily to increases in maintenance revenue for the three and nine months ended December 31, 2004.

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Operating Expenses

      The following table presents certain information regarding our operating expenses during the three and nine months ended December 31, 2004 and 2003:

	Three Months Ended December 31,									Nine Months Ended December 31,
							Percentage									Percentage
	2004			2003			Change			2004			2003			Change
				As restated									As restated
	($ in thousands)
Operating expenses:
Sales and marketing*	$	22,103		$	24,617			(10	)%	$	63,143		$	68,534			(8	)%
% of total revenue		40	%		49	%					43	%		50	%
Research and development*		10,877			11,446			(5	)%		32,747			33,503			(2	)%
% total revenue		20	%		23	%					22	%		25	%
General and administrative*		7,093			4,333			64	%		17,034			13,282			28	%
% of total revenue		13	%		9	%					12	%		10	%
Stock based compensation and warrant charge		661			695			(5	)%		1,983			2,128			(7	)%
% of total revenue		1	%		1	%					1	%		2	%
Restructuring charges		—			1,315			(100	)%		2,756			1,315			110	%
% of total revenue		0	%		3	%					2	%		1	%
In process research and development		—			4,284			(100	)%		—			4,284			(100	)%
% of total revenue		0	%		8	%					0	%		3	%
Total operating expenses	$	40,734		$	46,690			(13	)%	$	117,663		$	123,046			(4	)%
% of total revenue		74	%		93	%					80	%		90	%

*  Excludes stock based compensation and warrant charge, as applicable.

      Our operating expenses are primarily classified as sales and marketing, research and development and general and administrative. Each category includes related expenses for compensation, employee benefits, professional fees, travel, communications and allocated facilities, recruitment and overhead costs. Our sales and marketing expenses also include expenses which are specific to the sales and marketing activities, such as commissions, trade shows, public relations, business development costs, promotional costs and marketing collateral. Also included in our operating expenses is the amortization of deferred stock compensation and warrant charge, as applicable and restructuring charges. For the three months ended December 31, 2004, our operating expenses, excluding stock based compensation and warrant charge, restructuring charges and in process research and development, decreased by $323,000 to $40.1 million compared to $40.4 million in the prior year period. This decrease was due primarily to our continued focus on controlling expenses. For the nine months ended December 31, 2004, our operating expenses, excluding stock based compensation and warrant charge, restructuring charges and in process research and development, decreased $2.4 million to $113.0 million from $115.3 million in the prior year period.

      For the three months ended December 31, 2004, our sales and marketing expense, excluding stock based compensation and warrant charge, decreased by $2.5 million and decreased as a percentage of revenue compared to the prior year period. The absolute dollar decrease was primarily due to lower personnel costs due to a decrease in the number of sales and marketing employees, as well as decreases in marketing program costs and lower travel costs. For the nine months ended December 31, 2004 sales and marketing expense, excluding stock based compensation and warrant charge, decreased by $5.4 million and decreased as a percent of revenue compared to the prior year period. The absolute dollar decrease was primarily due to lower personnel costs due to a decrease in the number of sales and marketing employees, as well as decreases in commission expenses, marketing program costs and travel costs. For the three and nine months ended December 31, 2004, research and development expense, excluding stock based

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compensation, decreased $569,000 and $756,000, respectively, in absolute dollars and decreased as a percentage of revenue due to the increase in total revenue.

      For the three months ended December 31, 2004, general and administrative expense, excluding stock based compensation, increased by $2.8 million and increased to 13% as a percentage of revenue compared to 9% in the prior year period. For the nine months ended December 31, 2004, general and administrative expense, excluding stock based compensation, increased by $3.8 million and increased as a percentage of revenue compared to the prior year period. In both the three and nine month periods ended December 31, 2004, the increases were primarily due to an increase in accounting and legal services associated with the internal investigation of the Company’s Japanese subsidiary as discussed in Note 2 above, as well as additional personnel costs, Sarbanes-Oxley Act compliance costs and costs related to an employment matter.

      Stock based compensation and warrant charge was $2.0 million and $2.2 million during the nine months ended December 31 2004 and 2003, respectively, of which $57,000 was included in cost of sales for the nine months ended December 31, 2003. Stock based compensation and warrant charge was $661,000 and $707,000 in the three months ended December 31, 2004 and 2003, respectively, of which $12,000 was included in cost of sales for the three months ended December 31, 2003. Deferred stock based compensation and warrant charge was recorded for the following transactions:

      (i) The grant of stock options to employees and non-employee directors at exercise prices less than the deemed fair value of our common stock at the date of the grant; and

      (ii) An OEM/ Reseller agreement we entered into with i2 Technologies (i2) in March 2001 under which we issued a warrant which, as amended, permits i2 to purchase 710,000 shares of webMethods, Inc. common stock at an exercise price of $28.70 per share. The fair value of the warrant, based on the Black-Scholes valuation model, was $23.6 million on the date of issuance which has been recorded as a deferred warrant charge. As part of the amended agreement, i2 will pay us OEM fees of $8.8 million over the amended term of the OEM/ Reseller agreement which will be recorded as a reduction to the deferred warrant charge and will not be recorded as revenue.

      The deferred stock compensation and warrant charge is presented as a reduction of stockholders’ equity and is amortized over the vesting period of the applicable equity arrangement and is shown by expense category.

Interest Income

      Interest income was $615,000 for the three months ended December 31, 2004 compared to $549,000 for the prior year period. For the nine months ended December 31, 2004, interest income decreased to $1.7 million compared to $2.3 million for the prior year period primarily due to decreased cash and marketable securities balances related primarily to the cash used in connection with the October 2003 acquisitions.

Interest Expense

      Interest expense is primarily due to equipment leasing arrangements in the Americas. During the three and nine months ended December 31, 2004, interest expense was $28,000 and $84,000, respectively as compared to $56,000 and $162,000, respectively for the prior year periods.

Other Expense

      Other expense is primarily due to net losses on foreign currency transactions. During the three and nine months ended December 31, 2004, we incurred other expense of $27,000 and $31,000, respectively, compared to $196,000 and $171,000 in the respective prior year periods.

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Income Taxes

      We have recorded a valuation allowance for the full amount of our net deferred tax assets, as the realizability of the deferred tax assets is not currently probable.

      As of March 31, 2004, we had net operating loss carry-forwards of approximately $279.8 million. These net operating loss carry-forwards are available to reduce future taxable income and begin to expire in fiscal year 2007. Under the provisions of the Internal Revenue Code, certain substantial changes in our ownership have limited the amount of net operating loss carry-forwards that could be utilized annually in the future to offset taxable income.

      During the three and nine months ended December 31, 2004, our operations from foreign subsidiaries incurred tax expense of $126,000 and $195,000, respectively, that the Company cannot offset by utilizing its net operating losses generated in prior years.

LIQUIDITY AND CAPITAL RESOURCES

      As of December 31, 2004, cash and marketable securities available for sale totaled $145.9 million compared to $155.9 million as of March 31, 2004.

      Net cash used in operating activities was $7.4 million and $12.7 million for the nine months ended December 31, 2004 and 2003, respectively. The decrease in cash used in operating activities during the nine months ended December 31, 2004, compared to the nine months ended December 31, 2003, was due primarily to a $9.5 million reduction in net loss, offset by $3.5 million in net changes in non-cash expenses and charges.

      Net cash used in investing activities was $485,000 and $6.4 million for the nine months ended December 31, 2004 and 2003, respectively. During the nine months ended December 31, 2004, net cash provided from the maturity of marketable securities was $3.4 million, as compared to $26.9 million for the nine months ended December 31, 2003, and net cash used in the acquisitions of business and technology totaled $32.4 million. Capital expenditures were $3.9 million and $2.0 million in the nine months ended December 31, 2004 and 2003, respectively. Capital expenditures consisted of purchases of operating resources to manage operations, including computer hardware and software, office furniture and equipment and leasehold improvements. We generally fund capital expenditures through capital leases and the use of working capital. Additionally, for the months ended December 31, 2003, we received $1.0 million in proceeds from the prepayment of a portion of an investment in a private company.

      Net cash used in financing activities was $362,000 for the nine months ended December 31, 2004, and net cash provided by financing activities was $474,000 for the nine months ended December 31, 2003. These cash flows primarily reflect net cash proceeds from exercises of stock options, Employee Stock Purchase Plan common stock issuances and short-term borrowings by the Company’s Japanese subsidiary, offset by payments on capital leases and short-term borrowings in the nine months ended December 31, 2004 and 2003. Net cash proceeds from exercises of stock options and Employee Stock Purchase Plan common stock issuances were $2.9 million and $3.3 million for each of the nine months ended December 31, 2004 and 2003, respectively. Net cash proceeds from short-term borrowings by the Company’s Japanese subsidiary, were $3.5 million and $3.3 million for the nine months ended December 31, 2004 and 2003, respectively. Payments on short-term borrowings were $6.1 million and $3.4 million for the nine months ended December 31, 2004 and 2003, respectively. As of December 31, 2004, the Company had no borrowings outstanding. Payments on capital leases were $747,000 and $2.8 million for the nine months ended December 31, 2004 and 2003, respectively.

      We have a line of credit to borrow up to a maximum principal amount of $20,000,000 with a maturity date of April 30, 2005. We intend to renew the line of credit before it expires. Any borrowings under this line bear interest at the bank’s prime rate per annum. As of December 31, 2004, we had not borrowed against this line of credit. In connection with the line of credit, we have outstanding letters of credit totaling approximately $1.1 million related to office leases. In connection with leasing of replacement office

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space, we will be required to supply additional letters of credit that are expected to total $1.5 million. Borrowings under this line are limited to 80% of eligible accounts receivable.

      We believe that our existing working capital and our line of credit will be sufficient to meet our operating resource expenditure requirements for at least the next twelve months. However, we may utilize cash resources to fund acquisitions or investments in complementary businesses, technologies or product lines. In the event additional financing is required, we may not be able to raise it on acceptable terms or at all. We are not a party to any agreements with, or commitments to, any special-purpose entities that would constitute off-balance sheet financing.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

      In December 2004 the Financial Accounting Standards Board issued revised SFAS No. 123R, “Share-Based Payment,” which sets forth accounting requirements for “share-based” compensation to employees and requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based compensation. The Company currently provides pro forma disclosure of the effect on net income or loss and earnings or loss per share of the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123R is effective in interim or annual periods beginning after June 15, 2005. Accordingly, beginning in its second quarter of fiscal 2006, the Company will be required to adopt SFAS No. 123R and recognize the cost of all share-based payments to employees, including stock option grants, in the income statement based on their fair values. The Company is currently evaluating the impact of the adoption of SFAS 123R on its financial position and results of operations, including the valuation methods and support for the assumptions that underlie the valuation of the awards. However, we currently believe that the adoption of SFAS 123R will have a material effect on our results of operations.

FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

      You should consider the following factors when evaluating our statements in this report and elsewhere. The Company is subject to risks in addition to those described below, which, at the date of this report, we may not be aware of or which we may not consider significant. Those risks may adversely affect our business, financial condition, results of operations or the market price of webMethods’ common stock.

Unanticipated fluctuations in our quarterly revenue or operating results, or failure to return to and maintain profitability, could significantly affect the price of webMethods’ common stock.

      Quarter-to-quarter or year-to-year comparisons of our financial results are not necessarily meaningful indicators of our future revenue or operating results and should not be relied on as an indication of our future performance. If our quarterly or annual revenue or operating results fail to meet the guidance we provide publicly or the expectations of investors or analysts, that could have a material adverse effect on the market price of webMethods’ common stock. Our quarterly operating results have varied substantially in the past and may vary substantially in the future depending upon a number of factors, including the changes in demand for our products and services, the timing and terms of large transactions with customers, competitive pressures, fluctuations in the revenue of our geographic regions, our ability to execute on our business plans, the impact of investigations and changes on management or other personnel in various geographical regions, the amount and timing of operating costs, the costs of investigating allegations or resolving pending or threatened legal claims, delays in the availability of new products or new releases of existing products, costs of legal compliance and modification, testing and remediation of internal controls and changes that we may make in our business, operations and infrastructure. In addition, economic conditions and other events beyond our control, such as economic uncertainties, geopolitical developments or uncertainties, travel limitations, infectious outbreaks like SARS, terrorist acts and other major, unanticipated events may have significant negative impact on our quarterly operating results and delay our ability to return to and maintain profitability on a basis determined in accordance with accounting principles generally accepted in the United States (GAAP). Further, the expensing of stock options in the future, the costs of compliance with the Sarbanes-Oxley Act and other legal and compliance

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requirements could add significant costs that may impede or delay our ability to return to and maintain profitability on a GAAP basis. If our quarterly revenue or operating results are adversely impacted, that could have a material adverse effect on the market price of webMethods’ common stock.

      We generally close a substantial number of license transactions in the last month of each quarter, which makes it more difficult to gauge the level of license revenue we will have in any quarter until near to, or after, its conclusion. We expect to continue devoting resources to our sales and marketing operations and our research and development activities. Our operating expenses, which include sales and marketing, research and development and general and administrative expenses, are based on our expectations of future revenue and are relatively fixed in the short term. If revenue falls below our expectations in a quarter or our operating costs increase in a quarter and we are not able to quickly reduce our spending in response, our operating results for that quarter could be significantly below the guidance we provide publicly or expectations of investors or analysts. It is possible that our revenue or operating results in the future may be below the guidance we provide publicly and the expectations of investors or analysts and, as a result, the market price of webMethods’ common stock may fall significantly. In addition, the stock market, particularly the stock prices of independent infrastructure software companies, has been very volatile. This volatility is often not related to the operating performance of the companies. From our initial public offering in February 2000 until February 11, 2005, the closing price of webMethods’ stock on the Nasdaq National Market has ranged from a high of $308.06 to a low of $3.96.

Growth of our sales may slow from time to time, causing our quarterly operating results to fluctuate and possibly resulting in significant volatility in the market price of webMethods’ common stock.

      Due to customer demand, economic conditions, the timing and terms of large transactions with customers, competitive pressures, our ability to execute on our business plan, changes that we may make in our business or operations, seasonal factors or major, unanticipated events, we may experience a lower growth rate for, no growth in, or a decline in quarterly or annual revenue from sales of our software and services in some or all of the geographic regions in which we operate. For example, the growth rate for revenue from sales of our software and services during summer months may be lower than at other times during the year, particularly in European markets, and may be impacted by the annual nature of our sales compensation plans. Growth of revenue from sales of software in Japan may be impacted by the recent investigation of improper activities there.

      We also may experience delays or declines in expected revenue due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers, purchasing practices and requirements of prospective customers, including contract provisions or contingencies they may request, changes in demand for our software and services, changes that we may make in our business or operations, economic uncertainties, geopolitical developments or uncertainties, travel limitations, infectious outbreaks like SARS, terrorist acts or other major unanticipated events. These periods of slower or no growth may lead to lower revenue, which could cause fluctuations in our quarterly operating results. In addition, variations in sales cycles may have an impact on the timing of our revenue, which in turn could cause our quarterly operating results to fluctuate. To successfully sell our software and services, we generally must educate our potential customers regarding their use and benefits, which can require significant time and resources. Any misperception by us in the needs of our customers and prospective customers, or any delay in sales of our software and services could cause our revenue and operating results to vary significantly from quarter to quarter, which could result in significant volatility in the market price of webMethods’ common stock.

We are a relatively young company and have a relatively limited operating history with which to evaluate our business and the prospects of achieving our anticipated growth and our forecasts of operating results.

      We commenced operations in September 1996. Active Software, with which we completed a merger in August 2000, was incorporated in September 1995. We have been operating as a combined company since August 2000. In addition, we have acquired several businesses and technologies with limited operating histories. During much of our history, we have sustained losses from operations. For a number of

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reasons described in other factors listed here, we may not be able to achieve our anticipated revenue growth, and control costs of operations, to achieve our forecasts of operating results, including returning to and maintaining profitability on a GAAP basis. That situation could have a material adverse effect on the market price of webMethods’ common stock. If we do not generate sufficient revenue to achieve and maintain income from operations, our growth could be limited unless we are willing to incur operating losses that may be substantial and are able to fund those operating losses from our available assets or, if necessary, from the sale of additional capital through public or private equity or debt financings. If we are unable to grow as planned, our chances of returning to and maintaining profitability and the anticipated or forecasted results of operations could be reduced, which, in turn, could have a material adverse effect on the market price of webMethods’ common stock.

Our target markets are highly competitive, and we may not be able to compete effectively.

      The markets for business integration solutions, Service Oriented Architecture capabilities, Business Activity Monitoring and Business Process Management solutions and Composite Application framework capabilities are rapidly changing and intensely competitive. There are a variety of methods available to integrate software applications, monitor and optimize business processes and workflows, provide Service-Oriented Architectures, enable Web services and provide customers the capabilities to run, manage and optimize their enterprise. We expect that competition will remain intense as the number of entrants and new technologies increases. We do not know if our target markets will widely adopt and deploy our Service Oriented Architecture technology, our webMethods Fabric product suite or other solutions we offer or have announced. If our technology, software and solutions are not widely adopted by our target markets or if we are not able to compete successfully against current or future competitors, our business, operating results and financial condition may be harmed. Our current and potential competitors include, among others, large software vendors; companies that develop their own integration software or Web services technology; business integration software vendors; electronic data interchange vendors; vendors of proprietary enterprise application integration; vendors of portal products; and application server vendors. We also face competition from providers of various technologies to enable Web services. Further, we face competition for some aspects of our software and service offerings from major system integrators, both independently and in conjunction with corporate in-house information technology departments, which have traditionally been the prevalent resource for application integration. In addition, application software vendors with whom we currently have or have had strategic relationships sometimes offer competitive solutions or may become or are competitors. Some of our competitors or potential competitors may have more experience developing technologies or solutions competitive with ours, larger technical staffs, larger customer bases, more established distribution channels, greater brand recognition and greater financial, marketing and other resources than we do. Our competitors may be able to develop products and services that are superior to our solutions, that achieve greater customer acceptance or that have significantly improved functionality or performance as compared to our existing solutions and future software and services. In addition, negotiating and maintaining favorable customer and strategic relationships is critical to our business. Our competitors may be able to negotiate strategic relationships on more favorable terms than we are able to negotiate. Many of our competitors may also have well-established relationships with our existing and prospective customers. Increased competition may result in reduced margins, loss of sales, decreased market share or longer sales cycles or sales processes involving more extensive demonstrations of product capabilities, which in turn could harm our business, operating results and financial condition.

Costs of legal investigations and compliance matters, and demands on management time and attention relating to those matters, may increase our operating expenses and impact our operating results.

      The recently-concluded investigation by our Audit Committee concerning certain activities of personnel in our Japanese subsidiary, as well as the costs associated with a personnel matter have resulted in significant expense and management time and attention, and we anticipate that we will incur significant expense relating to the Audit Committee investigation and the associated restatements of financial statements. Further investigations, personnel matters or other legal compliance matters could significantly increase expenses and demands on management time and attention, thereby possibly adversely impacting

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our operating results, and potentially leading to unanticipated increases in expenses in the future, which could materially decrease the market price of webMethods’ common stock.

Our financial statements have been impacted, and could again be impacted, by improper activities of our personnel.

      As we have recently experienced with our restatements for the fiscal year ended March 31, 2004 and the three months ended June 30, 2004, our financial statements can be adversely impacted by our employees’ improper activities and unauthorized actions and their concealment of their activities. For instance, revenue recognition depends upon the terms of our agreements with our customers, among other things. Our personnel may act outside of their authority, such as by negotiating additional terms or modifying terms, without our knowledge that could impact our ability to recognize revenue in a timely manner, and they could commit us to obligations or arrangements that may have a serious financial impact to our results of operations or financial condition. In addition, depending upon when we learn of improper activities or unauthorized actions, we may have to restate our financial statements for a previously reported period, which could have a significant adverse impact on our business, operating results and financial condition. We have implemented, and are implementing, new or additional controls to prevent such conduct, but we cannot be certain that these new or additional controls will be effective.

We rely on strategic alliances with major system integrators and other similar relationships to promote and implement our software and, if these relationships diminish or terminate, we may lose important deals and marketing opportunities.

      We have established strategic relationships with system integration partners and others. These strategic partners provide us with important sales and marketing opportunities, create opportunities to license our solutions, and greatly increase our implementation capabilities. We also have similar relationships with resellers, distributors and other technology leaders. During our fiscal year 2004 and the first three quarters of our fiscal year 2005, our systems integrator partners directly or indirectly influenced a significant portion of our license revenue, and we expect that leverage to continue in future periods. If our relationships with our strategic business partners diminished or terminated or if we failed to work effectively with our partners or to grow our base of strategic partners, resellers and distributors, we might lose important opportunities, including sales and marketing opportunities, our business may suffer and our financial results could be adversely impacted. Our partners often are not required to market or promote our software and generally are not restricted from working with vendors of competing software or solutions or offering their own solutions providing similar capabilities. Accordingly, our success will depend on their willingness and ability to devote sufficient resources and efforts to marketing our software and solutions rather than the products of competitors or that they offer themselves. If these relationships are not successful or if they terminate, our revenue and operating results could be materially adversely affected, our ability to increase our penetration of our target markets could be impaired, we may have to devote substantially more resources to the distribution, sales and marketing, implementation and support of our software than we would otherwise, and our efforts may not be as effective as those of our partners, which could harm our business, our operating results and the market price of webMethods’ common stock.

Our assessment as to the adequacy of our internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002 may cause our operating expenses to increase. If we are unable to certify the adequacy of our internal controls and our independent auditors are unable to attest thereto, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of webMethods’ common stock.

      As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission adopted rules requiring public companies to include a report of management on the company’s internal control over financial reporting in their annual reports on Form 10-K. These rules will first apply to webMethods with respect to our fiscal year ending March 31, 2005. To comply with the Sarbanes-Oxley Act and the SEC’s new rules and regulations, we are evaluating our internal control

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systems and taking remedial actions to allow management to report on, and our independent auditors to attest to, our internal control over financial reporting. As a result, we have incurred expenses, and expect to incur additional expenses, and diversion of management’s time and attention, which may increase our operating expenses and impair our ability to sustain profitability on a pro forma basis and achieve profitability on a GAAP basis. While we are endeavoring to implement the requirements relating to internal controls and all other aspects of Section 404 in a timely manner, there can be no assurance that we will be able to maintain our schedule to complete all assessment and testing in a timely manner and, if we do not, that we and our independent auditors will have the resources available to complete necessary assessment and reporting on internal controls on a timely basis. The material weakness in our internal controls discovered as a result of the recently-completed internal investigation concerning our Japanese subsidiary increases the difficulty of completing the modification, testing and remediation of our internal controls by March 31, 2005. Further, we cannot be certain that our testing of internal controls and resulting remediation actions will yield adequate internal controls over financial reporting as required by Section 404. If we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance, there could be an adverse reaction in the financial markets due to a loss of confidence in the reliability of the our financial statements, which could cause the market price of webMethods’ common stock to decline.

Our disclosure controls and procedures and our internal controls over financial reporting may not be effective to detect all errors or to detect and deter wrongdoing, fraud or improper activities in all instances.

      Our management, including our Chief Executive Officer and Chief Financial Officer, do not expect that our disclosure controls and procedures or our internal controls over financial reporting will prevent all errors and fraud. In designing our control systems, management recognizes that any control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the desired control objectives. Further, the design of a control system must reflect the necessity of considering the cost-benefit relationship of possible controls and procedures. Because of inherent limitations in any control system, no evaluation of controls can provide absolute assurance that all control issues and instances of wrongdoing, if any, that may affect our operations have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, that breakdowns can occur because of simple error or mistake and that controls may be circumvented by individual acts by some person, by collusion of two or more people or by management’s override of the control. The design of any control system also is based in part upon certain assumptions about the likelihood of a potential future event, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in cost-effective control systems, misstatements due to error or wrongdoing may occur and not be detected. Over time, it is also possible that controls may become inadequate because of changes in conditions that could not be, or were not, anticipated at inception or review of the control systems.

Treating stock options and employee stock purchase plan participation as a compensation expense could significantly impair our ability to return to and maintain profitability.

      The Financial Accounting Standards Board has proposed requiring companies to record compensation expense regarding stock options and participation in employee stock purchase plans. We grant stock options to our employees, officers and directors and we administer an employee stock purchase plan (ESPP). Information on our stock option plan and ESPP, including the shares reserved for issuance under those plans, the terms of options granted, the terms of ESPP participation, and the shares subject to outstanding stock options, is included in Note 15 of the Notes to Consolidated Financial Statements of webMethods, Inc. included in our Amendment No. 2 on Form 10-K for our fiscal year ended March 31, 2004. If we choose, or are required, to record an expense for our stock-based compensation plans, we could incur a significant compensation expense, and any such expense could significantly impair our ability to return to and maintain profitability on a GAAP basis. That impact on our ability to return to and maintain profitability on a GAAP basis could have a material adverse effect on the market price of webMethods’ common stock.

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Our operating results may decline and our customers may become dissatisfied if we do not provide professional services to implement our solutions or if we are unable to establish and maintain relationships with third-party implementation providers.

      Customers that license our software typically engage our professional services staff or third-party consultants to assist with product implementation, training and other professional consulting services, and we believe our strong focus on ensuring that our software is successfully put into production is a strong competitive advantage and differentiator. We believe that many of our software sales depend, in part, on our ability to provide our customers with these services and to attract and educate third-party consultants to provide similar services. New professional services personnel and service providers require training and education and take time to reach full productivity. Competition for qualified personnel and service providers is intense. Our business may be harmed if we are unable to provide professional services to our customers to implement our solutions of if we are unable to establish and maintain relationships with third-party implementation providers.

Our executive officers and certain key personnel are critical to our business, and these officers and key personnel may not always remain with us.

      Our success depends upon the continued service of our executive officers and other key employees, and none of these officers or key employees is bound by an employment agreement for any specific term. If we lose the services of one or more of our executive officers or key employees, our business, operating results and financial condition could be harmed. Our future success will also depend in large part on our ability to attract and retain experienced technical, sales, marketing and management personnel.

We may not be able to increase market awareness and sales of our software if we do not maintain our sales and distribution capabilities.

      We need to maintain and further develop our direct and indirect sales and distribution efforts, both domestically and internationally, in order to increase market awareness and sales of our software and the related services we offer. Our software and solutions require a sophisticated sales effort targeted at multiple departments within an organization. Competition for qualified sales and marketing personnel is intense, and we might not be able to hire and retain adequate numbers of such personnel. Our competitors have attempted to hire employees away from us, and we expect that they will continue such attempts in the future. We also plan to use our relationships with system integrators and other third-party resellers to further develop our indirect sales channel. As we continue to develop our indirect sales channel, we will need to manage potential conflicts between our direct sales force and third-party reselling efforts, which may impact our business and operating results.

We intend to continue expanding our international sales efforts, and our inability to do so or lapses that may occur, could harm our business and operating results.

      We have been, and intend to continue, expanding our international sales efforts. We have relatively limited experience in marketing, selling and supporting our software and services in certain international markets. Expansion of our international operations will require a significant amount of attention from our management and substantial financial resources. If we are unable to continue expanding our international operations successfully and in a timely manner, our business and operating results could be harmed. In addition, doing business internationally involves additional risks, particularly: the difficulties and costs of staffing and managing foreign operations; the difficulty of ensuring adherence to our revenue recognition and other policies, internal controls and disclosure controls; unexpected changes in regulatory requirements, business practices, taxes, trade laws and tariffs; differing intellectual property rights; differing labor regulations; and changes in a specific country’s or region’s political or economic conditions.

      We currently do not engage in any currency hedging transactions. Our foreign sales generally are invoiced in the local currency, and, as we expand our international operations or if there is continued volatility in exchange rates, our exposure to gains and losses in foreign currency transactions may increase

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when we determine that foreign operations are expected to repay intercompany debt in the foreseeable future. Moreover, the costs of doing business abroad may increase as a result of adverse exchange rate fluctuations. For example, if the United States dollar declines in value relative to a local currency and we are funding operations in that country from our U.S. operations, we could be required to pay more for salaries, commissions, local operations and marketing expenses, each of which is paid in local currency. In addition, exchange rate fluctuations, currency devaluations or economic crises may reduce the ability of our prospective customers to purchase our software and services.

If we experience delays in developing solutions, or if our software contains defects, we could lose partners, customers and revenue.

      We expect that the rapid evolution of business integration software and related standards and technologies and protocols, as well as general technology trends such as changes in or introductions of operating systems or enterprise applications, will require us to adapt our software and solutions to remain competitive. Our software and solutions could become obsolete, unmarketable or less desirable to prospective customers if we are unable to adapt to new technologies or standards. Serious defects may be found during the period immediately following introduction of new software or enhancements to existing software or in product implementations in varied information technology environments. Internal quality assurance testing and customer testing may reveal product performance issues or desirable feature enhancements that could lead us to reallocate product development resources or postpone the release of new versions of our software. The reallocation of resources associated or any postponement could cause delays in the development and release of future enhancements to our currently available software, could require significant additional professional services work to address operational issues and could damage the reputation of our software in the marketplace. Although we attempt to resolve all errors that we believe would be considered serious by our partners and customers, our software is not error-free. Undetected errors or performance problems may be discovered in the future, and known errors that we consider minor may be considered serious by our partners and customers. This could result in lost revenue or delays in customer deployment and would be detrimental to our reputation, which could harm our business, operating results and financial condition. If our software experiences performance problems or ceases to demonstrate technology leadership, we may have to increase our product development costs and divert our product development resources to address the problems. In addition, because our customers and certain partners depend on our software for their critical systems and business functions, any interruptions in operation of our software or solutions could cause our customers and certain partners to initiate warranty or product liability suits against us.

Because our software could interfere with the operations of our partners’ and customers’ other software applications, we may be subject to potential product liability and warranty claims by these partners and customers, which may be time consuming, costly to defend and may not be adequately covered by insurance.

      Our software enables customers’ and certain partners’ software applications to provide Web services, or to integrate with networks and software applications, and is often used for mission critical functions or applications. Errors, defects, other performance problems in our software or failure to provide technical support could result in financial or other damages to our partners and customers. Partners and customers could seek damages for losses from us, which, if successful, could have a material adverse effect on our business, operating results or financial condition. In addition, the failure of our software and solutions to perform to partners’ and customers’ expectations could give rise to warranty claims. Although our license agreements typically contain provisions designed to limit our exposure to potential product liability claims, existing or future laws or unfavorable judicial decisions could negate these limitation of liability provisions. Although we have not experienced any product liability claims to date, sale and support of our software entail the risk of such claims. The use of our software to enable partners’ and customers’ software applications to provide Web services, and the integration of our software with our partners’ and customers’ networks and software applications, increase the risk that a partner or customer may bring a lawsuit against several suppliers if an integrated computer system fails and the cause of the failure cannot easily

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be determined. Even if our software is not at fault, a product liability claim brought against us, even if not successful, could be time consuming and costly to defend and could harm our reputation. In addition, although we carry general liability insurance, our current insurance coverage would likely be insufficient to protect us from all liability that may be imposed under these types of claims.

We may not have sufficient resources available to us in the future to take advantage of certain opportunities.

      In the future, we may not have sufficient resources available to us to take advantage of growth, acquisition, product development or marketing opportunities. We may need to raise additional funds in the future through public or private debt or equity financings in order to: take advantage of opportunities, including more rapid international expansion or acquisitions of complementary businesses or technologies; developing new software or services; or responding to competitive pressures. Additional financing needed by us in the future may not be available on terms favorable to us, if at all. If adequate funds are not available, not available on a timely basis, or are not available on acceptable terms, we may not be able to take advantage of opportunities, develop new software or services or otherwise respond to unanticipated competitive pressures. In such case, our business, operating results and financial condition could be harmed.

Third-party claims that we infringe upon their intellectual property rights may be costly to defend or settle or could damage our business.

      We cannot be certain that our software and the services do not infringe issued patents, copyrights, trademarks or other intellectual property rights of third parties. Litigation regarding intellectual property rights is common in the software industry, and we have been subject to, and may be increasingly subject to, legal proceedings and claims from time to time, including claims of alleged infringement of intellectual property rights of third parties by us or our licensees concerning their use of our software products, technologies and services. Although we believe that our intellectual property rights are sufficient to allow us to market our software without incurring liability to third parties, third parties have brought, and may bring in the future, claims of infringement against us or our licensees. Because our software is integrated with our customers’ networks and business processes, as well as other software applications, third parties may bring claims of infringement against us, as well as our customers and other software suppliers, if the cause of the alleged infringement cannot easily be determined. We have agreed, and may agree in the future, to indemnify certain of our customers against claims that our software infringes upon the intellectual property rights of others. Furthermore, former employers of our current and future employees may assert that our employees have improperly disclosed confidential or proprietary information to us. Such claims may be with or without merit.

      Claims of alleged infringement, regardless of merit, may have a material adverse effect on our business in a number of ways. Claims may discourage potential customers from doing business with us on acceptable terms, if at all. Litigation to defend against claims of infringement or contests of validity may be very time-consuming and may result in substantial costs and diversion of resources, including our management’s attention to our business. In addition, in the event of a claim of infringement, we, as well as our customers, may be required to obtain one or more licenses from third parties, which may not be available on acceptable terms, if at all. Furthermore, a party making such a claim could secure a judgment that requires us to pay substantial damages, and also include an injunction or other court order that could prevent us from selling our software or require that we re-engineer some or all of our products. Five of our customers have been subject to such claims and litigation, and we or other customers may in the future be subject to additional claims and litigation. We have settled one such claim and may in the future settle any other such claims with which we may be involved, regardless of merit, to avoid the cost and uncertainty of continued litigation. Defense of any lawsuit or failure to obtain any such required licenses could significantly harm our business, operating results and financial condition and the price of webMethods’ common stock. Although we carry general liability insurance, our current insurance coverage

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may not apply to, and likely would not protect us from, all liability that may be imposed under these types of claims. Our current insurance programs do not cover claims of patent infringement.

If we are unable to protect our intellectual property, we may lose a valuable asset, experience reduced market share, or incur costly litigation to protect our rights.

      Our success depends, in part, upon our proprietary technology and other intellectual property rights. To date, we have relied primarily on a combination of copyright, trade secret, trademark and patent laws, and nondisclosure and other contractual restrictions on copying and distribution to protect our proprietary technology. We have one patent and several pending patent applications for technology related to our software, but we cannot assure you that this patent is valid or that these applications will be successful. A small number of our agreements with customers and system integrators contain provisions regarding the rights of third parties to obtain the source code for our software, which may limit our ability to protect our intellectual property rights in the future. Despite our efforts to protect our proprietary rights, unauthorized parties may copy aspects of our software and obtain and use information that we regard as proprietary. In addition, other parties may breach confidentiality agreements or other protective contracts we have entered into, and we may not be able to enforce our rights in the event of these breaches. Furthermore, we expect to continue increasing our international operations in the future, and the laws of certain foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States.

      Our means of protecting our intellectual property rights in the United States or abroad may not be adequate to fully protect our intellectual property rights. Litigation to enforce our intellectual property rights or protect our trade secrets could result in substantial costs, may not result in timely relief and may not be successful. Any inability to protect our intellectual property rights could seriously harm our business, operating results and financial condition.

Future acquisitions of companies or technologies may result in disruptions to our business, dilution or other adverse effects on future financial results or the distraction of our management.

      We may make investments in, or acquisitions of, technology, products or companies in the future to maintain or improve our competitive position. We may not be able to identify future suitable acquisition or investment candidates, and even if we identify suitable candidates, may not be able to make these acquisitions or investments on commercially acceptable terms, or at all. With respect to our potential future acquisitions, we may not be able to realize future benefits we expected to achieve at the time of entering into the transaction, or our recognition of those benefits may be delayed. In such acquisitions, we will likely face many or all of the risks inherent in integrating corporate cultures, product lines, operations and businesses. We will be required to train our sales, professional services and customer support staff with respect to acquired software products, which can detract from executing against goals in the current period, and we may be required to modify priorities of our product development, customer support, systems engineering and sales organizations. Further, we may have to incur debt or issue equity securities to pay for any future acquisitions or investments, the issuance of which could be dilutive to our stockholders.

We adopted a stockholder rights plan in October 2001, and previously implemented certain provisions in our certificate of incorporation and bylaws, that may have anti-takeover effects.

      Our Board of Directors adopted a rights plan and declared a dividend distribution of one right for each outstanding share of webMethods’ common stock. Each right, when exercisable, entitles the registered holder to purchase certain securities at a specified purchase price, subject to adjustment. The rights plan may have the anti-takeover effect of causing substantial dilution to a person or group that attempts to acquire webMethods on terms not approved by our Board of Directors. The existence of the rights plan could limit the price that certain investors might be willing to pay in the future for shares of webMethods’ stock and could discourage, delay or prevent a merger or acquisition of webMethods, Inc. that stockholders may consider favorable. In addition, provisions of the current certificate of incorporation and bylaws of webMethods, Inc., as well as Delaware corporate law, could make it more difficult for a

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third-party to acquire us without the support of our Board of Directors, even if doing so would be beneficial to our stockholders.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

      We are exposed to a variety of risks, including changes in interest rates affecting the return on our investments and foreign currency fluctuations. We have established policies and procedures to manage our exposure to fluctuations in interest rates and foreign currency exchange rates.

      Interest rate risk. We maintain our funds in money market accounts, corporate bonds, commercial paper, Treasury notes and agency notes. Our exposure to market risk due to fluctuations in interest rates relates primarily to our interest earnings on our cash deposits. These securities are subject to interest rate risk inasmuch as their fair value will fall if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from the levels prevailing as of March 31, 2004, the fair value of the portfolio would not decline by a material amount. We do not use derivative financial instruments to mitigate risks. However, we do have an investment policy that would allow us to invest in short-term and long-term investments such as money market instruments and corporate debt securities. Our policy attempts to reduce such risks by typically limiting the maturity date of such securities to no more than twenty-four months with a maximum average maturity to our whole portfolio of such investments at twelve months, placing our investments with high credit quality issuers and limiting the amount of credit exposure with any one issuer.

      Foreign currency exchange rate risk. Our exposure to market risk due to fluctuations in foreign currency exchange rates relates primarily to the intercompany balances of our subsidiaries located in Australia, Canada, United Kingdom, France, Germany, India, Japan, the Netherlands, the Peoples Republic of China, South Korea, Hong Kong, Malaysia and Singapore. Transaction gains or losses have not been significant in the past, and there is no hedging activity on foreign currencies. We would not experience a material foreign exchange loss based on a hypothetical 10% adverse change in the price of the euro or other local currency of the country in which our subsidiaries are located, against the U.S. dollar. Consequently, we do not expect that a reduction in the value of such accounts denominated in foreign currencies resulting from even a sudden or significant fluctuation in foreign exchange rates would have a direct material impact on our financial position, results of operations or cash flows.

      Notwithstanding the foregoing, the direct effects of interest rate and foreign currency exchange rate fluctuations on the value of certain of our investments and accounts, and the indirect effects of fluctuations in foreign currency could have a material adverse effect on our business, financial condition and results of operations. For example, international demand for our products is affected by foreign currency exchange rates. In addition, interest rate fluctuations may affect the buying patterns of our customers. Furthermore, interest rate and currency exchange rate fluctuations have broad influence on the general condition of the U.S. foreign and global economics, which could materially adversely affect our business, financial condition, results of operations and cash flows.

Item 4. CONTROLS AND PROCEDURES

  Disclosure Controls and Procedures

      Disclosure controls and procedures are designed with the objective of ensuring that information required to be disclosed in our reports filed or submitted under the Securities and Exchange Commission’s rules and forms is recorded, processed, summarized and reported within the time periods specified under such rules and forms. Disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

      On November 1, 2004, an employee of our Japanese subsidiary notified webMethods’ management of the employee’s concerns regarding certain transactions involving a small number of that subsidiary’s

29

resellers. The Audit Committee of webMethods’ Board of Directors promptly took action, including hiring independent legal counsel, which in turn engaged forensic accountants, to conduct an independent investigation into the allegations. In late January 2005, the independent legal counsel provided the Audit Committee with a report of its findings. As a result of the investigation, the Company’s Audit Committee concluded that improper activities of certain employees of the Japanese subsidiary caused the Company to misstate revenue and expenses for the year ended March 31, 2004 and certain quarters therein and the three months ended June 30, 2004, as well as misstate accounts receivable, deferred revenue, debt and certain other items attributable to the operations of the Japanese subsidiary. The Company promptly announced that it was restating its financial statements for fiscal year 2004 (ended March 31, 2004), as well as quarterly financial statements for each of the three interim quarterly reports in that fiscal year and for the three months ended June 30, 2004.

      The Audit Committee’s investigation and additional efforts undertaken by the Company found that the improper activities included, among other things, engaging in improper licensing and professional services transactions and misrepresenting the transactions to the Company’s management; causing the Japanese subsidiary to engage in undisclosed and unauthorized borrowings; failing to record expenses and recording improper expenses; and creating false documents in support of improper transactions. The Audit Committee also determined that those employees of the Japanese subsidiary acted to conceal their improper activities from webMethods’ management. As a result of those findings and determinations, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures in effect as of December 31, 2004 were not effective at the reasonable assurance level due to a material weakness in internal controls over financial reporting with respect to our Japanese subsidiary discussed below.

  Internal Controls Over Financial Reporting

      In connection with the Audit Committee investigation and other efforts by the Company, we have identified a material weakness in our internal controls over financial reporting with respect to our Japanese subsidiary in effect as of December 31, 2004. The identified material weakness relates to the ineffectiveness of the procedures relating to our Japanese subsidiary for timely detection, deterrence and mitigation of wrongdoing and improper activities that led to the restatement of our financial statements.

      In order to reduce the risks of recurrence of such material weakness in future periods, we have implemented, or are implementing, the following steps to strengthen our internal controls over financial reporting:

•  We have placed the employees of our Japanese subsidiary who were principally involved in the improper activities on a special status under Japanese labor law under which they have no further access to the offices or e-mail system of our Japanese subsidiary and are precluded from conducting business on behalf of the Company. We are pursuing disciplinary actions, which may include termination and restitution, concerning each employee implicated in wrongdoing in accordance with Japanese labor law and the work rules of the Company’s Japanese subsidiary.

•  We have engaged an experienced financial consulting firm in Japan to assist the Company in providing financial and accounting services on behalf of our Japanese subsidiary.

•  We have recommunicated to employees of our Japanese subsidiary, and have confirmed their understanding of, our policy requiring collection and preservation of appropriate documentation that evidences an end-user’s purchase of a license to the Company’s products in the quarter in which

30

	the revenue is recognized. We have reiterated this policy to all of our senior management, sales management and finance managers.
•	We have reiterated to all of our senior management, sales management and finance managers that borrowing from banks or any third party is strictly prohibited unless specifically authorized in writing by certain specified executive officers of the Company and by the Board of Directors of the respective borrowing entity. Verification of compliance with this policy has been added to certifications collected from members of management of the Company and our subsidiaries each quarter.
•	We have reiterated to all of our senior management, sales management and finance managers that no employee of the Company may engage in verbal or written side agreements, including without limitation, side agreements that modify, cancel or agree to cancel any order or agreement for the license of our software products from a reseller or end-user or that modify, cancel or agree to modify or cancel any associated account receivable without complying with the applicable Company procedures. Clarification and verification of compliance with this policy has been added to certifications collected from members of management of the Company and our subsidiaries each quarter.
•	We have recruited and hired a Director, Internal Audit, who will be developing and implementing internal audit plans and procedures with respect to the Company’s domestic and international operations.
•	We are evaluating more comprehensive procedures for the timely detection, deterrence, and mitigation of wrongdoing and improper activities, as well as procedures to test compliance with our revenue recognition policy and our code of business conduct.
•	We are implementing organizational changes to clarify that persons responsible for finance, accounting and legal functions concerning the Company’s Japanese subsidiary report directly to persons responsible for the appropriate function in the global management team.
•	We are evaluating our relationships with each of our Japanese resellers, including reviewing arrangements with them to ensure that they are providing to the Company those materials required by the Company’s revenue recognition policy.
•	We are studying new or modified procedures under which the appropriate persons within the Company’s global management team will have greater levels of involvement in, and oversight of, international operations.

      We are continuing our evaluation, documentation and testing of our internal controls over financial reporting so that management will be able to report on, and our independent registered public accounting firm will be able to attest to, our internal controls as of March 31, 2005, as required by applicable laws and regulations, and we will remediate our internal controls to the extent that our testing reveals inadequacies in the control system. We cannot be certain that our efforts to date will be sufficient to identify and remediate all material weaknesses in our internal controls over financial reporting prior to March 31, 2005. In addition, we have not yet tested the operating effectiveness of all remedial controls, and we cannot be certain that the remedial controls will operate effectively for a sufficient period of time for us to complete our evaluation. We also cannot be certain that sufficient time exists for our independent registered public accounting firm to complete their assessment of the Company’s internal controls over financial reporting by the due date of the Company’s Form 10-K for the fiscal year ended March 31, 2005. We believe we will have adequate internal controls over financial reporting as of March 31, 2005 but we cannot be certain that our independent auditors will be able to attest to our assessment of these controls on a timely basis or that our independent auditors will agree with our assessment of our controls as there is no precedent available by which we can measure the adequacy of our control system in advance.

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PART II

OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

      On November 30, 2001, a purported class action lawsuit was filed in the Southern District of New York naming webMethods, several of its executive officers at the time of our initial public offering (IPO) and the managing underwriters of our initial public offering as defendants. The amended complaint alleges, among other things, that underwriters of webMethods’ IPO solicited and received excessive commissions and demanded tie-in arrangements from the underwriters’ customers in connection with their allocation of shares in webMethods’ IPO, and that those activities allegedly undertaken by the underwriters of webMethods’ IPO were not disclosed in the registration statement and final prospectus for webMethods’ IPO or disclosed to the public after webMethods’ IPO. The amended complaint also alleges that false analysts’ reports were issued by the underwriters. The amended complaint seeks unspecified damages on behalf of a purported class of purchasers of webMethods, Inc. common stock between February 10, 2000 and December 6, 2000. This case has been consolidated as part of In Re Initial Public Offering Securities Litigation (SDNY). Claims against webMethods’ executive officer defendants have been dismissed without prejudice. webMethods has considered and conditionally agreed to enter into a proposed settlement with representatives of the plaintiffs in the consolidated proceeding. Under the proposed settlement, the plaintiffs would dismiss and release their claims against webMethods in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuers in the consolidated action and assignment or surrender to the plaintiffs by the settling issuers of certain claims that may be held against the underwriter defendants. We believe that any material liability on behalf of webMethods or its executive officers that may accrue under that settlement offer would be covered by our insurance policies.

      From time to time, webMethods is involved in other disputes and litigation in the normal course of business.

Item 5.  OTHER INFORMATION

      On February 9, 2005, the Board of Directors of webMethods adopted the Second Amended and Restated Bylaws of webMethods, Inc., effective as of such date. The Second Amended and Restated Bylaws of webMethods, attached as Exhibit 3.2 to this Form 10-Q, reflect changes designed to address current developments in securities law and corporate governance, changes in webMethods’ management structure and changes in Delaware corporate law over the past few years. The material changes effected by the Second Amended and Restated Bylaws are to: (i) revise the procedure for stockholders to submit proposals and nominations for directors; (ii) allow for methods of giving notice and holding of stockholder and board meetings using new or improved technologies pursuant to recent amendments to Delaware corporate law; (iii) eliminate the designation of the Chairman of the Board as an officer position reflecting the current status of the non-executive Chairman of the Board; (iv) separate the offices of Chief Executive Officer and President; (v) allow for subcommittees pursuant to recent amendments to Delaware corporate law; and (vi) remove the requirement that the Board of Directors cause an annual audit, which is not required under Delaware corporate law and could be deemed to interfere with the Audit Committee’s duties regarding the audit.

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Item 6. EXHIBITS

Exhibit
Number			Description
	2.1(1	)	Agreement and Plan of Merger dated as of May 20, 2000, by and among webMethods, Inc., Wolf Acquisition, Inc. and Active Software, Inc.
	3.1(2	)	Fifth Amended and Restated Certificate of Incorporation of webMethods, Inc., as amended
	3.2*		Second Amended and Restated Bylaws of webMethods, Inc.
	4.1(3	)	Specimen certificate for shares of webMethods Common Stock
	4.2(4	)	Rights Agreement dated as of October 18, 2001 between webMethods, Inc. and American Stock Transfer & Trust Company
	10.1(3	)	Second Amended and Restated Investor Rights Agreement
	10.2(5	)	webMethods, Inc. Amended and Restated Stock Option Plan
	10.3(3	)	Employee Stock Purchase Plan
	10.4(3	)	Indemnification Agreement and entered into between webMethods, Inc. and each of its directors and executive officers
	10.5(6	)	Executive Agreement entered into between webMethods, Inc. and certain of its executive officers
	10.6(7	)	Form of Stock Option Agreement for stock option grants to employees or officers other than California residents
	10.7(8	)	Form of Stock Option Agreement for stock option grants to directors
	10.8(7	)	Form of notice of grant of stock option
	10.9(8	)	Form of Deferred Compensation Plan for Directors
	10.10(	8)	Consulting Agreement dated October 3, 2004 between Phillip Merrick and webMethods, Inc.
	31.1*		Rule 13a-14(a) Certification of Chief Executive Officer
	31.2*		Rule 13a-14(a) Certification of Chief Financial Officer
	32.1*#		Section 1350 Certification of Chief Executive Officer
	32.2*#		Section 1350 Certification of Chief Financial Officer

(1)	Incorporated by reference to webMethods’ Registration Statement on Form S-4, as amended (File No. 333-39572).
(2)	Incorporated by reference to webMethods’ Annual Report on Form 10-K for the year ended March 31, 2002 (File No. 1-15681).
(3)	Incorporated by reference to webMethods’ Registration Statement on Form S-1, as amended (File No. 333-91309).
(4)	Incorporated by reference to webMethods’ Registration Statement on Form 8-A (File No. 1-15681).
(5)	Incorporated by reference to webMethods’ Annual Report on Form 10-K for the year ended March 31, 2003 (File No. 1-15681).
(6)	Incorporated by reference to webMethods’ Form 10-Q for the quarter ended June 30, 2004 (File No. 1-15681).
(7)	Incorporated by reference to webMethods’ Form 8-K dated October 2, 2004 (File No. 1-15681).
(8)	Incorporated by reference to web Methods’ Form 10-Q for the quarter ended September 30, 2004 (File No. 1-15681).
*	Filed herewith.
#	This item is furnished as an exhibit to this report but is not filed with the Securities and Exchange Commission.

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SIGNATURES

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

WEBMETHODS, INC.

By:  /s/ David Mitchell

David Mitchell

President and Chief Executive Officer

Date: February 14, 2005

By:  /s/ Mary Dridi

Mary Dridi

Chief Financial Officer

(Principal Financial Officer)

Date: February 14, 2005

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INDEX TO EXHIBITS

Exhibit
Number			Description
	2	.1(1)	Agreement and Plan of Merger dated as of May 20, 2000, by and among webMethods, Inc., Wolf Acquisition, Inc. and Active Software, Inc.
	3	.1(2)	Fifth Amended and Restated Certificate of Incorporation of webMethods, Inc., as amended
	3	.2*	Second Amended and Restated Bylaws of webMethods, Inc.
	4	.1(3)	Specimen certificate for shares of webMethods Common Stock
	4	.2(4)	Rights Agreement dated as of October 18, 2001 between webMethods, Inc. and American Stock Transfer & Trust Company
	10	.1(3)	Second Amended and Restated Investor Rights Agreement
	10	.2(5)	webMethods, Inc. Amended and Restated Stock Option Plan
	10	.3(3)	Employee Stock Purchase Plan
	10	.4(3)	Indemnification Agreement entered into between webMethods, Inc. and each of its directors and executive officers
	10	.5(6)	Executive Agreement entered into between webMethods, Inc. and certain of its executive officers
	10	.6(7)	Form of Stock Option Agreement for stock option grants to employees or officers other than California residents
	10	.7(8)	Form of Stock Option Agreement for stock option grants to directors
	10	.8(7)	Form of notice of grant of stock option
	10	.9(8)	Form of Deferred Compensation Plan for Directors
	10	.10(8)	Consulting Agreement dated October 3, 2004 between Phillip Merrick and web Methods, Inc.
	31	.1*	Rule 13a-14(a) Certification of Chief Executive Officer
	31	.2*	Rule 13a-14(a) Certification of Chief Financial Officer
	32	.1*#	Section 1350 Certification of Chief Executive Officer
	32	.2*#	Section 1350 Certification of Chief Financial Officer

(1)	Incorporated by reference to webMethods’ Registration Statement on Form S-4, as amended (File No. 333-39572).
(2)	Incorporated by reference to webMethods’ Annual Report on Form 10-K for the year ended March 31, 2002 (File No. 1-15681).
(3)	Incorporated by reference to webMethods’ Registration Statement on Form S-1, as amended (File No. 333-91309).
(4)	Incorporated by reference to webMethods’ Registration Statement on Form 8-A (File No. 1-15681).
(5)	Incorporated by reference to webMethods’ Annual Report on Form 10-K for the year ended March 31, 2003 (File No. 1-15681).
(6)	Incorporated by reference to webMethods’ Form 10-Q for the quarter ended June 30, 2004 (File No. 1-15681).
(7)	Incorporated by reference to webMethods’ Form 8-K dated October 2, 2004 (File No. 1-15681).
(8)	Incorporated by reference to web Methods’ Form 10-Q for the quarter ended September 30, 2004 (File No. 1-15681).

* Filed herewith.

# This item is furnished as an exhibit to this report but is not filed with the Securities and Exchange Commission.

EX-3.2

Exhibit 3.2

SECOND

AMENDED AND RESTATED

BYLAWS OF

WEBMETHODS, INC.,

A DELAWARE CORPORATION

TABLE OF CONTENTS

ARTICLE 1: OFFICE AND RECORDS	1
Section 1.1 Delaware Office	1
Section 1.2 Other Offices	1
Section 1.3 Books and Records	1
ARTICLE 2: STOCKHOLDERS	1
Section 2.1 Annual Meeting	1
Section 2.2 Special Meeting	1
Section 2.3 Place of Meeting	1
Section 2.4 Notice of Meeting	1
Section 2.5 Quorum and Adjournment	2
Section 2.6 Proxies	2
Section 2.7 Notice of Stockholder Business and Nominations	2
Section 2.8 Procedure for Election of Directors	4
Section 2.9 Inspectors of Elections; Opening And Closing The Pools	5
Section 2.10 Consent of Stockholders In Lieu of Meeting	5
Section 2.11 Fixing Date For Determination Of Stockholders Of Record	5
Section 2.12 List of Stockholders Entitled To Vote	5
ARTICLE 3: BOARD OF DIRECTORS	6
Section 3.1 General Powers	6
Section 3.2 Number, Tenure and Qualifications	6
Section 3.3 Regular Meetings	6
Section 3.4 Special Meetings	6
Section 3.5 Notice	6
Section 3.6 Conference Telephone Meetings	7
Section 3.7 Quorum	7
Section 3.8 Vacancies	7
Section 3.9 Committees	7
Section 3.10 Removal	8
Section 3.11 Written Action By Directors	8
Section 3.12 Compensation Of Directors	8
ARTICLE 4: OFFICERS	8
Section 4.1 Elected Officers	8
Section 4.2 Election And Term Of Office	8
Section 4.3 Chairman Of The Board	9
Section 4.4 President and Chief Executive Officer	9
Section 4.5 Secretary	9
Section 4.6 Treasurer	9
Section 4.7 Removal	10
Section 4.8 Vacancies	10

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ARTICLE 5: STOCK CERTIFICATES AND TRANSFERS	10
Section 5.1 Stock Certificate and Transfers	10
ARTICLE 6: INDEMNIFICATION	11
Section 6.1 Right To Indemnification	111
Section 6.2 Right To Advancement Of Expenses	11
Section 6.3 Right Of Indmenitee To Bring Suit	12
Section 6.4 Non-Exclusivity Of Rights	12
Section 6.5 Insurance	12
Section 6.6 Indemnification Contracts	12
Section 6.7 Effect Of Amendment	133
ARTICLE 7: MISCELLANEOUS PROVISIONS	13
Section 7.1 Fiscal Year	13
Section 7.2 Dividends	13
Section 7.3 Seal	13
Section 7.4 Waiver Of Notice	13
Section 7.5 Audits
Section 7.6 Resignations	13
Section 7.7 Contracts	134
Section 7.8 Proxies	144
Section 7.9 Severability	14
ARTICLE 8: AMENDMENTS	14
Section 8.1 Amendments	14

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ARTICLE 1

OFFICES AND RECORDS

     Section 1.1 DELAWARE OFFICE. The registered office of webMethods, Inc. (the “Corporation”) in the State of Delaware shall be located in the City of Wilmington, County of New Castle.

     Section 1.2 OTHER OFFICES. The Corporation may have such other offices, either within or without the State of Delaware, as the Board of Directors may designate or as the business of the Corporation may from time to time require.

     Section 1.3 BOOKS AND RECORDS. The books and records of the Corporation may be kept at the Corporation’s headquarters in Fairfax, Virginia or at such other locations outside the State of Delaware as may from time to time be designated by the Board of Directors.

ARTICLE 2

STOCKHOLDERS

     Section 2.1 ANNUAL MEETING. The annual meeting of the stockholders of the Corporation shall be held at such date, place and/or time as may be fixed by resolution of the Board of Directors.

     Section 2.2 SPECIAL MEETING. Special meetings of stockholders of the Corporation may be called only by the Chairman of the Board or the President or by the Board of Directors acting pursuant to a resolution adopted by a majority of the Whole Board. For purposes of these Second Amended and Restated Bylaws (these “Bylaws”), the term “Whole Board” shall mean the total number of authorized directors whether or not there exist any vacancies in previously authorized directorships.

     Section 2.3 PLACE OF MEETING. The Board of Directors may designate the place of meeting for any meeting of the stockholders. The Board of Directors may, in its sole discretion, determine that the meeting shall not be held at any place, but may instead be held solely by means of remote communication in a manner compliant with applicable law. If no designation is made by the Board of Directors, the place of meeting shall be the principal office of the Corporation.

     Section 2.4 NOTICE OF MEETING. Except as otherwise required by law, written or printed notice, stating the place, day and hour of the meeting and the purposes for which the meeting is called, shall be prepared and delivered by the Corporation not less than ten days nor more than sixty days before the date of the meeting, either personally, or by mail or by electronic

1

transmission to any stockholder who has consented to receive notice in such manner, to each stockholder of record entitled to vote at such meeting. If mailed, such notice shall be deemed to be delivered when deposited in the United States mail with postage thereon prepaid, addressed to the stockholder at his address as it appears on the stock transfer books of the Corporation. If delivered by facsimile telecommunication, such notice shall be deemed to be delivered when directed to a number at which the stockholder has consented to receive notice. If delivered by electronic mail, such notice shall be deemed to be delivered when directed to an electronic mail address at which the stockholder has consented to receive notice. Such further notice shall be given as may be required by law. Meetings may be held without notice if all stockholders entitled to vote are present (except as otherwise provided by law), or if notice is waived by those not present. Any previously scheduled meeting of the stockholders may be postponed and (unless the Corporation’s Fifth Amended and Restated Certificate of Incorporation, as it may be amended from time to time [the “Certificate of Incorporation”], otherwise provides) any special meeting of the stockholders may be cancelled, by resolution of the Board of Directors upon public notice given prior to the time previously scheduled for such meeting of stockholders.

     Section 2.5 QUORUM AND ADJOURNMENT. Except as otherwise provided by law or by the Certificate of Incorporation, the holders of a majority of the voting power of the outstanding shares of the Corporation entitled to vote generally in the election of directors (the “Voting Stock”), represented in person or by proxy, shall constitute a quorum at a meeting of stockholders, except that when specified business is to be voted on by a class or series voting separately as a class or series, the holders of a majority of the voting power of the shares of such class or series shall constitute a quorum for the transaction of such business. The chairman of the meeting or a majority of the shares of Voting Stock so represented may adjourn the meeting from time to time, whether or not there is such a quorum (or, in the case of specified business to be voted on by a class or series, the chairman or a majority of the shares of such class or series so represented may adjourn the meeting with respect to such specified business). No notice of the time and place of adjourned meetings need be given except as required by law. The stockholders present at a duly organized meeting may continue to transact business until adjournment, notwithstanding the withdrawal of enough stockholders to leave less than a quorum.

     Section 2.6 PROXIES. At all meetings of stockholders, a stockholder may vote by proxy executed in writing by the stockholder or as may be permitted by law, or by his duly authorized attorney-in-fact. Such proxy must be filed with the Secretary of the Corporation or his representative at or before the time of the meeting.

     Section 2.7 NOTICE OF STOCKHOLDER BUSINESS AND NOMINATIONS.

          A. Nominations of persons for election to the Board of Directors and the proposal of business to be transacted by the stockholders may be made at an annual meeting of stockholders (1) pursuant to the Corporation’s notice with respect to such meeting, (2) by or at the direction of the Board of Directors or (3) by any stockholder of record of the Corporation who was a stockholder of record at the time of the giving of the notice provided for in the following paragraph, who is entitled to vote at the meeting and who has complied with the notice procedures set forth in this Section 2.7.

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          B. For nominations or other business to be properly brought before an annual meeting by a stockholder pursuant to paragraph (A)(3) of this Section 2.7, (1) the stockholder must have given timely notice thereof in writing to the Secretary of the Corporation and (2) such business must be a proper matter for stockholder action under the General Corporation Law of the State of Delaware. To be timely, a stockholder’s notice shall be delivered to the Secretary at the principal executive offices of the Corporation not less than 45 or more than 75 days prior to the first anniversary (the “Anniversary”) of the date on which the Corporation first mailed its proxy materials for the preceding year’s annual meeting of stockholders; provided, however, that if the date of the annual meeting is advanced more than 30 days prior to or delayed by more than 30 days after the anniversary of the preceding year’s annual meeting, or the Corporation did not hold an annual meeting the preceding year, notice by the stockholder to be timely must be so delivered not later than the close of business on the later of (x) the 90th day prior to such annual meeting or (y) the 10th day following the day on which public announcement of the date of such meeting is first made. Such stockholder’s notice shall set forth (a) as to each person whom the stockholder proposes to nominate for election or reelection as a director all information relating to such person as would be required to be disclosed in solicitations of proxies for the election of such nominees as directors pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and such person’s written consent to serve as a director if elected; (b) as to any other business that the stockholder proposes to bring before the meeting, a brief description of such business, the reasons for conducting such business at the meeting and any material interest in such business of such stockholder and the beneficial owner, if any, on whose behalf the proposal is made; and (c) as to the stockholder giving the notice and the beneficial owner, if any, on whose behalf the nomination or proposal is made (i) the name and address of such stockholder, as they appear on the Corporation’s books, and of such beneficial owner and (ii) the class and number of shares of the Corporation that are owned beneficially and of record by such stockholder and such beneficial owner.

          C. Notwithstanding anything in the second sentence of paragraph (B) of this Section 2.7 to the contrary, in the event that the number of directors to be elected to the Board of Directors is increased and there is no public announcement naming all of the nominees for director or specifying the size of the increased Board made by the Corporation at least 55 days prior to the Anniversary, a stockholder’s notice required by this Bylaw shall also be considered timely, but only with respect to nominees for any new positions created by such increase, if it shall be delivered to the Secretary at the principal executive offices of the Corporation not later than the close of business on the 10th day following the day on which such public announcement is first made by the Corporation.

          D. Only persons nominated in accordance with the procedures set forth in this Section 2.7 shall be eligible to serve as directors and only such business shall be conducted at an annual meeting of stockholders as shall have been brought before the meeting in accordance with the procedures set forth in this Section 2.7. The chair of the meeting shall have the power and the duty to determine whether a nomination or any business proposed to be brought before the meeting has been made in accordance with the procedures set forth in these Bylaws and, if any proposed nomination or business is not in compliance with these Bylaws, to declare that such defective proposed business or nomination shall not be presented for stockholder action at the meeting and shall be disregarded.

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          E. Only such business shall be conducted at a special meeting of stockholders as shall have been brought before the meeting pursuant to the Corporation’s notice of meeting. Nominations of persons for election to the Board of Directors may be made at a special meeting of stockholders at which directors are to be elected (1) pursuant to the Corporation’s notice of meeting, (2) by or at the direction of the Board of Directors or (3) provided that the Board of Directors has determined that Directors shall be elected at such special meeting, by any stockholder of record of the Corporation who is a stockholder of record at the time of giving of notice provided for in this paragraph, who shall be entitled to vote at the meeting and who complies with the notice procedures set forth in this Section 2.7. In the event that the Corporation calls a special meeting of stockholders for the purpose of elect one or more Directors to the Board of Directors, nominations by stockholders of persons for election to the Board of Directors may be made at such a special meeting of stockholders if the stockholder’s notice required by paragraph (B) of this Section 2.7 shall be delivered to the Secretary at the principal executive offices of the Corporation not later than the close of business on the later of the 90th day prior to such special meeting or the 10th day following the day on which public announcement is first made of the date of the special meeting and of the nominees proposed by the Board to be elected at such meeting. In no event shall the public announcement of a postponement or adjournment of a special meeting to a later date or time commence a new time period for the giving of a stockholder’s notice as described above.

          F. For purposes of this Section 2.7, “public announcement” shall mean disclosure in a press release reported by the Dow Jones News Service, Associated Press or a comparable national news service or in a document publicly filed by the Corporation with the Securities and Exchange Commission pursuant to Section 13, 14 or 15(d) of the Exchange Act.

          G. Notwithstanding the foregoing provisions of this Section 2.7, a stockholder shall also comply with all applicable requirements of the Exchange Act and the rules and regulations thereunder with respect to matters set forth in this Section 2.7. Nothing in this Section 2.7 shall be deemed to affect any rights of stockholders to request inclusion of proposals in the Corporation’s proxy statement pursuant to Rule 14a-8 under the Exchange Act.

     Section 2.8 PROCEDURE FOR ELECTION OF DIRECTORS. Election of directors at all meetings of the stockholders at which directors are to be elected shall be by written ballot, and, except as otherwise set forth in the Certificate of Incorporation with respect to the right of the holders of any series of Preferred Stock or any other series or class of stock to elect additional directors under specified circumstances, a plurality of the votes cast thereat shall elect directors. Except as otherwise provided by law, the Certificate of Incorporation or these Bylaws, all matters other than the election of directors submitted to the stockholders at any meeting shall be decided by the affirmative vote of a majority of the voting power of the outstanding Voting Stock present in person or represented by proxy at the meeting and entitled to vote thereon.

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     Section 2.9 INSPECTORS OF ELECTIONS; OPENING AND CLOSING THE POLLS.

          A. The Board of Directors by resolution shall appoint one or more inspectors, which inspector or inspectors may include individuals who serve the Corporation in other capacities, including, without limitation, as officers, employees, agents or representatives of the Corporation, to act at the meeting and make a written report thereof. One or more persons may be designated as alternate inspectors to replace any inspector who fails to act. If no inspector or alternate has been appointed to act, or if all inspectors or alternates who have been appointed are unable to act, at a meeting of stockholders, the chairman of the meeting shall appoint one or more inspectors to act at the meeting. Each inspector, before discharging his or her duties, shall take and sign an oath faithfully to execute the duties of inspector with strict impartiality and according to the best of his or her ability. The inspectors shall have the duties prescribed by the General Corporation Law of the State of Delaware.

          B. The chairman of the meeting shall fix and announce at the meeting the date and time of the opening and the closing of the polls for each matter upon which the stockholders will vote at a meeting.

     Section 2.10 CONSENT OF STOCKHOLDERS IN LIEU OF MEETING. Any action required or permitted to be taken by the stockholders of the Corporation must be effected at a duly called annual or special meeting of stockholders of the Corporation and may not be effected by any consent in writing by such stockholders.

     Section 2.11 FIXING DATE FOR DETERMINATION OF STOCKHOLDERS OF RECORD. In order that the Corporation may determine the stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, or entitled to receive payment of any dividend or other distribution or allotment of any rights, or entitled to exercise any rights in respect of any change, conversion or exchange of stock or for the purpose of any other lawful action, the Board of Directors may fix, in advance, a record date, which shall not precede the date upon which the resolution fixing the record date is adopted by the Board of Directors and which shall not be more than sixty nor less than ten days before the date of such meeting, nor more than sixty days prior any other action. If no record date is fixed by the Board of Directors, then the record date shall be provided by applicable law. A determination of stockholders of record entitled to notice of or to vote at a meeting of stockholders shall apply to any adjournment of the meeting; PROVIDED, HOWEVER, that the Board of Directors may fix a new record date for the adjourned meeting.

     Section 2.12 LIST OF STOCKHOLDERS ENTITLED TO VOTE. A complete list of stockholders entitled to vote at any meeting of stockholders, arranged in alphabetical order and showing the address of each stockholder and the number of shares registered in the name of each stockholder, shall be open for the examination of any stockholder, for any purpose germane to the meeting, during ordinary business hours, for a period of at least ten days prior to the meeting, either at a place within the city where the meeting is to be held, which place shall be specified in the notice of the meeting, or, if not so specified, at the place where the meeting is to be held. The list shall also be produced and kept at the time and place of the meeting during the whole time thereof and may be inspected by any stockholder who is present at the meeting.

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ARTICLE 3

BOARD OF DIRECTORS

     Section 3.1 GENERAL POWERS. The business and affairs of the Corporation shall be managed by or under the direction of the Board of Directors. In addition to the powers and authority expressly conferred upon them by statute or by the Certificate of Incorporation or by these Bylaws, the directors are hereby empowered to exercise all such powers and do all such acts and things as may be exercised or done by the Corporation.

     Section 3.2 NUMBER, TENURE AND QUALIFICATIONS. Subject to the rights of the holders of any series of Preferred Stock to elect additional directors under specified circumstances, the number of directors shall be fixed from time to time exclusively by the Board of Directors pursuant to a resolution adopted by a majority of the Whole Board. The directors, other than those who may be elected by the holders of any series of Preferred Stock under specified circumstances, shall be divided into three classes pursuant to the Certificate of Incorporation. At each annual meeting of stockholders, directors elected to succeed those directors whose terms expire shall be elected for a term of office to expire at the third succeeding annual meeting of stockholders after their election. Directors need not be stockholders of the Corporation.

     Section 3.3 REGULAR MEETINGS. A regular meeting of the Board of Directors shall be held without notice other than this Bylaw immediately after, and at the same place as, each annual meeting of stockholders. The Board of Directors may, by resolution, provide the time and place for the holding of additional regular meetings without notice other than such resolution.

     Section 3.4 SPECIAL MEETINGS. Special meetings of the Board of Directors shall be called at the request of the Chairman of the Board, the President or a majority of the Board of Directors. The person or persons authorized to call special meetings of the Board of Directors may fix the place and time of the meetings.

     Section 3.5 NOTICE. Notice of any special meeting shall be given to each director at his business or residence in writing or by telegram, facsimile transmission, telephone communication or electronic mail. If mailed, such notice shall be deemed adequately delivered when deposited in the United States mails so addressed, with postage thereon prepaid, at least five days before such meeting. If by telegram, such notice shall be deemed adequately delivered when the telegram is delivered to the telegraph company at least twenty-four hours before such meeting. If by facsimile transmission or electronic mail, such notice shall be transmitted at least twenty-four hours before such meeting. If by telephone, the notice shall be given at least twelve hours prior to the time set for the meeting. Neither the business to be transacted at, nor the purpose of, any regular or special meeting of the Board of Directors need be specified in the notice of such meeting, except for amendments to these Bylaws as provided under Section 8.1 of Article VIII hereof. A meeting may be held at any time without notice if all the directors are present (except as otherwise provided by law) or if those not present waive notice of the meeting in writing, either before or after such meeting.

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     Section 3.6 TELEPHONE OR VIDEO CONFERENCE MEETINGS. Members of the Board of Directors, or any committee thereof, may participate in a meeting of the Board of Directors or such committee by means of telephone or video conference or similar communications equipment by means of which all persons participating in the meeting can hear each other, and such participation in a meeting shall constitute presence in person at such meeting.

     Section 3.7 QUORUM. A whole number of directors equal to at least a majority of the Whole Board shall constitute a quorum for the transaction of business, but if at any meeting of the Board of Directors there shall be less than a quorum present, a majority of the directors present may adjourn the meeting from time to time without further notice. The act of the majority of the directors present at a meeting at which a quorum is present shall be the act of the Board of Directors.

     Section 3.8 VACANCIES. Subject to the rights of the holders of any series of Preferred Stock then outstanding, newly created directorships resulting from any increase in the authorized number of directors or any vacancies in the Board of Directors resulting from death, resignation, retirement, disqualification, removal from office or other cause shall, unless otherwise provided by law or by resolution of the Board of Directors, be filled only by a majority vote of the directors then in office, though less than a quorum, and directors so chosen shall hold office for a term expiring at the annual meeting of stockholders at which the term of office of the class to which they have been chosen expires. No decrease in the authorized number of directors shall shorten the term of any incumbent director.

     Section 3.9 COMMITTEES.

          A. The Board of Directors may designate one or more committees, each committee to consist of one or more of the directors of the Corporation. The Board of Directors may specify the term for each such committee, whether it be a standing committee, a committee existing for a specified term or a committee continuing until resolution of a particular matter, and may amend the term of any such committee from time to time. The Board of Directors may designate one or more directors as alternate members of any committee, who may replace any absent or disqualified member at any meeting of the committee. In the absence or disqualification of a member of the committee, the member or members thereof present at any meeting and not disqualified from voting, whether or not he or they constitute a quorum, may unanimously appoint another member of the Board of Directors to act at the meeting in place of any such absent or disqualified member. Any such committee, to the extent permitted by law and to the extent provided in the resolution of the Board of Directors, shall have and may exercise all the powers and authority of the Board of Directors in the management of the business and affairs of the Corporation, and may authorize the seal of the Corporation to be affixed to all papers which may require it.

          B. Unless the Board of Directors otherwise provides, each committee designated by the Board of Directors may make, alter and repeal rules for the conduct of its business. In the absence of such rules each committee shall conduct its business in the same manner as the Board of Directors conducts its business pursuant to these Bylaws. Unless otherwise provided by the resolution of the Board of Directors designating the committee, a committee may create one or

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more subcommittees, each subcommittee to consist of one or more members of the committee, and delegate to a subcommittee any or all of the powers and authority of the committee.

     Section 3.10 REMOVAL. Subject to the rights of the holders of any series of Preferred Stock then outstanding, any directors, or the entire Board of Directors, may be removed from office at any time, but only for cause and only by the affirmative vote of the holders of at least sixty-six and two-thirds percent (66-2/3%) of the voting power of all of the then-outstanding shares of capital stock of the Corporation entitled to vote generally in the election of directors, voting together as a single class.

     Section 3.11 WRITTEN ACTION BY DIRECTORS. Any action required or permitted to be taken at any meeting of the Board of Directors, or any committee thereof, may be taken without a meeting if all members of the Board of Directors, or such committee, as the case may be, consent thereto in writing, and the writing or writings are filed with the proceedings of the Board of Directors or committee, respectively.

     Section 3.12 COMPENSATION OF DIRECTORS. Directors, as such, may receive, pursuant to a resolution of the Board of Directors, fees and other compensation for their services as directors, including, without limitation, their services as members of committees of the Board of Directors.

     Section 3.13 CHAIRMAN OF THE BOARD OF DIRECTORS. The Board of Directors may elect from among the Directors a Chairman of the Board by affirmative vote of a majority of the whole Board taken at any regular or special meeting of the Board of Directors. The Chairman of the Board shall act as chairman at all meetings of the stockholders at which the Chairman of the Board is present and shall preside at meetings of the Board of Directors at which the Chairman of the Board is present.

ARTICLE 4

OFFICERS

     Section 4.1 ELECTED OFFICERS. The elected officers of the Corporation shall be a Chief Executive Officer, a President, a Secretary, a Treasurer, and such other officers, including a Chief Operating Officer, a Chief Financial Officer and/or Chief Accounting Officer, a General Counsel and a Chief Technology Officer, as the Board of Directors from time to time may deem proper. All officers chosen by the Board of Directors shall each have such powers and duties as generally pertain to their respective offices, subject to the specific provisions of this Article IV. Such officers shall also have powers and duties as from time to time may be conferred by the Board of Directors or by any committee thereof.

     Section 4.2 ELECTION AND TERM OF OFFICE. The elected officers of the Corporation shall be elected annually by the Board of Directors at the regular meeting of the Board of Directors held after each annual meeting of the stockholders. If the election of officers shall not be held at such meeting, such election shall be held as soon thereafter as convenient.

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Subject to Section 4.7 of these Bylaws, each officer shall hold office until his successor shall have been duly elected and shall have qualified or until his death or until he shall resign.

     Section 4.3 CHIEF EXECUTIVE OFFICER. The Chief Executive Officer shall be the general manager of the Corporation, subject to the control of the Board of Directors. The Chief Executive Officer shall have general supervision of the affairs of the Corporation, shall sign or countersign or authorize another officer to sign all certificates, contracts, and other instruments of the Corporation as authorized by the Board of Directors. The Chief Executive Officer may employ and discharge employees and agents of the Corporation, except such as shall be appointed by the Board, and the Chief Executive Officer may delegate these powers. The Chief Executive Officer shall make reports to the Board of Directors and stockholders, and shall perform all such other duties as are incident to such office or are properly required by the Board of Directors.

     Section 4.4 PRESIDENT. In the absence of a designation of a Chief Executive Officer by the Board of Directors, the President shall have the duties of the Chief Executive Officer. The President shall sign or countersign or authorize another officer to sign all certificates, contracts, and other instruments of the Corporation as authorized by the Board of Directors, and shall perform all such other duties as are incident to such office or are properly required by the Board of Directors.

     Section 4.5 SECRETARY. The Secretary shall give, or cause to be given, notice of all meetings of stockholders and directors and all other notices required by law or by these Bylaws, and in case of his absence or refusal or neglect so to do, any such notice may be given by any person thereunto directed by the Chairman of the Board or the President, or by the Board of Directors, upon whose request the meeting is called as provided in these Bylaws. He shall record all the proceedings of the meetings of the Board of Directors, any committees thereof and the stockholders of the Corporation in a book to be kept for that purpose, and shall perform such other duties as may be assigned to him by the Board of Directors, the Chairman of the Board or the President. He shall have custody of the seal of the Corporation and shall affix the same to all instruments requiring it, when authorized by the Board of Directors, the Chairman of the Board or the President, and attest to the same.

     Section 4.6 TREASURER. The Treasurer shall have the custody of the corporate funds and securities and shall keep full and accurate receipts and disbursements in books belonging to the Corporation. The Treasurer shall deposit all moneys and other valuables in the name and to the credit of the Corporation in such depositaries as may be designated by the Board of Directors. The Treasurer shall disburse the funds of the Corporation as may be ordered by the Board of Directors the Chairman of the Board, or the President, taking proper vouchers for such disbursements. The Treasurer shall render to the Chairman of the Board, the President and the Board of Directors, whenever requested, an account of all his transactions as Treasurer and of the financial condition of the Corporation. If required by the Board of Directors, the Treasurer shall give the Corporation a bond for the faithful discharge of his duties in such amount and with such surety as the Board of Directors shall prescribe.

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     Section 4.7 REMOVAL. Any officer elected by the Board of Directors may be removed by a majority vote of the Board of Directors whenever, in its judgment, the best interests of the Corporation would be served thereby. No elected officer shall have any contractual rights against the Corporation for compensation by virtue of such election beyond the date of the election of his successor, his death, his resignation or his removal, whichever event shall first occur, except as otherwise provided in an employment contract or an employee plan.

     Section 4.8 VACANCIES. A newly created office and a vacancy in any office because of death, resignation, or removal may be filled by the Board of Directors for the unexpired portion of the term at any meeting of the Board of Directors.

ARTICLE 5

STOCK CERTIFICATES AND TRANSFERS

     Section 5.1 STOCK CERTIFICATES AND TRANSFERS.

          A. The interest of each stockholder of the Corporation shall be evidenced by certificates for shares of stock in such form as the appropriate officers of the Corporation may from time to time prescribe. The shares of the stock of the Corporation shall be transferred on the books of the Corporation by the holder thereof in person or by his attorney, upon surrender for cancellation of certificates for the same number of shares, with an assignment and power of transfer endorsed thereon or attached thereto, duly executed, and with such proof of the authenticity of the signature as the Corporation or its agents may reasonably require.

          B. The certificates of stock shall be signed, countersigned and registered in such manner as the Board of Directors may by resolution prescribe, which resolution may permit all or any of the signatures on such certificates to be in facsimile. In case any officer, transfer agent or registrar who has signed or whose facsimile signature has been placed upon a certificate has ceased to be such officer, transfer agent or registrar before such certificate is issued, it may be issued by the Corporation with the same effect as if he were such officer, transfer agent or registrar at the date of issue.

          C. The Corporation may issue a new certificate of stock in the place of any certificate previously issued by it, alleged to have been lost, stolen or destroyed, and the Corporation may require the owner of the lost, stolen or destroyed certificate , or such owner’s legal representative, to agree to indemnify the Corporation and/or to give the Corporation a bond sufficient to indemnify it, against any claim that may be made against it on account of the alleged loss, theft or destruction of any such certificate or the issuance of such new certificate.

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ARTICLE 6

INDEMNIFICATION

     Section 6.1 RIGHT TO INDEMNIFICATION. Each person who was or is made a party or is threatened to be made a party to or is otherwise involved in any action, suit or proceeding, whether civil, criminal, administrative or investigative (hereinafter a “proceeding”), by reason of the fact that he or she is or was a director or officer of the Corporation or is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation or of a partnership, joint venture, trust or other enterprise, including service with respect to an employee benefit plan (hereinafter an “indemnitee”), whether the basis of such proceeding is alleged action in an official capacity as a director, officer, employee or agent or in any other capacity while serving as a director, officer, employee or agent, shall be indemnified and held harmless by the Corporation to the fullest extent authorized by the General Corporation Law of the State of Delaware, as the same exists or may hereafter be amended (but, in the case of any such amendment, only to the extent that such amendment permits the Corporation to provide broader indemnification rights than permitted prior thereto), against all expense, liability and loss (including attorneys’ fees, judgments, fines, ERISA excise taxes or penalties and amounts paid in settlement) reasonably incurred or suffered by such indemnitee in connection therewith and such indemnification shall continue as to an indemnitee who has ceased to be a director, officer, employee or agent and shall inure to the benefit of the indemnitee’s heirs, executors and administrators; PROVIDED, HOWEVER, that, except as provided in Section 6.3 hereof with respect to proceedings to enforce rights to indemnification, the Corporation shall indemnify any such indemnitee in connection with a proceeding (or part thereof) initiated by such indemnitee only if such proceeding (or part thereof) was authorized by the Board of Directors of the Corporation.

     Section 6.2 RIGHT TO ADVANCEMENT OF EXPENSES. The right to indemnification conferred in Section 6.1 shall include the right to be paid by the Corporation the expenses incurred in defending any proceeding for which such right to indemnification is applicable in advance of its final disposition (hereinafter an “advancement of expenses”); PROVIDED, HOWEVER, that, if the General Corporation Law of the State of Delaware requires, an advancement of expenses incurred by an indemnitee in his or her capacity as a director or officer (and not in any other capacity in which service was or is rendered by such indemnitee, including, without limitation, service to an employee benefit plan) shall be made only upon delivery to the Corporation of an undertaking (hereinafter an “undertaking”), by or on behalf of such indemnitee, to repay all amounts so advanced if it shall ultimately be determined by final judicial decision from which there is no further right to appeal (hereinafter a “final adjudication”) that such indemnitee is not entitled to be indemnified for such expenses under this Section or otherwise; and PROVIDED, FURTHER, that the Corporation shall not be required to advance any expenses to a person against whom the Corporation directly brings a claim, in a proceeding, alleging that such person has breached such person’s duty of loyalty to the Corporation, committed an act or omission not in good faith or that involves intentional misconduct or a knowing violation of law, or derived an improper personal benefit from a transaction.

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     Section 6.3 RIGHT OF INDEMNITEE TO BRING SUIT. The rights to indemnification and to the advancement of expenses conferred in Section 6.1 and Section 6.2, respectively, shall be contract rights. If a claim under Section 6.1 or Section 6.2 is not paid in full by the Corporation within sixty days after a written claim has been received by the Corporation, except in the case of a claim for an advancement of expenses, in which case the applicable period shall be twenty days, the indemnitee may at any time thereafter bring suit against the Corporation to recover the unpaid amount of the claim. If successful in whole or in part in any such suit, or in a suit brought by the Corporation to recover an advancement of expenses pursuant to the terms of an undertaking, the indemnitee shall be entitled to be paid also the expense of prosecuting or defending such suit. In (A) any suit brought by the indemnitee to enforce a right to indemnification hereunder (but not in a suit brought by the indemnitee to enforce a right to an advancement of expenses) it shall be a defense that, and (B) in any suit by the Corporation to recover an advancement of expenses pursuant to the terms of an undertaking the Corporation shall be entitled to recover such expenses upon a final adjudication that, the indemnitee has not met any applicable standard for indemnification set forth in the General Corporation Law of the State of Delaware. Neither the failure of the Corporation (including its Board of Directors, independent legal counsel, or its stockholders) to have made a determination prior to the commencement of such suit that indemnification of the indemnitee is proper in the circumstances because the indemnitee has met the applicable standard of conduct set forth in the General Corporation Law of the State of Delaware, nor an actual determination by the Corporation (including its Board of Directors, independent legal counsel, or its stockholders) that the indemnitee has not met such applicable standard of conduct, shall create a presumption that the indemnitee has not met the applicable standard of conduct or, in the case of such a suit brought by the indemnitee, be a defense to such suit. In any suit brought by the indemnitee to enforce a right to indemnification or to an advancement of expenses hereunder, or by the Corporation to recover an advancement of expenses pursuant to the terms of an undertaking, the burden of proving that the indemnitee is not entitled to be indemnified, or to such advancement of expenses, under this Section or otherwise shall be on the Corporation.

     Section 6.4 NON-EXCLUSIVITY OF RIGHTS. The rights to indemnification and to the advancement of expenses conferred in this Section shall not be exclusive of any other right which any person may have or hereafter acquire under the Certificate of Incorporation, these Bylaws, or any statute, agreement, vote of stockholders or disinterested directors or otherwise.

     Section 6.5 INSURANCE. The Corporation may maintain insurance, at its expense, to protect itself and any director, officer, employee or agent of the Corporation or another corporation, partnership, joint venture, trust or other enterprise against any expense, liability or loss, whether or not the Corporation would have the power to indemnify such person against such expense, liability or loss under the General Corporation Law of the State of Delaware.

     Section 6.6 INDEMNIFICATION CONTRACTS. The Board of Directors is authorized to cause the Corporation to enter into indemnification contracts with any director, officer, employee or agent of the Corporation, or any person serving at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, including employee benefit plans, providing indemnification rights to such person. Such rights may be greater than those provided by this Article.

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     Section 6.7 EFFECT OF AMENDMENT. Any amendment, repeal or modification of any provision of this Article shall be prospective only, and shall not adversely affect any right or protection conferred on a person pursuant to this Article and existing at the time of such amendment, repeal or modification.

ARTICLE 7

MISCELLANEOUS PROVISIONS

     Section 7.1 FISCAL YEAR. The fiscal year of the Corporation shall begin on the first day of April and end on the 31st day of March of each year.

     Section 7.2 DIVIDENDS. The Board of Directors may from time to time declare, and the Corporation may pay, dividends on its outstanding shares in the manner and upon the terms and conditions provided by law and its Certificate of Incorporation.

     Section 7.3 SEAL. The corporate seal shall have inscribed the name of the Corporation thereon and shall be in such form as may be approved from time to time by the Board of Directors.

     Section 7.4 WAIVER OF NOTICE. Whenever any notice is required to be given to any stockholder or director of the Corporation under the provisions of the General Corporation Law of the State of Delaware, a waiver thereof in writing, signed by the person or persons entitled to such notice, whether before or after the time stated therein, shall be deemed equivalent to the giving of such notice. Neither the business to be transacted at, nor the purpose of, any annual or special meeting of the stockholders of the Board of Directors need be specified in any waiver of notice of such meeting.

     Section 7.5 RESIGNATIONS. Any director or any officer, whether elected or appointed, may resign at any time by serving written notice of such resignation on the Chairman of the Board, the President or the Secretary, and such resignation shall be deemed to be effective as of the close of business on the date said notice is received by the Chairman of the Board, the President, or the Secretary or at such later date as is stated therein. No formal action shall be required of the Board of Directors or the stockholders to make any such resignation effective.

     Section 7.6 CONTRACTS. Except as otherwise required by law, the Certificate of Incorporation or these Bylaws, any contracts or other instruments may be executed and delivered in the name and on the behalf of the Corporation by such officer or officers of the Corporation as the Board of Directors may from time to time direct. Such authority may be general or confined to specific instances as the Board may determine. The President or any Vice President may execute bonds, contracts, deeds, leases and other instruments to be made or executed for or on behalf of the Corporation. Subject to any restrictions imposed by the Board of Directors, the President or any Vice President of the Corporation may delegate contractual powers to others under his jurisdiction, it being understood, however, that any such delegation of power shall not relieve such officer of responsibility with respect to the exercise of such delegated power.

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     Section 7.7 PROXIES. Unless otherwise provided by resolution adopted by the Board of Directors, the President or any Vice President may from time to time appoint any attorney or attorneys or agent or agents of the Corporation, in the name and on behalf of the Corporation, to cast the votes which the Corporation may be entitled to cast as the holder of stock or other securities in any other corporation or other entity, any of whose stock or other securities may be held by the Corporation, at meetings of the holders of the stock and other securities of such other corporation or other entity, or to consent in writing, in the name of the Corporation as such holder, to any action by such other corporation or other entity, and may instruct the person or persons so appointed as to the manner of casting such votes or giving such consent, and may execute or cause to be executed in the name and on behalf of the Corporation and under its corporate seal or otherwise, all such written proxies or other instruments as he may deem necessary or proper in the premises.

     Section 7.8 SEVERABILITY. If any provision of these Bylaws shall be held to be invalid, illegal, unenforceable or in conflict with the provisions of the Corporation’s Certificate of Incorporation, then such provision shall nonetheless be enforced to the maximum extent possible consistent with such holding and the remaining provisions of these Bylaws (including without limitation, all portions of any section of these Bylaws containing any such provision held to be invalid, illegal, unenforceable or in conflict with the Certificate of Incorporation, that are not themselves invalid, illegal, unenforceable or in conflict with Certificate of Incorporation) shall remain in full force and effect.

ARTICLE 8

AMENDMENTS

     Section 8.1 AMENDMENTS. Subject to the provisions of the Certificate of Incorporation, these Bylaws may be amended, altered, added to, rescinded or repealed at any meeting of the Board of Directors or of the stockholders, provided notice of the proposed change was given in the notice of the meeting and, in the case of a meeting of the Board of Directors, in a notice given no less than twenty-four hours prior to the meeting.

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CERTIFICATE OF SECRETARY OF

WEBMETHODS, INC.

     The undersigned, Douglas W. McNitt, hereby certifies that he is the duly elected and acting Secretary of webMethods, Inc., a Delaware corporation (the “Corporation”), and that the Bylaws attached hereto constitute the Bylaws of said Corporation as duly adopted by the Directors on February 9, 2005.

     IN WITNESS WHEREOF, the undersigned has hereunto subscribed his name this ninth day of February, 2005.

/S/ DOUGLAS McNITT

Douglas W. McNitt, Secretary

15

EX-31.1

EXHIBIT 31.1

CERTIFICATION OF CHIEF EXECUTIVE OFFICER
PURSUANT TO SECTION 302
OF THE SARBANES-OXLEY ACT OF 2003

     I, David Mitchell, President and Chief Executive Officer of webMethods, Inc., have executed this certification in connection with the filing with the Securities and Exchange Commission of the registrant’s Quarterly Report on Form 10-Q for the three months ended December 31, 2004. I certify that:

1.    I have reviewed this report on Form 10-Q of webMethods, Inc.;

2.    Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.    Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.    The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the registrant and have:

(a)	designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)	evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and
(c)	disclosed in this report any change in the registrants internal control over financial reporting that occurred during the registrants most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrants internal control over financial reporting; and

5.    The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons fulfilling the equivalent function):

(a)	all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting, which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b)	any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: February 14, 2005	/S/ DAVID MITCHELL
	Name: David Mitchell
	Title: President and Chief Executive Officer

EX-31.2

EXHIBIT 31.2

CERTIFICATION OF CHIEF FINANCIAL OFFICER
PURSUANT TO SECTION 302
OF THE SARBANES-OXLEY ACT OF 2003

     I, Mary Dridi, the Executive Vice President and Chief Financial Officer of webMethods, Inc., have executed this certification in connection with the filing with the Securities and Exchange Commission of the registrant’s Quarterly Report on Form 10-Q for the three months ended December 31, 2004. I certify that:

1.    I have reviewed this report on Form 10-Q of webMethods, Inc.;

2.    Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.    Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.    The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the registrant and have:

(a)	designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)	evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and
(c)	disclosed in this report any change in the registrants internal control over financial reporting that occurred during the registrants most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrants internal control over financial reporting; and

5.    The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons fulfilling the equivalent function):

(a)	all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting, which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
(b)	any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: February 14, 2005	/S/ MARY DRIDI
	Name: Mary Dridi
	Title: Executive Vice President and Chief Financial Officer

EX-32.1

EXHIBIT 32.1

CERTIFICATION OF CHIEF EXECUTIVE OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2003

     In connection with the Quarterly Report on Form 10-Q of webMethods, Inc (the Company) for the period ended December 31, 2004 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, David Mitchell, President and Chief Executive Officer of the Company, hereby certifies pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2003, that:

     (1)    the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

     (2)    the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: February 14, 2005 /S/ DAVID MITCHELL

Name: David Mitchell
Title: President and Chief Executive Officer

EX-32.2

EXHIBIT 32.2

CERTIFICATION OF CHIEF FINANCIAL OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2003

     In connection with the Quarterly Report on Form 10-Q of webMethods, Inc (the Company) for the period ended December 31, 2004 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Mary Dridi, the Chief Financial Officer and Executive Vice President of the Company, hereby certifies pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2003, that:

     (1)    the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

     (2)    the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: February 14, 2005 /S/ MARY DRIDI

Name: Mary Dridi
Title: Executive Vice President and Chief Financial Officer