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 QUARTERLY PERIOD ENDED June 30, 2004

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

FOR THE TRANSITION PERIOD FROM              TO             .

Commission File Number: 0-22350

MERCURY INTERACTIVE CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	77-0224776
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

379 North Whisman Road, Mountain View, California 94043-3969

(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (650) 603-5200

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 a shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).    YES  x    NO  ¨

The number of shares of Registrant’s Common Stock outstanding as of July 30, 2004 was 93,146,117.

MERCURY INTERACTIVE CORPORATION

TABLE OF CONTENTS

		Page
PART I.	FINANCIAL INFORMATION
Item 1.	Unaudited Financial Statements
	Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003	1
	Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2004 and 2003	2
	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003	3
	Notes to Condensed Consolidated Financial Statements	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	44
Item 4.	Controls and Procedures	46
PART II.	OTHER INFORMATION
Item 4.	Submission of Matters to a Vote of Stockholders	47
Item 6.	Exhibits and Reports on Form 8-K	48
Signatures		49

MERCURY INTERACTIVE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)

	June 30, 2004			December 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	573,960		$	549,278
Short-term investments		167,690			157,082
Trade accounts receivable, net of sales reserves of $5,459 and $6,117, respectively		147,484			142,908
Prepaid expenses and other assets		77,659			64,485
Total current assets		966,793			913,753
Long-term investments		648,628			527,348
Property and equipment, net		72,657			73,203
Investments in non-consolidated companies		12,479			13,928
Debt issuance costs, net		13,111			14,965
Goodwill		347,779			347,616
Intangible assets, net		37,443			45,126
Restricted cash		6,000			6,000
Interest rate swap		5,184			11,557
Other assets		18,268			17,456
Total assets	$	2,128,342		$	1,970,952
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	18,486		$	17,584
Accrued liabilities		104,163			96,637
Deferred tax liabilities, net		28,253			28,367
Income taxes payable		40,328			35,404
Short-term deferred revenue		239,757			212,716
Total current liabilities		430,987			390,708
Convertible notes		804,803			811,159
Long-term deferred revenue		87,574			67,909
Other long-term payables, net		2,598			807
Total liabilities		1,325,962			1,270,583
Commitments and contingencies (Note 8 and 9)
Stockholders’ equity:
Preferred stock		—			—
Common stock		186			181
Additional paid-in capital		536,969			468,150
Treasury stock		(16,082	)		(16,082	)
Notes receivable from issuance of common stock		(4,639	)		(6,580	)
Unearned stock-based compensation		(963	)		(1,533	)
Accumulated other comprehensive loss		(6,062	)		(6,219	)
Retained earnings		292,971			262,452
Total stockholders’ equity		802,380			700,369
Total liabilities and stockholders’ equity	$	2,128,342		$	1,970,952

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

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MERCURY INTERACTIVE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Revenues:
License fees	$	59,942		$	48,004		$	117,515		$	92,790
Subscription fees		34,628			22,487			70,535			41,761
Total product revenues		94,570			70,491			188,050			134,551
Maintenance fees		48,143			38,745			95,032			74,330
Professional service fees		16,334			8,820			32,771			19,560
Total revenues		159,047			118,056			315,853			228,441
Costs and expenses:
Cost of license and subscription		9,883			6,757			19,702			13,307
Cost of maintenance		3,952			2,829			7,544			5,508
Cost of professional services (excluding stock-based compensation)		14,855			7,460			28,398			14,080
Marketing and selling (excluding stock-based compensation)		76,248			55,806			150,211			108,491
Research and development (excluding stock-based compensation)		17,763			13,120			35,049			24,709
General and administrative (excluding stock-based compensation)		12,024			9,722			24,269			18,822
Stock-based compensation*		183			195			392			384
Acquisition related charges		—			1,280			—			1,280
Integration and other related charges		1,131			917			2,110			917
Amortization of intangible assets		3,744			699			7,684			1,157
Excess facilities charge		9,178			—			9,178			—
Total costs and expenses		148,961			98,785			284,537			188,655
Income from operations		10,086			19,271			31,316			39,786
Interest income		9,803			8,968			19,063			17,735
Interest expense		(4,811	)		(4,921	)		(9,622	)		(9,921	)
Other expense, net		(1,640	)		(1,606	)		(2,845	)		(3,046	)
Income before provision for income taxes		13,438			21,712			37,912			44,554
Provision for income taxes		1,827			4,777			7,393			9,475
Net income	$	11,611		$	16,935		$	30,519		$	35,079
Net income per share (basic)	$	0.13		$	0.20		$	0.33		$	0.41
Net income per share (diluted)	$	0.12		$	0.19		$	0.31		$	0.39
Weighted average common shares (basic)		92,448			85,610			91,949			85,322
Weighted average common shares and equivalents (diluted)		98,237			90,506			98,006			89,945
* Stock-based compensation:
Cost of professional services	$	25		$	7		$	62		$	7
Marketing and selling		84			105			171			212
Research and development		69			73			149			139
General and administrative		5			10			10			26
	$	183		$	195		$	392		$	384

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

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MERCURY INTERACTIVE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Six months ended June 30,
	2004			2003
Cash flows from operating activities:
Net income	$	30,519		$	35,079
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		10,092			8,143
Sales reserves		(242	)		(1,236	)
Unrealized (gain) loss on interest rate swap		18			(92	)
Amortization of intangible assets		7,684			1,157
Stock-based compensation		392			384
Loss on investments in non-consolidated companies		455			1,339
Loss on disposals of assets		275			—
Gain on sale of available-for-sale securities		(336	)		—
Unrealized gain on warrant		(392	)		—
Write-off of in-process research and development		—			1,280
Excess facilities charge		9,178			—
Tax benefit from employee stock options		1,592			—
Deferred income taxes		(2,663	)		1,076
Changes in assets and liabilities, net of effect of acquisitions:
Trade accounts receivable		(4,306	)		13,157
Prepaid expenses and other assets		(8,580	)		(2,558	)
Accounts payable		646			(308	)
Accrued liabilities		5,128			1,048
Income taxes payable		4,910			2,061
Deferred revenue		46,657			30,883
Other long-term payables		2,057			—
Net cash provided by operating activities		103,084			91,413
Cash flows from investing activities:
Maturities of investments		637,470			1,180,168
Purchases of investments		(769,152	)		(1,285,356	)
Proceeds from sale of available-for-sale securities		1,696			—
Proceeds from return on investment in non-consolidated company		1,525			—
Purchases of investments in non-consolidated companies		(1,500	)		(750	)
Cash paid in conjunction with the acquisition of Performant		—			(21,925	)
Cash paid in conjunction with the acquisition of Kintana		(163	)		—
Net proceeds from sale of vacant facilities and assets		2,640			—
Acquisition of property and equipment, net		(19,280	)		(7,633	)
Net cash used in investing activities		(146,764	)		(135,496	)
Cash flows from financing activities:
Proceeds from issuance of convertible notes, net		—			488,198
Proceeds from issuance of common stock under stock option and employee stock purchase plans		66,918			23,533
Collection of notes receivable from issuance of common stock		1,436			2,446
Net cash provided by financing activities		68,354			514,177
Effect of exchange rate changes on cash		8			825
Net increase in cash and cash equivalents		24,682			470,919
Cash and cash equivalents at beginning of period		549,278			349,123
Cash and cash equivalents at end of period	$	573,960		$	820,042

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

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1—OUR SIGNIFICANT ACCOUNTING POLICIES

Basis of presentation

The accompanying condensed consolidated financial statements include the accounts of Mercury Interactive Corporation and its subsidiaries. We have a wholly-owned research and development and sales subsidiary incorporated in Israel. In addition, we have sales subsidiaries and offices in the Americas; Europe, the Middle East, and Africa (EMEA); Asia Pacific (APAC); and Japan. The Americas includes Brazil, Canada, Mexico, and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. All significant intercompany accounts and transactions have been eliminated.

These interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information, and the rules and regulations of the Securities and Exchange Commission for interim financial statements and accounting policies, consistent, in all material respects, with those applied in preparing our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003. The unaudited financial information furnished herein reflects all adjustments, consisting only of normal recurring adjustments, that in our opinion are necessary to fairly state our consolidated financial position, the results of operations, and cash flows for the periods presented. This Quarterly Report on Form 10-Q should be read in conjunction with our audited financial statements for the year ended December 31, 2003, included in the 2003 Form 10-K. The condensed consolidated statements of operations for the three and six months ended June 30, 2004 are not necessarily indicative of results to be expected for any subsequent periods or for the entire year ending December 31, 2004.

Increase in authorized common stock

At the 2004 Annual Meeting of the stockholders held in May 2004, the stockholders approved an increase in the number of authorized shares of common stock of Mercury from 240 million to 560 million shares.

Short-term and long-term investments

We consider all debt securities with remaining maturities of less than one year to be short-term investments and all debt securities with remaining maturities greater than one year to be long-term investments. In accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities, we have categorized our debt securities as “held to maturity” securities. These debt securities, which all have contractual maturities of less than three years, are carried at cost plus accrued interest. Marketable equity securities are classified as available-for-sale and are reported at fair value, based on quoted market prices, with unrealized gains or losses, net of tax, recorded as a component of “Accumulated other comprehensive income or loss” in our consolidated statement of stockholders’ equity. The cost basis of securities sold is based on the specific identification method. We evaluate whether or not any of our marketable equity securities has experienced an other-than-temporary decline in fair value on a regular basis. As part of the evaluation process, we consider factors such as earnings/revenue outlook, operational performance, management/ownership changes, competition, and stock price performance. If we determine that a decline in fair value of a marketable equity security below carrying value is other-than-temporary, it is our policy to record a loss on investment in our consolidated statement of operations and write down the marketable equity security to its fair value. Gains are recognized in our consolidated statement of operations when they are realized.

Property and equipment

Property and equipment are stated at cost less accumulated depreciation. Depreciation and amortization are provided using the straight-line method over the estimated economic lives of assets, which are five to seven years for office furniture and equipment, two to three years for computers and related equipment, three years for internal use software, seven to ten years for building improvements, and thirty years for buildings. Leasehold improvements are depreciated using the straight-line method over the estimated economic lives or the remaining lease terms, whichever is shorter.

Investments in non-consolidated companies

Investments in non-consolidated companies consist of minority equity investments in publicly traded companies, privately held companies, and private equity funds. We make these investments for business and strategic purposes. These investments are accounted

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

for under the cost method, as we do not have the ability to exercise significant influence over these companies’ operations. Our investments in publicly traded companies were classified as available-for-sale in accordance with SFAS No. 115 and were included as “Short-term investments” in our consolidated balance sheet. We periodically monitor our investments for impairment and will record reductions in carrying values for investments in privately held companies and private equity funds if and when necessary. The evaluation process is based on information that we request from these privately held companies. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, recent financing activities, financing needs, earnings/revenue outlook, operational performance, management/ownership changes, and competition. If we determine that the carrying value of an investment is at an amount above fair value, or if a company has completed a financing with new third-party investors based on a valuation significantly lower than the carrying value of our investment and the decline is other-than-temporary, it is our policy to record a loss on investment in our consolidated statement of operations. In calculating the loss on our investments, we take into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors.

Consolidation of Variable Interest Entities

In January 2003, the Financial Accounting Standard Board (FASB) issued FASB Interpretation (FIN) No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51, which relates to the identification of, and financial reporting for, variable-interest entities. FIN No. 46 requires that if an entity is the primary beneficiary of a variable interest entity, the assets, liabilities, and results of operations of the variable interest entity should be included in the consolidated financial statements of the entity. The provisions of FIN No. 46 are effective immediately for all arrangements entered into after January 31, 2003. For those arrangements entered into prior to February 1, 2003, the provisions of FIN No. 46 are required to be adopted at the beginning of the first interim or annual period beginning after June 15, 2003. In December 2003, the FASB issued FIN No. 46(R). The FASB deferred the effective date for variable-interest entities that are non-special purpose entities created before February 1, 2003, to the first interim or annual reporting period that ends after March 15, 2004. The adoption of FIN No. 46(R) did not have a material impact on our financial position or results of operations.

Stock-based compensation

We account for stock-based compensation for our employees using the intrinsic value method presented in Accounting Principles Board (APB) Statement No. 25, Accounting for Stock Issued to Employees, and related interpretations, and comply with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation, and with the disclosure provisions of SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure Amendment of SFAS No. 123. Under APB No. 25, compensation expense is based on the difference, as of the date of the grant, between the fair value of our stock and the exercise price. No stock-based compensation has been recorded for stock options granted to our employees because we have granted stock options to our employees at fair market value of the underlying stock on the date of grant. We account for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (EITF) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. We do not issue stock options to non-employees, except for our non-employee members of our Board of Directors. In accordance with FIN No. 44, Accounting for Certain Transactions Involving Stock Compensation, an interpretation of APB No. 25, we value stock options assumed in a purchase business combination at the date of acquisition at their fair value calculated using the Black-Scholes option-pricing model. The fair value of assumed options is included as a component of the purchase price. The intrinsic value attributable to unvested options is recorded as unearned stock-based compensation and amortized over the remaining vesting period of the stock options.

5

MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Pro forma information regarding net income (loss) and earnings (loss) per share is required by SFAS No. 123. This information is required to be determined as if we had accounted for our employee stock options and stock purchase plans under the fair value based method of SFAS No. 123, as amended by SFAS No. 148. The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (in thousands, except per share amounts):

	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Net income, as reported	$	11,611		$	16,935		$	30,519		$	35,079
Add:
Stock-based compensation expense included in reported net income		183			195			392			384
Deduct:
Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(28,176	)		(33,127	)		(57,516	)		(65,582	)
Pro forma net loss	$	(16,382	)	$	(15,997	)	$	(26,605	)	$	(30,119	)
Net income per share (basic), as reported	$	0.13		$	0.20		$	0.33		$	0.41
Net loss per share (basic), pro forma	$	(0.18	)	$	(0.19	)	$	(0.29	)	$	(0.35	)
Net income per share (diluted), as reported	$	0.12		$	0.19		$	0.31		$	0.39
Net loss per share (diluted), pro forma	$	(0.18	)	$	(0.19	)	$	(0.29	)	$	(0.35	)

We calculate stock-based compensation expense under the fair value based method for shares issued pursuant to the 1998 Employee Stock Purchase Plan (ESPP) based upon actual shares issued, except for the period since the most recent purchase in February 2004. We estimate the number of shares issuable under the 1998 ESPP based upon actual contributions made by employees for the period from February 16 through June 30, 2004 and the lower of the fair market value of our common stock on February 16, 2004 or June 30, 2004.

We amortize unearned stock-based compensation expense using the straight-line method over the vesting periods of the related options, which is generally four years for non-qualified and incentive stock options. Stock-based employee compensation expense determined under the fair value based method for non-qualified options issued pursuant to the stock option plans is tax affected. Stock-based employee compensation expense determined under the fair value based method for incentive stock options issued pursuant to the stock option plans and shares issued pursuant to the 1998 ESPP is not tax affected.

The fair value of stock options and shares issued pursuant to the stock option plans and the 1998 ESPP at the grant date were estimated using the Black-Scholes option-pricing model, with the following weighted average assumptions, for the three and six months ended June 30, 2004 and 2003:

	Stock option plans				ESPP				Stock option plans				ESPP
	Three months ended June 30,								Six months ended June 30,
	2004		2003		2004		2003		2004		2003		2004		2003
Expected life (years)	4.00		4.00		0.50		0.50		4.00		4.00		0.50		0.50
Risk-free interest rate	3.78	%	2.61	%	1.64	%	0.94	%	3.03	%	2.96	%	1.23	%	2.17	%
Volatility	84	%	89	%	84	%	89	%	85	%	89	%	84	%	89	%
Dividend yield	None		None		None		None		None		None		None		None

        The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. We use projected volatility rates, which are based upon historical volatility rates. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our options. Based upon the above assumptions, the weighted average fair value per share of options granted under the option plans during the three and six months ended June 30, 2004 was $29.81, and $29.49 respectively. The weighted average fair value per share of options granted under the option plans during the three and

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

six months ended June 30, 2003 was $24.29 and $21.20, respectively. The weighted average fair value per share of options granted under the 1998 ESPP during the three and six months ended June 30, 2004 was $19.02 and $16.85, respectively. The weighted average fair value per share of options granted under the 1998 ESPP during the three and six months ended June 30, 2003 was $14.03 and $11.28, respectively.

Revenue recognition

Revenue consists of fees for licenses and subscription licenses of our software products, maintenance fees, and professional service fees. We apply the provisions of Statement of Position (SOP) No. 97-2, Software Revenue Recognition, as amended by SOP No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition, With Respect to Certain Transactions, to all transactions involving the sale of software products and services. In addition, we apply the provisions of the EITF Issue No. 00-03, Application of AICPA SOP No. 97-2 to Arrangements that Include the Right to Use Software Stored on Another Entity’s Hardware, to our managed services software transactions. We also apply EITF No. 01-09, Accounting for Consideration Given by Vendor to a Customer or a Reseller of the Vendor’s Products to account for transactions related sales incentives.

License revenue consists of license fees charged for the use of our products licensed under perpetual or multiple-year arrangements in which the fair value of the license fee is separately determinable from undelivered items such as maintenance and professional services. We recognize revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been delivered, the fee is fixed or determinable, and collection of the resulting receivable is probable. Delivery generally occurs when product is delivered to a common carrier. At the time of the transaction, we assess whether the fee associated with our revenue transactions is fixed or determinable based on the payment terms associated with the transaction and whether or not collection is probable. If a significant portion of a fee is due after our normal payment terms, which are generally within 30-60 days of the invoice date in the U.S., APAC and Japan (slightly longer in EMEA), we account for the fee as not being fixed or determinable. In these cases, we recognize revenue at the earlier of cash collection or as the fees become due. We assess collection based on a number of factors, including past transaction history with the customer. We do not request collateral from our customers. If we determine that collection of a fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon receipt of cash. For all sales, except those completed over the Internet, we use either a customer order document or a signed license or service agreement as evidence of an arrangement. For sales over the Internet, we use a credit card authorization as evidence of an arrangement.

Subscription revenue, including managed service revenue, represents license fees to use one or more software products, and to receive maintenance support (such as hotline support and product updates) for a limited period of time. Since subscription licenses include bundled products and services, which are sold as a combined product offering and for which the fair value of the license fee is not separately determinable from maintenance, both product and service revenue is generally recognized ratably over the term of the subscription. Customers do not pay a set up fee associated with a subscription arrangement.

Maintenance revenue consists of fees charged for post-contract customer support, which are determinable based upon vendor specific objective evidence of fair value. Maintenance fee arrangements include ongoing customer support and rights to product updates on an if and when available basis. Payments for maintenance are generally made in advance and are nonrefundable. Revenue is recognized ratably over the period of the maintenance contract.

Professional service revenue consists of fees charged for product training and consulting services, which are determinable, based upon vendor specific objective evidence of fair value. Professional service revenue is recognized as the services are provided.

For arrangements with multiple elements (for example, license and undelivered maintenance and support), we allocate revenue to each component of the arrangement using the residual value method based on the fair value of the undelivered elements, which is specific to Mercury. This means that we defer revenue from the arrangement fee equivalent to the fair value of the undelivered elements. Fair values for the ongoing maintenance and support obligations within an arrangement are based upon renewal rates quoted in contracts, and, in the absence of stated renewal rates, upon separate sales of renewals to other customers. Fair value of services, such as training or consulting, is based upon separate sales by us of these services to other customers. Most of our arrangements involve multiple elements. Our arrangements do not generally include acceptance clauses. However, if an arrangement includes an acceptance provision, revenue is deferred until the earlier of receipt of a written customer acceptance or expiration of the acceptance period.

We derive a portion of our business from sales of our products through our alliance partners, which include value-added resellers and major systems integration firms.

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Advertising expense

We expense the costs of producing advertisements at the time production occurs and expense the cost of communicating advertising in the period during which the advertising space or airtime is used. For the three and six months ended June 30, 2004, advertising expenses totaled $2.4 million and $4.1 million, respectively. For the three and six months ended June 30, 2003, advertising expenses totaled $2.8 million and $5.1 million, respectively.

Reclassifications

Certain reclassifications have been made to the December 31, 2003 balances to conform to the June 30, 2004 presentation, namely the classification of deferred tax assets and liabilities. Certain reclassifications have been made to the consolidated statements of operations for the three and six months ended June 30, 2003 to conform to the presentation adopted for the three and six months ended June 30, 2004.

Recent accounting pronouncement

In November 2003, the EITF reached a consensus on disclosure guidance previously discussed under EITF Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The consensus provided for certain disclosure requirements that were effective for fiscal years ending after December 15, 2003. We adopted the disclosure requirements during the year ended December 31, 2003.

In March 2004, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF Issue No. 03-01. The consensus clarified the meaning of other-than-temporary impairment and its application to debt and equity investments accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and other investments accounted for under the cost method. The recognition and measurement guidance for which the consensus was reached in March 2004 is to be applied to other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. The consensus reached in March 2004 also provided for certain disclosure requirements associated with cost method investments that were effective for fiscal years ending after June 15, 2004. We do not believe that the consensus on the recognition and measurement guidance will have an impact on our results of operations.

NOTE 2—SALES RESERVE

Our license agreements and reseller agreements do not offer our customers or vendors the unilateral right to terminate or cancel the contract and receive a cash refund. In addition, the terms of our license agreements do not offer customers price protection.

We do provide for sales returns based upon estimates of potential future credits, warranty cost of product and services, and write-offs of bad debts related to current period product revenues. We analyze historical credits, historical bad debts, current economic trends, average deal size, changes in customer demand, and acceptance of our products when evaluating the adequacy of the sales reserve. Revenues for the period are reduced to reflect the provision for sales returns.

The following table summarizes changes in our sales reserve during the three and six months ended June 30, 2004 and 2003 (in thousands):

	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Sales reserve:
Beginning balance	$	6,274		$	6,599		$	6,117		$	7,431
Decrease in sales reserve (increase in revenues)		(479	)		(829	)		(242	)		(1,236	)
Write-off of accounts receivable against reserve		(332	)		(518	)		(409	)		(957	)
Currency translation adjustments		(4	)		60			(7	)		74
Ending balance	$	5,459		$	5,312		$	5,459		$	5,312

NOTE 3—CONSOLIDATION OF FACILITIES

On January 30, 2004, we sold two of our four buildings we own in Sunnyvale, California at the carrying value to a third party for $2.7 million in cash. In April 2004, we completed our move into our new leased headquarters in Mountain View, California and have placed one of the two remaining buildings we own for sale. As a result of our move and our decision to sell one of these two buildings, we took a charge to write down the net book value of the building that is held for sale to its appraised market value. We took into account the cost to maintain the facility until sold and sales commissions related to the sale of the building when we calculated the charge. Accordingly, we reclassified the building as asset held for sale. Asset held for sale was included in “Prepaid expenses and other assets” in our consolidated balance sheet as of June 30, 2004. In connection with our move into our consolidated headquarters, we also vacated two leased facilities from the Kintana acquisition. In the second quarter of 2004, we recorded a charge for the remaining lease payments, as well as associated costs to protect and maintain the leased facilities prior to returning these leased facilities to the lessor. These lease agreements expire in September 2004 and December 2005. Due to the short duration of the remaining lease terms, it is not likely that we can sublease the facilities; as such, no sublease income was included in the facilities lease costs calculation. We also wrote off leasehold improvements and recorded the disposal of fixed assets, net of cash proceeds, associated with these facilities. The total excess facilities charge recorded in the second quarter of 2004 was $9.2 million.

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

NOTE 4—INVESTMENTS IN NON-CONSOLIDATED COMPANIES

At June 30, 2004, our equity investments in non-consolidated companies were composed of investments in privately held companies of $4.6 million, a private equity fund of $7.1 million, and a warrant to purchase common stock of Motive, Inc. of $0.8 million. At December 31, 2003, our equity investments in non-consolidated companies were composed of investments in privately held companies of $7.5 millions, a private equity fund of $6.0 millions, and the Motive warrant of $0.4 million. Through June 30, 2004, we have made capital contributions to a private equity fund totaling $7.9 million. We have committed to make additional capital contributions up to $7.1 million in the future. For the three months ended June 30, 2004, we did not record any losses on our investments in privately held companies nor the private equity fund. Unrealized gain related to a change in the fair value of the Motive warrant was $0.1 million for the three months ended June 30, 2004. For the six months ended June 30, 2004, we recorded a loss of $0.5 million on one of our investments in privately held companies. The loss was partially offset by an unrealized gain of $0.4 million related to a change in fair value of the Motive warrant. For the three months ended June 30, 2003, we recorded a loss of $0.6 million on one of our investments in privately held companies and a loss of $0.2 million on our investment in the private equity fund. For the six months ended June 30, 2003, we recorded a loss of $1.1 million on two of our investments in privately held companies and a loss of $0.2 million on our investment in the private equity fund. In calculating the loss on our investments, we took into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors. We calculated the fair value of the warrant using the Black-Scholes option-pricing model with the following assumptions: risk-free interest rate of 3.92%, contractual life of 5 years, volatility of 75% and zero dividend rate. We had not exercised the warrant at June 30, 2004. We believe that the carrying value of our investments in non-consolidated companies approximated their fair value at June 30, 2004 and December 31, 2003.

In February 2004, one of the privately held companies in which we had an equity investment was acquired by a public company. We received $1.5 million cash and common stock of that company. Cash proceeds received by us were recorded as a return of investment in the privately held company. The common stock we received from the public company was recorded at the carrying value of our investment in the privately held company, net of cash received, and was treated as available-for-sale marketable equity securities. Unrealized gains related to the available-for-sale marketable equity securities was included as a component of “Accumulated other comprehensive loss,” until the common stock was sold. On May 7, 2004, we sold the common stock of the public company for $1.7 million in cash, resulting in a realized gain of approximately $0.3 million.

NOTE 5—ACQUISITIONS

Kintana

On August 15, 2003, we acquired Kintana, a leading provider of Information Technology (IT) governance software and services for an aggregate purchase price of $267.4 million. Kintana’s IT governance expands our product line to include products which enable our customers to govern and manage the priorities, processes, and people required to run IT as a business. We recorded goodwill of $217.2 million, intangible assets of $44.3 million, in-process research and development (IPR&D) of $10.7 million, and unearned stock-based compensation of $1.3 million as a result of the Kintana acquisition.

The acquired IPR&D is related to the next generation of Kintana’s IT governance software products including changes to existing applications and the addition of new applications. The value of IPR&D was determined through the discounted cash flow approach. The expected future cash flow attributable to the in-process technology is discounted at 23%. This rate takes into account that the product leverages core and current technology found in the versions of the existing software, the increasing complexity and criticality of distributed software applications, the demand for faster turnaround of new distributed applications and enhancements, the expected growth in the industry, the continuing introduction of new functionality into the products, and the percentage of completion of approximately 35%. As of June 30, 2004, the IPR&D projects were completed.

The transaction was accounted for as a purchase and, accordingly, the operating results of Kintana have been included in our accompanying condensed consolidated statements of operations from the date of acquisition. The following unaudited pro forma information presents the combined results of Mercury and Kintana as if the acquisition had occurred as of the beginning of 2003, after applying certain adjustments, including amortization of intangible assets, amortization of unearned stock-based compensation, rent expense adjustment associated with unfavorable operating leases assumed by us, and interest income, net of related tax effects. IPR&D of $10.7 million has been excluded from the following presentation as it is a non-recurring charge (in thousands, except per share amounts):

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

	Three months ended June 30, 2003		Six months ended June 30, 2003
Net revenues	$	128,760	$	251,915
Net income	$	13,628	$	29,968
Net income per share (basic)	$	0.16	$	0.34
Net income per share (diluted)	$	0.15	$	0.33

Performant

On May 5, 2003, we acquired all of the outstanding stock and assumed the unvested stock options of Performant, a provider of Java 2 Enterprise Edition (J2EE) diagnostics software for an aggregate purchase price of $22.5 million. Performant’s technology pinpoints performance problems at the application code level. The Performant acquisition allows our customers to diagnose J2EE performance issues across the application delivery and application management cycles from pre-production testing to production operations. We recorded goodwill of $17.2 million, intangible assets of $3.4 million, IPR&D of $1.3 million, and unearned stock-based compensation of $0.3 million as a result of the Performant acquisition.

The acquired IPR&D is related to the development of the Microsoft version of the diagnostics software or .NET. The value of IPR&D was determined through the discounted cash flow approach. The expected future cash flow attributable to the in-process technology was discounted at 29%, taking into account the percentage of completion of approximately 46%, the rate technology changes in the industry, product life cycles, the future markets, and various projects’ stage of development. The IPR&D projects are currently expected to be completed in the next three to six months and the estimated costs to complete the project are insignificant during that time.

The transaction was accounted for as a purchase and, accordingly, the operating results of Performant have been included in our accompanying condensed consolidated statements of operations from the date of acquisition. The following unaudited pro forma information presents the combined results of Mercury and Performant as if the acquisition had occurred as of the beginning of 2003, after applying certain adjustments, including amortization of intangible assets, amortization of unearned stock-based compensation, and interest income, net of related tax effects. IPR&D of $1.3 million has been excluded from the following presentation as it is a non-recurring charge (in thousands, except per share amounts):

	Three months ended June 30, 2003		Six months ended June 30, 2003
Net revenues	$	118,071	$	228,572
Net income	$	17,164	$	33,718
Net income per share (basic)	$	0.20	$	0.40
Net income per share (diluted)	$	0.19	$	0.38

In conjunction with the acquisition of Performant, we committed to a license agreement for certain technology. The agreement was entered into in August 2000 and remains in effect until April 2018. The total estimated commitment is approximately $0.2 million, although the maximum commitment could reach approximately $0.8 million. We have paid $21,000 through June 30, 2004.

In conjunction with the acquisition of Performant, we entered into a milestone bonus plan related to certain research and development activities. The plan entitles each eligible employee to receive bonuses, in the form of cash payments, based on the achievement of certain performance milestones by applicable target dates. The commitment will be earned equally over time as milestones are achieved and expensed as incurred. For the three and six months ended June 30, 2004, we recorded $1.1 million and $2.1 million, respectively, as “Integration and other related charges” in our condensed consolidated statement of operations, associated with the milestone bonus plan. The maximum total payment under the plan is $5.5 million, of which $3.7 million has been paid through June 30, 2004.

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

NOTE 6—GOODWILL AND INTANGIBLE ASSETS

The changes in the carrying amount of goodwill for the six months ended June 30, 2004 are as follows (in thousands):

Balance at December 31, 2003	$	347,616
Additional goodwill amount for acquisition of Kintana		163
Balance at June 30, 2004	$	347,779

We increased our goodwill from the Kintana acquisition due to additional payments for pre-acquisition liabilities.

The carrying amounts of intangible assets are as follows (in thousands):

	June 30, 2004						December 31, 2003
	Gross Carrying Amount		Accumulated Amortization		Net		Net
Intangible assets:
Existing technology	$	20,166	$	8,578	$	11,588	$	14,685
Patents and core technology		13,330		3,746		9,584		10,985
Maintenance and support contracts		6,106		891		5,215		5,724
Employment agreements		720		560		160		400
Customer contracts and other		14,093		4,167		9,926		12,255
Domain name		1,135		165		970		1,077
	$	55,550	$	18,107	$	37,443	$	45,126

The weighted average amortization period of existing technology is 38 months, patents and core technology is 56 months, employment agreements is 18 months, maintenance and support contracts is 72 months, customer contracts and other intangible assets are 36 months, and domain name is 60 months. The weighted average amortization period of all intangible assets is 46 months. The aggregate amortization expense of intangible assets was $3.7 million and $7.7 million for the three and six months ended June 30, 2004, respectively. The aggregate amortization expense of intangible assets was $0.7 million and $1.2 million for the three and six months ended June 30, 2003, respectively.

Future amortization expense of intangible assets at June 30, 2004 is as follows (in thousands):

Year ending December 31,
2004 (remainder of fiscal year)	$	6,896
2005		13,471
2006		10,067
2007		3,818
2008		2,555
Thereafter		636
	$	37,443

NOTE 7—LONG-TERM DEBT

        In July 2000, we issued $500.0 million in Convertible Subordinated Notes (2000 Notes). The 2000 Notes mature on July 1, 2007 and bear interest at a rate of 4.75% per annum, payable semiannually on January 1 and July 1 of each year. The 2000 Notes are subordinated in right of payment to all of our future senior debt. The 2000 Notes are convertible into shares of our common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. We may redeem the 2000 Notes, in whole or in part, at any time on or after July 1, 2003. Accrued interest to the redemption date will be paid by us in any such redemption. We had not redeemed any portion of the 2000 Notes at June 30, 2004. From December 2001 through June 30, 2002, we retired $200.0 million face value of the 2000 Notes. The face value of the 2000 Notes was $300.0 million at June 30, 2004 and December 31, 2003.

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

In connection with the issuance of our 2000 Notes, we incurred $14.6 million of issuance costs, which primarily consisted of investment banker, legal, and other professional fees. In conjunction with the retirement of a portion of our 2000 Notes, we wrote-off $3.8 million of debt issuance costs. The remaining costs are being amortized using a straight-line method over the remaining term of the 2000 Notes. Amortization expense related to the issuance costs was $0.3 million and $0.6 million for the three and six months ended June 30, 2004, respectively. Amortization expense related to the issuance costs was $0.4 million and $0.8 million for the three and six months ended June 30, 2003, respectively. At June 30, 2004 and December 31, 2003, net debt issuance costs associated with our 2000 Notes were $4.0 million and $4.6 million, respectively.

In April 2003, we issued $500.0 million of Zero Coupon Convertible Notes (2003 Notes) due on May 1, 2008 in a private offering. The 2003 Notes do not bear interest, have a zero yield to maturity and may be convertible into our common stock. Holders of the 2003 Notes may convert their 2003 Notes prior to maturity only if:

• during any quarter (beginning with the third quarter of 2003) the closing sale price of our common stock for at least 20 trading days in the 30 trading-day period ending on the last trading day of the immediately preceding quarter exceeds 110% of the conversion price of the 2003 Notes as in effect on that 30^th trading day; or

• during the period beginning January 1, 2008 through the maturity of the 2003 Notes, the closing sale price of our common stock on the previous trading day was 110% or more of the conversion price of the 2003 Notes on that previous trading day; or

• specified corporate transactions have occurred; specified corporate transactions include:

i. we distribute to all holders of our common stock rights entitling them to purchase common stock at less than the average sale price of the common stock for the 10 trading days preceding the declaration date for such distribution; or

ii. we elect to distribute to all holders of our common stock, cash or other assets, debt securities, or rights to purchase our securities, which distribution has a per share value exceeding 15% of the sale price of the common stock on the business day preceding the declaration date for the distribution, then at least 20 days prior to the ex-dividend date for the distribution we must notify the holders of the 2003 Notes in writing of the occurrence of such event. Once we have given that notice, holders may surrender their 2003 Notes for conversion at any time until the earlier of the close of business on the business day immediately prior to the ex-dividend date or the date of our announcement that the distribution will not take place, in the case of a distribution. No adjustment to the ability of a holder of 2003 Notes to convert will be made if the holder may participate in the distribution without conversion; or

iii. we are party to a consolidation, merger or binding share exchange pursuant to which our common stock would be converted into cash, securities or other property, a holder may surrender 2003 Notes for conversion at any time from and after the date which is 15 days prior to the anticipated effective date of the transaction until 15 days after the actual date of the transaction.

Upon conversion, we have the right to deliver cash instead of shares of our common stock. We may not redeem the 2003 Notes prior to their maturity.

In connection with the issuance of our 2003 Notes, we incurred $11.9 million of issuance costs, which primarily consisted of investment banker, legal, and other professional fees. These costs are being amortized using a straight-line method over the term of the 2003 Notes. Amortization expense related to the issuance costs was $0.6 million and $1.3 million for the three and six months ended June 30, 2004, respectively. Amortization expense related to the issuance costs was $0.4 million for each of the three and six months ended June 30, 2003. At June 30, 2004 and December 31, 2003, net debt issuance costs associated with our 2003 Notes were $9.1 million and $10.4 million, respectively.

NOTE 8—COMMITMENTS AND CONTINGENCIES

Royalty agreement

On June 30, 2003, we entered into a non-exclusive agreement (amended in February 2004) to license technology from Motive. The agreement is non-transferable, except in the case of a merger, acquisition, spin-out or other transfer of all or substantially all of the business, stock or assets to which the agreement relates. The licensed technology will be combined with our other existing Mercury products, which should be generally available in the latter half of 2004. The agreement is in effect until

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

December 31, 2006 with a right to renew and an option to purchase a fully paid up, perpetual license to the technology prior to July 1, 2008. Under the original agreement, we had committed to royalty payments totaling $15.0 million, of which $8.0 million had been paid as of December 31, 2003. In accordance with the addendum, the remaining royalty balance of $7.0 million was accelerated and was paid in February 2004. We recorded such payments as prepaid royalties. Prepaid royalties are included in “Prepaid expenses and other assets” in our consolidated balance sheet and will be amortized to cost of license and subscription at the greater of the actual revenue over total forecasted revenue or straight line over the estimated useful life of the licensed technology.

Executive severance

In December 2003, we entered into a severance agreement with a former executive officer. In accordance with the agreement, the former executive officer is entitled to salary and bonus through October 3, 2005 totaling $1.5 million. Under the agreement, we also accelerated the vesting of options to purchase 374,479 shares of common stock with exercise prices ranging from $29.29 to $60.88. The exercise period of these accelerated options and the vested portion of options to purchase 255,208 shares of common stock with an exercise price of $60.88 was extended through October 3, 2005. Accrued salaries and bonuses related to this executive severance agreement were $1.0 million and $1.5 million at June 30, 2004 and December 31, 2003, respectively.

Lease commitments

We lease facilities for sales offices in the U.S. and foreign locations under non-cancelable operating leases that expire through 2015. Certain of these leases contain renewal options. We lease certain equipment under various lease agreements with lease terms ranging from month-to-month up to one year. On October 21, 2003, we entered into a lease agreement for our new headquarters facility. The lease began on January 1, 2004 and expires on February 20, 2014. Future minimum payments under the facilities, including the two vacant facilities from the Kintana acquisition, and equipment leases with non-cancelable terms in excess of one year at June 30, 2004 are as follows (in thousands):

Year ending December 31,
2004 (remainder of year)	$	9,074
2005		15,901
2006		10,729
2007		7,856
2008		5,807
Thereafter		25,027
	$	74,394

Letters of credit

At June 30, 2004, we had four irrevocable letter of credit agreements totaling $1.4 million with Wells Fargo & Company (Wells Fargo). Wells Fargo is a related party to us as one of the members of our Board of Directors is an executive officer of Wells Fargo. Two of the agreements are related to facility lease agreements assumed by us in conjunction with the acquisition of Kintana in 2003. One of the agreements has an automatic annual renewal provision under which the expiration date cannot be extended beyond March 1, 2006 and the other agreement expires in September 2004. The third agreement is related to a facility lease agreement assumed by us in conjunction with the acquisition of Freshwater in 2001. This agreement has an automatic annual renewal provision under which the expiration dates cannot be extended beyond August 31, 2006. The fourth agreement is related to the facility lease agreement for our new headquarters in Mountain View, California and this agreement automatically renews annually after January 1, 2005 unless we provide a termination notice to Wells Fargo. At June 30, 2004, no amounts had been drawn on the letters of credit.

Contingencies

From time to time, we may have certain contingent liabilities that arise in the ordinary course of our business activities. We accrue for contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. Our former Vice President of Tax, Uzi Sasson, filed a complaint on August 4, 2004, alleging that we wrongfully terminated his employment. We believe these claims are without merit and intend to vigorously defend the lawsuit. In the opinion of management, there are no pending claims of which the outcome is expected to result in a material adverse effect on our financial position, results of operations, or cash flows.

NOTE 9—GUARANTEES

As permitted under Delaware law, we have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

for the officer’s or director’s term in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a director and officer insurance policy that limits our exposure and enables us to recover a portion of some future amounts to be paid, as allowed by law. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.

We enter into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners, subsidiaries and/or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is insignificant. Accordingly, we have no liabilities recorded for these agreements at June 30, 2004.

We may, at our discretion and in the ordinary course of business, subcontract the performance of any of our services. Accordingly, we enter into standard indemnification agreements with our customers, whereby they are indemnified for other acts, such as personal property damage, of our subcontractors. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have general and umbrella insurance policies that enable us to recover a portion of any amounts paid. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is insignificant. Accordingly, we have no liabilities recorded for these agreements at June 30, 2004.

When, as part of an acquisition, we acquire all of the stock or all of the assets and liabilities of a company, we assume the liability for certain events or occurrences that took place prior to the date of acquisition. We are not aware of any potential obligations arising as a result of acquisitions and we are therefore unable to determine the maximum potential payments we could be required to make for such obligations at this time. Accordingly, we have no liabilities recorded for these types of agreements at June 30, 2004.

We have arrangements with certain vendors whereby we guarantee the expenses incurred by certain of our employees. The term is from execution of the arrangement until cancellation and payment of any outstanding amounts. We would be required to pay any unsettled employee expenses upon notification from the vendor. The maximum potential amount of future payments we could be required to make under these arrangements is insignificant. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements at June 30, 2004.

We warrant that our software products will perform in all material respects in accordance with our standard published specifications in effect at the time of delivery of the licensed products to the customer for the life of the product. Additionally, we warrant that our maintenance services will be performed consistent with generally accepted industry standards through completion of the agreed upon services. If necessary, we would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history. We have not incurred significant expense under our product or services warranties. As a result, we believe the estimated fair value on these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements at June 30, 2004.

NOTE 10—NET INCOME PER SHARE

Earnings per share are calculated in accordance with the provisions of SFAS No. 128, Earnings per Share. SFAS No. 128 requires the reporting of both basic earnings per share, which is the weighted-average number of common shares outstanding for the period, excluding unvested restricted common stock and diluted earnings per share, which includes the weighted-average number of common shares outstanding and all dilutive potential common shares outstanding including unvested restricted common stock, using the treasury stock method.

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

The following table summarizes our earnings per share computations (in thousands, except per share amounts):

	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
Numerator:
Net income	$	11,611	$	16,935	$	30,519	$	35,079
Denominator:
Denominator for basic net income per share – weighted average shares		92,448		85,610		91,949		85,322
Incremental common shares attributable to shares issuable under employee stock option plans and unvested restricted common stock		5,789		4,896		6,057		4,623
Denominator for diluted net income per share – weighted average shares		98,237		90,506		98,006		89,945
Net income per share (basic)	$	0.13	$	0.20	$	0.33	$	0.41
Net income per share (diluted)	$	0.12	$	0.19	$	0.31	$	0.39

For the three and six months ended June 30, 2004, options to purchase 6,620,000 shares and 6,396,000 shares of common stock with a weighted average exercise price of $59.98 and $60.45, respectively, were considered anti-dilutive because the options’ exercise price was greater than the average fair market value of our common stock for the periods then ended. For the three and six months ended June 30, 2003, options to purchase 9,124,000 and 9,617,000 shares of common stock with a weighted average exercise price of $54.26 and $53.33, respectively, were considered anti-dilutive because the options’ exercise price was greater than the average fair market value of our common stock for the periods then ended. For each of the three and six months ended June 30, 2004 and 2003, common stock reserved for issuance upon conversion of the outstanding 2000 Notes for 2,697,000 shares were not included in diluted earnings per share because the conversion would be anti-dilutive. When the 2003 Notes are required to be included in our earnings per share calculations, 9,673,050 shares would be included in the diluted weighted average common shares and equivalent for the diluted net income per share calculation.

NOTE 11—INCOME TAXES

The effective tax rates for the three and six months ended June 30, 2004 and 2003 differ from statutory tax rates principally because of our participation in taxation programs in Israel. This tax structure is dependent upon continued reinvestment in our Israeli operations. Other factors that cause the effective tax rate and statutory tax rates to differ include the treatment of charges for amortization of intangible assets, stock-based compensation, and in-process research and development.

NOTE 12—SUPPLEMENTAL CASH FLOW DISCLOSURES

Supplemental cash flow disclosures are as follows (in thousands):

	Six months ended June 30,
	2004		2003
Supplemental disclosure:
Cash paid during the period for income taxes, net of refunds of $92 and $30, respectively	$	1,936	$	4,835
Cash paid during the period for interest expense	$	9,619	$	12,333
Supplemental non-cash investing activities:
Common stock received in exchange for equity investment in privately held company	$	1,360	$	—
Accrued licenses	$	776	$	—

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

NOTE 13—COMPREHENSIVE INCOME

We report components of comprehensive income in our annual consolidated statements of shareholders’ equity. Comprehensive income consists of net income, foreign currency translation adjustments, and change in unrealized gain from available-for-sale marketable equity securities. Total comprehensive income for the three and six months ended June 30, 2004 and 2003 is as follows (in thousands):

	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004		2003
Net income	$	11,611		$	16,935		$	30,519	$	35,079
Foreign currency translation adjustments		730			(1,123	)		157		(1,003	)
Change in unrealized gain on available-for-sale marketable equity securities		(206	)		—			—		—
Comprehensive income	$	12,135		$	15,812		$	30,676	$	34,076

NOTE 14—DERIVATIVE FINANCIAL INSTRUMENTS

We comply with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The standard requires us to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through the statements of operations. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings, or recognized in other comprehensive income (loss) until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. The accounting for gains or losses from changes in fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship, as well as on the type of hedging relationship.

We enter into forward contracts to manage foreign currency exposures related to certain foreign currency denominated intercompany balances attributable to subsidiaries and foreign offices in the Americas, EMEA, APAC, and Japan. Additionally, we may adjust our foreign currency hedging position by taking out additional contracts, terminating, or offsetting existing forward contracts. These adjustments may result from changes in the underlying foreign currency exposures. We have not entered into forward contracts for speculative or trading purposes. The criteria used for designating a forward contract as a hedge considers its effectiveness in reducing risk by matching the hedging instruments to underlying transactions. Gains or losses on forward contracts are recognized in other income or expense in the same period as gains or losses on the underlying transactions. In May 2004, we effected a change to enter into hedge contracts of one-fiscal month duration to improve the overall effectiveness of our hedge strategy. We had outstanding forward contracts with notional amounts totaling $22.0 million and $31.5 million at June 30, 2004 and December 31, 2003, respectively. The forward contracts in effect at June 30, 2004 matured on July 30, 2004 and were hedges of certain foreign currency transaction exposures in the Australian Dollar, British Pound, Danish Kroner, Euro, Hong Kong Dollar, Indian Rupee, Japanese Yen, Korean Won, Norwegian Kroner, Singapore Dollar, South African Rand, and Swiss Franc.

We utilize forward exchange contracts of one fiscal-month duration to offset various non-functional currency exposures. Currencies hedged under this program include the Canadian Dollar, Hong Kong Dollar, Israeli Shekel, and Singapore Dollar. Increases or decreases in the value of these non-functional currency assets are offset by gains or losses on the forward exchange contracts to mitigate the risk associated with foreign exchange market fluctuations. We had outstanding forward contracts with notional amounts totaling $20.9 million and $42.6 million at June 30, 2004 and December 31, 2003, respectively. These forward exchange contracts contain credit risk in that the counterparties may be unable to meet the terms of the agreements. However, we minimize such risk of loss by limiting these agreements to major financial institutions. We also monitor closely the potential risk of loss with any one financial institution. We do not expect any material losses as a result of default by counterparties.

In November 2002, we merged our January and February 2002 interest rate swaps with Goldman Sachs Capital Markets, L.P. (GSCM) into a single interest rate swap with GSCM to improve the overall effectiveness of our interest rate swap arrangement. The November interest rate swap of $300.0 million, with a maturity date of July 2007, is designated as an effective hedge of the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) of our 2000 Notes. The objective of the swap is to convert the 4.75% fixed interest rate on the 2000 Notes to a variable interest rate based on the 3-month LIBOR plus 48.5 basis points. The gain or loss from changes in the fair value of the interest rate swap is expected to be highly effective at offsetting the gain or loss from changes in the fair value attributable to changes in the LIBOR throughout the life of the 2000 Notes. The interest rate swap creates a market exposure to changes in the LIBOR. Under the terms of the swap, we are required to provide initial collateral in the

16

MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

form of cash or cash equivalents to GSCM in the amount of $6.0 million as continuing security for our obligations under the swap (irrespective of movements in the value of the swap) and from time to time additional collateral can change hands between Mercury and GSCM as swap rates and equity prices fluctuate. We accounted for the initial collateral and any additional collateral as restricted cash in our consolidated balance sheet. If the price of our common stock exceeds the original conversion or redemption price of the 2000 Notes, we will be required to pay the fixed rate of 4.75% and receive a variable rate on the $300.0 million principal amount of the 2000 Notes. If we call the 2000 Notes at a premium (in whole or in part), or if any of the holders of the 2000 Notes elected to convert the 2000 Notes (in whole or in part), we will be required to pay a variable rate and receive the fixed rate of 4.75% on the principal amount of such called or converted 2000 Notes.

Our interest rate swap qualifies under SFAS No. 133 as a fair-value hedge. We record the fair value of our interest rate swap and the change in the fair value of the underlying 2000 Notes attributable to changes in the LIBOR in our consolidated balance sheet. We record the ineffectiveness arising from the difference between the two fair values in our consolidated statement of operations as “Other income (expense), net.” At June 30, 2004 and December 31, 2003, the fair value of the swap was approximately $5.2 million and $11.6 million, respectively, and the change in the fair value of our 2000 Notes attributable to changes in the LIBOR during the period resulted in a decrease in the carrying value of our 2000 Notes of $4.8 million and $11.2 million, respectively. The unrealized gains or losses on the interest rate swap were less than $0.1 million for three and six months ended June 30, 2004. The unrealized gains on interest rate swap were less than $0.1 million for the three and six months ended June 30, 2003. At June 30, 2004 and December 31, 2003, our total restricted cash associated with the swap was $6.0 million.

We have credit exposure with respect to GSCM as counterparty under the swap. However, we believe that the risk of such credit exposure is limited because GSCM is an affiliate of a major U.S. investment bank and because its obligations under the swap are guaranteed by the Goldman Sachs Group L.P.

For the three and six months ended June 30, 2004, we recorded interest expense of $1.2 million and $2.5 million, respectively, and interest income of $3.6 million and $7.1 million, respectively, as a result of our interest rate swap. For the three and six months ended June 30, 2003, we have recorded interest expense of $1.3 million and $2.8 million, respectively, and interest income of $3.6 million and $7.1 million, respectively, as a result of our interest rate swap. Our net interest expense, including the interest paid on our 2000 Notes, was $1.2 million and $2.5 million for the three and six months ended June 30, 2004. Our net interest expense, including the interest paid on our 2000 Notes, was $1.3 million and $2.8 million for the three and six months ended June 30, 2003, respectively.

NOTE 15—SEGMENT AND GEOGRAPHIC REPORTING

We have four reportable operating segments: the Americas, EMEA, APAC, and Japan. These segments are organized, managed, and analyzed geographically and operate in one industry segment: the development, marketing, and selling of integrated application delivery, application management, and IT governance solutions. Our chief decision makers evaluate operating segment performance based primarily on net revenues and certain operating expenses.

Revenues for our operating segments are as follows (in thousands):

	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
Revenues from third parties:
Americas (including U.S. of $95,420, $72,217, $192,199, and $138,007, respectively)	$	97,946	$	74,474	$	197,756	$	143,303
EMEA (including U.K. of $17,400, $13,579, $36,007 and $27,319, respectively)		48,514		35,908		93,538		69,266
APAC		9,053		5,332		17,487		10,097
Japan		3,534		2,342		7,072		5,775
	$	159,047	$	118,056	$	315,853	$	228,441

17

MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

Long-lived assets, which consist primarily of property and equipment, for our operating segments are as follows (in thousands):

	June 30, 2004		December 31, 2003
Property and equipment, net:
Americas (including U.S. of $37,030 and $40,750, respectively)	$	37,061	$	40,801
EMEA (including Israel of $30,971 and $28,288, respectively)		33,769		31,001
APAC		1,502		1,011
Japan		325		390
	$	72,657	$	73,203

International sales represented 38% and 37% of the total revenues from third parties for the three and six months ended June 30, 2004, respectively, and 37% for both the three and six months ended June 30, 2003. Revenues from the U.S. were 60% and 61% of the net revenues from third parties for the three and six months ended June 30, 2004, respectively, and 61% and 60% for the three and six months ended June 30, 2003, respectively. The subsidiary located in the U.K. accounted for 11% of the total revenues from third parties for both the three and six months ended June 30, 2004 and 12% for both the three and six months ended June 30, 2003. Operations located in the U.S. accounted for 76% and 74% of the consolidated identifiable assets at June 30, 2004 and December 31, 2003, respectively. Operations located in Israel accounted for 21% and 19% of the consolidated identifiable assets at June 30, 2004 and December 31, 2003, respectively.

Although we operate in one industry segment, our chief decision makers evaluate net revenues from the sale of our software products and services of our application delivery and application management, and IT governance solutions. The following tables present revenues for application delivery, application management, and IT governance for the three and six months ended June 30, 2004 and 2003 (in thousands):

	Three months ended June 30,
	2004								2003
	Application Delivery		Application Management		IT Governance		Total		Application Delivery		Application Management		IT Governance		Total
Revenues:
License fees	$	51,218	$	2,727	$	5,997	$	59,942	$	45,370	$	2,634	$	—	$	48,004
Subscription fees		16,782		17,507		339		34,628		9,152		13,335		—		22,487
Total product revenues		68,000		20,234		6,336		94,570		54,522		15,969		—		70,491
Maintenance fees		42,942		2,411		2,790		48,143		36,881		1,864		—		38,745
Professional service fees		8,569		2,666		5,099		16,334		7,995		825		—		8,820
	$	119,511	$	25,311	$	14,225	$	159,047	$	99,398	$	18,658	$	—	$	118,056
	Six months ended June 30,
	2004								2003
	Application Delivery		Application Management		IT Governance		Total		Application Delivery		Application Management		IT Governance		Total
Revenues:
License fees	$	94,433	$	6,387	$	16,695	$	117,515	$	87,982	$	4,808	$	—	$	92,790
Subscription fees		34,314		35,866		355		70,535		17,616		24,145		—		41,761
Total product revenues		128,747		42,253		17,050		188,050		105,598		28,953		—		134,551
Maintenance fees		85,450		4,702		4,880		95,032		70,627		3,703		—		74,330
Professional service fees		17,836		5,649		9,286		32,771		18,232		1,328		—		19,560
	$	232,033	$	52,604	$	31,216	$	315,853	$	194,457	$	33,984	$	—	$	228,441

18

MERCURY INTERACTIVE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(unaudited)

NOTE 16—SUBSEQUENT EVENTS

On May 12, 2004, we entered into a definitive agreement to acquire all of the outstanding shares of Appilog, Inc. and assume all outstanding vested stock options. The acquisition was completed on July 1, 2004. The total purchase price of approximately $61.9 million consists of $50.8 million in cash, $0.7 million in direct merger costs, and $10.4 million related to stock options exchanged. The purchase price will be allocated to the tangible and intangible assets acquired and liabilities assumed based on their respective fair values at the acquisition date.

On July 27, 2004, our Board of Directors approved a new program to repurchase up to $400.0 million of our common stock over the next two years. The specific timing and amount of repurchases will vary based on market conditions, securities law limitations, and other factors. Since the inception of our new stock repurchase program through August 6, 2004, we have repurchased 3,072,000 shares of our common stock at an average price of $35.59 for an aggregate purchase price of $109.3 million.

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

The following discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. In some cases, forward-looking statements are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “will,” “may,” and similar expressions. In addition, any statements that refer to our plans, expectations, strategies or other characterizations of future events or circumstances are forward-looking statements. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors.” Our business may have changed since the date hereof, and we undertake no obligation to update these forward-looking statements.

Overview

Mercury is the leading provider of software and services for the Business Technology Optimization (BTO) marketplace. BTO is a business strategy for aligning information technology (IT) and business goals while optimizing the quality, performance, and business availability of strategic software applications and systems. Our application delivery, application management, and IT governance products and services, and the Mercury Optimization Centers are designed to help our customers increase the business value of IT with BTO.

We have aligned our enterprise software business model with the way we believe customers want to license and deploy enterprise software today. We believe our customers value a choice between perpetual software licenses and flexible term or subscription based contracts. Customers also have the choice between running software in-house or having software delivered as a hosted or managed service. Mercury’s enterprise software business model enables our customers to license the right software, for the right period of time, and have it deployed the right way—while giving Mercury the right financial incentives to renew and expand our relationships with customers.

We believe that the success of our model can be seen in our financial results which include significant growth in revenue and deferred revenue. To understand our financial results, it is important to understand our changing business model and its impact on the consolidated statement of operations and the consolidated balance sheet. We continue to offer many of our products, including our IT governance products, on a perpetual license basis. We have continued to expand the number of offerings structured as subscription based contracts. The majority of these types of contracts are required to be recorded initially as deferred revenue in the consolidated balance sheet and then recognized in subsequent periods over the term of the contract as subscription revenue in our consolidated statement of operations (see below under Business Model). Therefore, to understand the full growth of our business, one must look at both revenue and the change in deferred revenue.

Business Model

Revenue consists of fees for the license and subscription of our software products, maintenance fees, and professional service fees. License revenue consists of license fees charged for the use of our products under perpetual or multiple-year arrangements in which the fair value of the license fee is separately determinable from maintenance and/or professional services. Subscription revenue, including managed service revenue, represents license fees to use one or more software products, and to receive maintenance support (such as hotline support and product updates) for a limited period of time. Since subscription licenses include bundled products and services, which are sold as a combined offering and for which the fair value of the license fee is not separately determinable from maintenance, both product and service revenue is generally recognized ratably over the term of the subscription. Maintenance revenue consists of fees charged for post-contract customer support, which are determinable based upon renewal rates quoted in the contracts, and, in the absence of stated renewal rates, upon separate sales of renewals to other customers. Professional service revenue consists of fees charged for product training and consulting services, which are determinable based upon separate sales of these services to other customers without bundling of other elements.

Due to the different treatment of subscription and perpetual licenses under applicable accounting rules, each type of license has a different impact on our consolidated financial statements. When a customer purchases a subscription license, the majority of the revenue will be recorded as deferred revenue in our consolidated balance sheet. The amount recorded as deferred revenue is equal to the portion of the license fee that has been invoiced or paid but not recognized as revenue. Deferred revenue is reduced as revenue is recognized. Under perpetual licenses (and some multiple-year arrangements for which separate vendor specific objective evidence of fair value exists for undelivered elements), a higher proportion of license revenue is recognized in the quarter that the product is delivered, with a lesser proportion recorded as deferred revenue. Vendor specific objective evidence of fair value is established by the price charged when that element is sold separately. Therefore, an order for a subscription license, or a perpetual license bundled with a subscription license, will result in significantly lower current-period revenue than an equal-sized order under a perpetual license. Conversely, an order for a subscription license will result in higher revenues recognized in future periods than an equal-sized order for a perpetual license. Further, generally, if a perpetual license is sold at the same time as a subscription based license to the same customer, then the two become bundled together and are recognized over the term of the contract.

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Our license revenue in any given quarter is dependent upon the volume of perpetual license orders delivered during the current quarter and the amount of subscription revenue amortized from deferred revenue from prior quarters and, to a small degree, revenue recognized on subscription orders received during the current quarter. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain mix of perpetual licenses and subscription licenses. The precise mix of orders is subject to substantial fluctuation in any given quarter or multiple quarter periods, and the actual mix of licenses sold affects the revenue we recognize in the period. If we achieve the target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we deliver more-than-expected subscription licenses) or may exceed them (if we deliver more-than-expected perpetual licenses). If we achieve the target license mix but the overall level of orders is below the target level, then we may not meet our revenue targets. Our ability to achieve our revenue targets is also impacted by the mix of domestic and international sales, together with fluctuations in foreign exchange rates. If there is an increase in value of other currencies relative to the U.S. dollar, our revenues from international sales may be positively impacted. On the other hand, if there is a decrease in value of other currencies relative to the U.S. dollar, our revenues from international sales may be negatively impacted.

Cost of license and subscription includes direct costs to produce and distribute our products, such as costs of materials, product packaging and shipping, equipment depreciation, production personnel, and outsourcing services. It also includes costs associated with our managed services business, including personnel-related costs, fees to providers of Internet bandwidth and related infrastructure, and depreciation expense of managed services equipment. Cost of maintenance includes direct costs of providing product customer support, largely consisting of personnel costs and related expenses, and the cost of providing upgrades to our customers. We have not broken out the costs associated with license and subscription because these costs cannot be separated between license and subscription cost of revenue. Cost of professional services includes direct costs of providing product training and consulting, largely consisting of personnel costs and related expenses and costs of outsourcing service. License and subscription, maintenance, and professional services costs also include allocated facility expenses and allocated IT infrastructure expenses.

The costs associated with subscription licenses, which include the cost of products and services, are expensed as incurred over the subscription term. In addition, we defer the portion of our commission expense related to subscription licenses and maintenance contracts and amortize the expense over the term of the subscription or maintenance contracts. See “Critical Accounting Policies and Estimates” for a full description of our estimation process for accrued liabilities.

21

Results of Operations

The following table sets forth, as a percentage of total revenues, certain condensed consolidated statements of operations data for the periods indicated. These operating results are not necessarily indicative of the results for any future period.

	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
Revenues:
License fees	38	%	41	%	38	%	41	%
Subscription fees	22		19		22		18
Total product revenues	60		60		60		59
Maintenance fees	30		33		30		32
Professional service fees	10		7		10		9
Total revenues	100		100		100		100
Costs and expenses:
Cost of license and subscription	6		6		6		6
Cost of maintenance	3		3		2		2
Cost of professional services (excluding stock-based compensation)	9		6		9		6
Marketing and selling (excluding stock-based compensation)	48		47		48		47
Research and development (excluding stock-based compensation)	11		11		11		11
General and administrative (excluding stock-based compensation)	8		8		8		8
Stock-based compensation	—		—		—		—
Acquisition related charges	—		1		—		1
Integration and other related charges	1		1		1		1
Amortization of intangible assets	2		1		2		1
Excess facilities charge	6		—		3		—
Total costs and expenses	94		84		90		83
Income from operations	6		16		10		17
Interest income	6		7		6		7
Interest expense	(3	)	(4	)	(3	)	(3	)
Other expense, net	(1	)	(1	)	(1	)	(1	)
Income before provision for income taxes	8		18		12		20
Provision for income taxes	1		4		2		5
Net income	7	%	14	%	10	%	15	%

Certain reclassifications have been made to the consolidated statements of operations for the three and six months ended June 30, 2003 to conform to the presentation adopted for the three and six months ended June 30, 2004.

Revenues

The following table summarizes license fees, subscription fees, maintenance fees, and professional service fees for the periods indicated (in thousands, except percentages):

	Three Months ended June 30,				Increase/ (Decrease)				Six Months ended June 30,				Increase/ (Decrease)
	2004		2003		in Dollars		in Percentage		2004		2003		in Dollars		in Percentage
Revenues:
License fees	$	59,942	$	48,004	$	11,938	25	%	$	117,515	$	92,790	$	24,725	27	%
Subscription fees		34,628		22,487		12,141	54	%		70,535		41,761		28,774	69	%
Maintenance fees		48,143		38,745		9,398	24	%		95,032		74,330		20,702	28	%
Professional service fees		16,334		8,820		7,514	85	%		32,771		19,560		13,211	68	%
Total revenues	$	159,047	$	118,056	$	40,991	35	%	$	315,853	$	228,441	$	87,412	38	%

License fees

The increase in licence fee revenue for the three and six months ended June 30, 2004 was due to an increased sales volume and average size of individual sale. For the three months ended June 30, 2004, the increase in license fee revenue was primarily attributable to the sale of IT governance products of $6.0 million and an increase in application delivery license sales of $5.8 million. For the six months ended June 30, 2004, the increase in license fee revenue was primarily attributable to the sale of IT governance products of $16.7 million and an increase in application delivery license sales of $6.5 million. We expect our license fee revenue to continue to increase in absolute dollars for the remainder of 2004.

22

Subscription fees

The increase in subscription fee revenue for the three and six months ended June 30, 2004 was primarily due to an increased average size of individual sale. For the three months ended June 30, 2004, the increase in subscription fee revenue was attributable to a continuous growth in license sales of application delivery products on a subscription basis of $7.6 million and an increase in license sales of application management products of $4.2 million, which are primarily offered on a subscription basis. For the six months ended June 30, 2004, the increase in subscription fee revenue was attributable to a continuous growth in license sales of application delivery products of $16.7 million on a subscription basis and an increase in license sales of application management products of $11.7 million, which are primarily offered on a subscription basis. As we continue to offer more products on a subscription basis and as more customers license our products on a subscription basis, we expect sales of our subscription fee revenue to increase in absolute dollars for the remainder of 2004.

Maintenance fees

The increase in maintenance fee revenue for the three and six months ended June 30, 2004 was primarily attributable to renewals of existing maintenance contracts and sales of first year maintenance contracts for application delivery licensed products and maintenance fees for IT governance products. For the three months ended June 30, 2004, the increase of maintenance fee revenue related to application delivery products, IT governance products, and application management products was $6.1 million, $2.8 million, and $0.5 million, respectively. For the six months ended June 30, 2004, the increase of maintenance fee revenue related to application delivery products, IT governance products, and application management products was $14.8 million, $4.9 million, and $1.0 million, respectively. We expect maintenance fee revenue to continue to increase in absolute dollars for the remainder of 2004.

Professional service fees

For the three months ended June 30, 2004, the increase in professional service fee revenue was primarily attributable to $5.1 million in consulting fees for service engagements related to IT governance products and higher professional service fees of $1.8 million and $0.6 million associated with application management products and application delivery products. For the six months ended June 30, 2004, the increase in professional service fee revenue was primarily attributable to $9.3 million in consulting fees for service engagements related to IT governance products and higher professional service fees of $4.3 million associated with application management products. The professional service fee revenue grew as a result of our continuous effort to expand our training and consulting services to our customers who license our products. We expect our professional service fee revenue to continue to increase in absolute dollars for the remainder of 2004.

International sales

International sales include revenues from Europe, the Middle East and Africa (EMEA), Asia Pacific (APAC), and Japan. International revenues for the three months ended June 30, 2004, compared to the three months ended June 30, 2003, were affected favorably by a weakening of the U.S. dollar relative to other currencies, primarily the Euro and British Pound. Total revenues from international sales for the three months ended June 30, 2004 were $61.1 million, an increase of $17.5 million, compared to the three months ended June 30, 2003. $4.0 million of this increase was due to fluctuations in foreign exchange rates. International sales represented 38% and 37% of our total revenues for the three months ended June 30, 2004 and 2003, respectively. Our international revenues increased 40% in absolute dollars for the three months ended June 30, 2004, compared to the same period in 2003, mainly due to a continuous weakening of the U.S. dollar relative to other currencies, primarily the Euro and British Pound, and an increase in sales in EMEA of $8.4 million and APAC of $4.2 million.

International revenues for the six months ended June 30, 2004, compared to the six months ended June 30, 2003, were affected favorably by a weakening of the U.S. dollar relative to other currencies, primarily the Euro and British Pound. Total revenues from international sales for the six months ended June 30, 2004 were $118.1 million, an increase of $33.0 million, compared to the six months ended June 30, 2003. $11.1 million of this increase was due to fluctuations in foreign exchange rates. International sales represented 37% of our total revenues for the six months ended June 30, 2004 and 2003. Our international revenues increased 39% in absolute dollars for the six months ended June 30, 2004, compared to the same period in 2003, due to a continuous weakening of the U.S. dollar relative to other currencies, primarily the Euro and British Pound, and an increase in sales in EMEA of $15.2 million and APAC of $6.7 million.

23

Costs of revenues and operating expenses

The following table summarizes cost of revenues for the periods indicated (in thousands, except percentages):

	Three Months ended June 30,						Increase/ (Decrease)				Six Months ended June 30,						Increase/ (Decrease)
	2004			2003			in Dollars		in Percentage		2004			2003			in Dollars		in Percentage
Costs of revenues:
Cost of license and subscription	$	9,883		$	6,757		$	3,126	46	%	$	19,702		$	13,307		$	6,395	48	%
Cost of maintenance		3,952			2,829			1,123	40	%		7,544			5,508			2,036	37	%
Cost of professional services		14,855			7,460			7,395	99	%		28,398			14,080			14,318	102	%
Total cost of revenues	$	28,690		$	17,046		$	11,644	68	%	$	55,644		$	32,895		$	22,749	69	%
Percentage of total revenues		18	%		15	%						17	%		14	%

Cost of license and subscription

The increase in cost of license and subscription for the three and six months ended June 30, 2004 was primarily attributable to higher personnel-related costs as a result of growth in headcount and an increase in outsourcing expense related to delivery of our ProTune products. Personnel-related costs increased by $1.4 million and $2.6 million for the three and six months ended June 30, 2004, respectively. Outsourcing expense increased by $0.5 million and $1.5 million for the three and six months ended June 30, 2004, respectively. Based upon our expected revenue growth as described in “Revenues,” we expect cost of license and subscription to continue to increase in absolute dollars for the remainder of 2004.

Cost of maintenance

The increase in cost of maintenance for the three months ended June 30, 2004 was primarily due to higher personnel-related costs of $0.9 million as a result of additional headcount to support our overall growth in business. The increase in cost of maintenance for the six months ended June 30, 2004 was primarily due to higher personnel-related costs of $1.9 million as a result of additional headcount and an increase in allocated facility expenses of $0.5 million. Our facility expenses increased primarily due to the lease for our new headquarters. Based upon our expected revenue growth as described in “Revenues,” we expect cost of maintenance to continue to increase in absolute dollars for the remainder of 2004.

Cost of professional services

The increase in cost of professional services for the three and six months ended June 30, 2004 was attributable to higher personnel-related costs as a result of growth in headcount and an increase in outsourcing expense. For the three and six months ended June 30, 2004, personnel-related costs increased by $3.8 million and $7.6 million, of which $2.7 million and $5.2 million was related to Kintana employees who joined us as part of that acquisition in 2003, respectively. The increase in outsourcing expense was primarily due to growth in professional services and our continuous effort to offer more training and consulting services to our customers who license our products. Outsourcing expense increased by $2.7 million and $5.0 million for the three and six months ended June 30, 2004, respectively. Based upon our expected revenue growth as described in “Revenues,” we expect cost of professional services to continue to increase in absolute dollars for the remainder of 2004.

The following table summarizes operating expenses for the periods indicated (in thousands, except percentages):

	Three Months ended June 30,						Increase/ (Decrease)					Six Months ended June 30,						Increase/ (Decrease)
	2004			2003			in Dollars			in Percentage		2004			2003			in Dollars			in Percentage
Operating expenses:
Marketing and selling	$	76,248		$	55,806		$	20,442		37	%	$	150,211		$	108,491		$	41,720		38	%
Research and development		17,763			13,120			4,643		35	%		35,049			24,709			10,340		42	%
General and administrative		12,024			9,722			2,302		24	%		24,269			18,822			5,447		29	%
Stock-based compensation		183			195			(12	)	(6	)%		392			384			8		2	%
Acquisition related charges		—			1,280			(1,280	)	(100	)%		—			1,280			(1,280	)	(100	)%
Integration and other related charges		1,131			917			214		23	%		2,110			917			1,193		130	%
Amortization of intangible assets		3,744			699			3,045		436	%		7,684			1,157			6,527		564	%
Excess facilities charge		9,178			—			9,178		*			9,178			—			9,178		*
Total operating expenses	$	120,271		$	81,739		$	38,532		47	%	$	228,893		$	155,760		$	73,133		47	%
Percentage of total revenues		76	%		69	%							73	%		69	%

 * Percentage is not meaningful.

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Marketing and selling

Marketing and selling expense consists of employee salaries and related costs, sales commissions, marketing programs, sales training, allocated facility expenses, and allocated IT infrastructure expenses. The increase in marketing and selling expense for the three and six months ended June 30, 2004 was primarily attributable to higher personnel-related costs due to growth in headcount, higher commission expense as a result of an increase in revenues together with growth in headcount, and higher professional service cost. The increase was also attributable to an increase in allocated facility expenses, allocated IT infrastructure expenses, spending on marketing programs, and sales training. Facility expenses and IT infrastructure expenses increased due to the lease for our new headquarters. For the three months ended June 30, 2004, personnel-related costs and commission expense increased by $10.7 million and $4.9 million, respectively, of which personnel-related costs of $3.2 million and commission expense of $1.7 million were related to Kintana employees who joined us as part of that acquisition in 2003. In addition, for the three months ended June 30, 2004, allocated facility expenses, allocated IT infrastructure expenses, spending on marketing programs, and professional service cost increased by $1.0 million, $0.9 million, $0.9 million, and $0.5 million, respectively.

For the six months ended June 30, 2004, personnel-related costs and commission expense increased by $21.0 million and $11.3 million, respectively, of which personnel-related costs of $6.4 million and commission expense of $2.5 million were related to Kintana employees who joined us as part of that acquisition in 2003. In addition, for the six months ended June 30, 2004, allocated facility expenses, sales training, professional service cost, allocated IT infrastructure expenses, and spending on marketing programs increased by $2.5 million, $1.7 million, $1.6 million, $1.2 million and $0.5 million, respectively. We expect marketing and selling expense to continue to increase in absolute dollars for the remainder of 2004.

Research and development

Research and development expense consists of employee salaries and related costs, consulting costs, equipment depreciation, allocated facility expenses, and allocated IT infrastructure expenses associated with the development of new products, enhancements of existing products, and quality assurance procedures. For the three months ended June 30, 2004, the increase in research and development expense was primarily attributable to higher personnel-related costs of $3.0 million as a result of growth in headcount, of which $2.2 million was related to Kintana employees who joined us as part of that acquisition in 2003. The increase was also attributable to higher allocated facility expenses of $0.7 million and higher allocated IT infrastructure expenses of $0.6 million due to our move to the new leased headquarters. The impact from foreign exchange rate fluctuation for the Israeli Shekel to the U.S. dollar was insignificant for the three months ended June 30, 2004.

For the six months ended June 30, 2004, the increase in research and development expense was primarily attributable to higher personnel-related costs of $6.2 million as a result of growth in headcount, of which $4.3 million was related to Kintana employees who joined us as part of that acquisition in 2003, higher allocated facility expenses of $1.4 million and higher allocated IT infrastructure expenses of $0.8 million due to our move to the new leased headquarters. The increase was also attributable to a $1.1 million devaluation of the U.S. dollar to the Israeli Shekel as a substantial portion of our research and development expense was in Israeli Shekel. Based on our product development plan, we expect research and development expense to increase in absolute dollars for the remainder of 2004.

General and administrative

General and administrative expense consists of employee salaries and related costs, and fees for audit, tax, legal and consulting services, as well as allocated facility expenses and allocated IT infrastructure expenses. For the three months ended June 30, 2004, the increase in general and administrative expenses was primarily attributable to higher personnel-related costs of $1.2 million as a result of growth in headcount and additional professional service fees for audit, tax, and other consulting services of $0.3 million.

For the six months ended June 30, 2004, the increase in general and administrative expenses was primarily attributable to higher personnel-related costs of $2.4 million as a result of growth in headcount, additional professional service fees for audit, tax, and other consulting services of $1.5 million, and an increase in allocated facility expenses of $0.5 million due to the lease for our new headquarters. We expect general and administrative expenses to continue to increase in absolute dollars for the remainder of 2004 due to a projected increase in headcount and fees for compliance with the Sarbanes-Oxley Act of 2002.

Stock-based compensation

Stock-based compensation for the three and six months ended June 30, 2004 and 2003 primarily consisted of amortization of unearned stock-based compensation associated with assumed options from the acquisitions of Kintana and Performant in 2003. We expect to record amortization of unearned stock-based compensation of $0.3 million for the remainder of 2004, $0.4 million for 2005, $0.3 million for 2006, and less than $0.1 million for 2007.

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Acquisition related charges

Acquisition related charges of $1.3 million for the six months ended June 30, 2003 were related to the acquired in-process research and development from the acquisition of Performant in May 2003. Upon the completion of the acquisition of Appilog on July 1, 2004, we expect to record a one-time charge of approximately $0.8 million to $1.0 million related to acquired in-process research and development in the third quarter of 2004.

Integration and other related charges

Integration and other related charges for the three and six months ended June 30, 2004 were attributable to a milestone bonus plan related to certain research and development activities, that was signed in conjunction with the acquisition of Performant in 2003. The plan entitles each eligible employee to receive bonuses, in the form of cash payments, based on the achievement of certain performance milestones by applicable target dates. The commitment will be earned over time as milestones are achieved and expensed as a charge to the consolidated statement of operations. The maximum total payment under the plan is $5.5 million, of which $3.7 million has been paid through June 30, 2004. On July 1, 2004, we completed the acquisition of Appilog. We do not expect the integration costs related to the Appilog integration to be significant.

Amortization of intangible assets

The increase in amortization of intangible assets was primarily due to a full quarter of amortization of intangible assets related to acquisitions of Performant in May 2003 and Kintana in August 2003, purchase of existing technology in the third quarter of 2003, and acquisition of a domain name in the fourth quarter of 2003.

Intangible assets are amortized on a straight-line basis over their useful lives or based on actual usage, whichever best represents the distribution of the economic value of the intangible assets.

Future amortization expense of intangible assets at June 30, 2004 is as follows (in thousands):

Year ending December 31,
2004 (remainder of fiscal year)	$	6,896
2005		13,471
2006		10,067
2007		3,818
2008		2,555
Thereafter		636
	$	37,443

Amortization expense of intangible assets related to the Appilog acquisition is expected to be in the range of $0.5 to $0.6 million per quarter.

Also see notes 5 and 6 to the condensed consolidated financial statements for additional information regarding the acquisitions completed in 2003 and the intangible assets acquired in each acquisition.

Excess facilities charge

Excess facilities charge of $9.2 million for the three and six months ended June 30, 2004 was primarily related to the write-down of a vacant building we own that has been placed for sale and the remaining lease payments for two leased facilities from the Kintana acquisition. In April 2004, we completed our move from our two buildings we own in Sunnyvale, California to our new leased headquarters in Mountain View, California. As a result of our move and our decision to vacate and sell one of the buildings we own in Sunnyvale, California, we took a charge to write down the net book value of the building that is held for sale to its appraised market value. We took into account the cost to maintain the facility until sold and sales commissions related to the sale of the building when we calculated the charge. In connection with our move into our consolidated headquarters, we also vacated two leased facilities from the Kintana acquisition. We recorded a charge for the remaining lease payments, as well as associated costs to protect and maintain the leased facilities prior to returning these leased facilities to the lessor. These lease agreements expire in September 2004 and December 2005. Due to the short duration of the remaining lease terms, it is not likely that we can sublease the facilities; as such, no sublease income was included in the facilities lease costs calculation. The excess facilities charge also included the write-off of leasehold improvements and the disposal of fixed assets, net of cash proceeds, associated with these facilities.

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Non-operating income (expense)

The following table summarizes non-operating income (expense) for the periods indicated (in thousands, except percentages):

	Three Months ended June 30,						Increase/ (Decrease)					Six Months ended June 30,						Increase/ (Decrease)
	2004			2003			in Dollars			in Percentage		2004			2003			in Dollars		in Percentage
Other income (expenses):
Interest income	$	9,803		$	8,968		$	835		9	%	$	19,063		$	17,735		$	1,328	7	%
Interest expense		(4,811	)		(4,921	)		110		(2	)%		(9,622	)		(9,921	)		299	(3	)%
Other expense, net		(1,640	)		(1,606	)		(34	)	2	%		(2,845	)		(3,046	)		201	(7	)%
Total other expenses, net	$	3,352		$	2,441		$	911		37	%	$	6,596		$	4,768		$	1,828	38	%
Percentage of total revenues		2	%		2	%							2	%		3	%

Interest income

The increase in interest income for the three and six months ended June 30, 2004 was attributable to interest earned on higher cash, cash equivalents, and investment balances in the first and second quarters of 2004 compared to the same quarters in 2003. In April 2003, we raised additional funds of $488.1 million, net of issuance costs of $11.9 million, from the issuance of Zero Coupon Convertible Notes (2003 Notes). Cash, cash equivalents, and investments were $1,390.3 million and $1,241.7 million at June 30, 2004 and 2003, respectively.

Interest expense

Interest expense for the three and six months ended June 30, 2004 and 2003 primarily consisted of interest expense associated with the interest rate swap and the Convertible Subordinated Notes (2000 Notes) we issued in July 2000.

In 2002, we entered into an interest rate swap arrangement with Goldman Sachs Capital Markets, L.P. The interest rate swap is designated as an effective hedge of the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) with respect to $300.0 million of our 2000 Notes. The objective of the swap is to convert the 4.75% fixed interest rate on the 2000 Notes to a variable interest rate based on the 3-month LIBOR plus 48.5 basis points. The interest rate swap qualifies for hedge accounting treatment in accordance with Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities and the related amendment.

Also, see Notes 7 and 14 to the condensed consolidated financial statements for additional information regarding our 2000 Notes and the related interest rate swap activities.

Other expense, net

Other expense, net primarily consists of net gain or loss on investments in non-consolidated companies and a warrant, amortization of debt issuance costs associated with the issuance of our 2003 Notes and 2000 Notes, and currency gains or losses. For the three months ended June 30, 2004, the increase in other expense, net was primarily attributable to an increase in currency losses of $1.0 million and amortization of debt issuance costs related to our 2003 Notes of $0.2 million. The increase was partially offset by a reduction in loss on investments in privately held companies and a private equity fund of $0.8 million, an unrealized gain on the change in fair value of the Motive warrant of $0.1 million, and realized gain on the sale of available-for-sale marketable equity securities of $0.3 million. For the six months ended June 30, 2004, the increase in other expense, net was primarily attributable to an increase in currency losses of $0.4 million and amortization of debt issuance costs related to our 2003 Notes of $0.7 million. The increase was partially offset by a reduction in loss on investments in privately held companies and a private equity fund of $0.8 million, an unrealized gain on the change in fair value of the Motive warrant of $0.4 million, and realized gain on the sale of available-for-sale marketable equity securities of $0.3 million.

The fair value of the Motive warrant was calculated by using the Black-Scholes option-pricing model, which requires subjective assumptions such as the expected stock price volatility of the company. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. A decline in the U.S. stock market and the market price of Motive’s common stock could contribute to volatility in our reported results of operations. In calculating the loss on our investments in privately held companies and private equity funds, we took into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors.

Also, see Notes 7 and 14 to the condensed consolidated financial statements for additional information regarding our 2000 and 2003 Notes and the related interest rate swap activities.

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Provision for income taxes

Historically, our operations resulted in a significant amount of income in Israel where tax rate incentives have been extended to encourage foreign investments. The tax holidays and rate reductions, which we will be able to realize under programs currently in effect, expire at various dates through 2013. Future provisions for taxes will depend upon the mix of worldwide income and the tax rates in effect for various tax jurisdictions. The effective tax rates for the three and six months ended June 30, 2004 and 2003 differ from statutory tax rates principally because of our participation in taxation programs in Israel. We intend to continue to increase our investment in our Israeli operations consistent with our overall tax strategy. Other factors that cause the effective tax rate and statutory tax rates to differ include the treatment of charges for amortization of intangible assets, stock-based compensation, and in-process research and development. U.S. income taxes and foreign withholding taxes were not provided for on undistributed earnings for certain non-U.S. subsidiaries. We intend to invest these earnings indefinitely in operations outside the U.S.

In 2002, we sold the economic rights of Freshwater’s intellectual property to our Israeli subsidiary. As a result of this intellectual property sale, we have recorded a current tax payable and a prepaid tax asset in the amount of $25.5 million, which will be amortized to income tax expense over eight years, which approximates the period over which the expected benefit is expected to be realized. We intend to migrate the economic ownership of the technology acquired from Performant and Kintana to our Israeli subsidiary in 2004, which may lead to a temporary increase in our effective tax rate. At June 30, 2004 and December 31, 2003, we had a prepaid tax asset of $17.5 million and $19.1 million, respectively.

Liquidity and Capital Resources

At June 30, 2004, our principal source of liquidity consisted of $1,390.3 million of cash and investments, compared to $1,233.7 million at December 31, 2003. The June 30, 2004 balance included $167.7 million of short-term, and $648.6 million of long-term investments in high quality financial, government, and corporate securities. During the six months ended June 30, 2004, we generated $103.1 million of cash from operating activities, compared to $91.4 million during the six months ended June 30, 2003. The increase in cash from operations during the six months ended June 30, 2004, compared to the six months ended June 30, 2003 was primarily due to an overall growth in our business.

During the six months ended June 30, 2004, cash proceeds from investing activities consisted of the sale of vacant facilities and assets of $2.6 million, sale of available-for-sale marketable equity securities of $1.7 million, and return on investment in one of the privately held companies of $1.5 million. Cash used for investing activities during the six months ended June 30, 2004 primarily consisted of net purchases of investments of $131.7 million, acquisition of property and equipment of $19.3 million, and an additional investment in a private equity fund of $1.5 million. Cash used in the acquisition of property and equipment in the first and second quarters of 2004 was primarily attributable to leasehold improvements and IT infrastructure for our new headquarters in Mountain View, California and new foreign offices. Cash was also used to purchase land in Israel in February 2004 for $2.2 million.

During the six months ended June 30, 2004, our primary financing activities consisted of cash proceeds of $66.9 million from common stock issued under our employee stock option and stock purchase plans.

In June 2003, we entered into a non-exclusive agreement (amended in February 2004) to license technology from Motive. The agreement is non-transferable, except in the case of a merger, acquisition, spin-out, or other transfer of all or substantially all of the business, stock, or assets to which the agreement relates. The licensed technology will be combined with our other existing Mercury products, which should be generally available in the latter half of 2004. The agreement is in effect until December 31, 2006 with a right to renew and an option to purchase a fully paid up, perpetual license to the technology prior to July 1, 2008. Under the original agreement, we had committed to royalty payments totaling $15.0 million, of which $8.0 million had been paid as of December 31, 2003. In accordance with the addendum, the remaining royalty balance of $7.0 million was accelerated and was paid in February 2004. We recorded such payments as prepaid royalties.

At June 30, 2004, we have committed to make additional capital contributions to a private equity fund totaling $7.1 million.

At June 30, 2004, we had four irrevocable letter of credit agreements totaling $1.4 million with Wells Fargo & Company (Wells Fargo). Wells Fargo is a related party to us as one of the members of Board of Directors is an executive officer of Wells Fargo. Two of the agreements are related to facility lease agreements assumed by us in conjunction with the acquisition of Kintana in 2003. One of the agreements has an automatic annual renewal provision under which the expiration date cannot be extended beyond March 1, 2006 and the other agreement expires in September 2004. The third agreement is related to a facility lease agreement assumed by us in conjunction with the acquisition of Freshwater in 2001. This agreement has an automatic annual renewal provision under which the expiration dates cannot be extended beyond August 31, 2006. The fourth agreement is related to the facility lease agreement for our new headquarters in Mountain View, California and this agreement automatically renews annually after January 1, 2005 unless we provide a termination notice to Wells Fargo. At June 30, 2004, no amounts had been drawn on the letters of credit.

We lease facilities for sales offices in the U.S. and foreign locations under non-cancelable operating leases that expire through 2015. Certain of these leases contain renewal options. In addition, we lease certain equipment under various lease agreements with lease terms ranging from month-to-month up to one year. On October 21, 2003, we entered into a lease agreement for our new headquarters facility. The lease began on January 1, 2004 and expires on February 20, 2014. In April 2004, we moved from the two Kintana facilities to our new headquarters in Mountain View, California. Future lease payments associated with these two facilities are included in the following table.

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Future payments due under debt, lease, and royalty agreements at June 30, 2004 are as follows (in thousands):

	Zero Coupon Senior Convertible Notes due 2008 (2003 Notes)		4.75% Convertible Subordinated Notes due 2007 (2000 Notes) (a)		Non- Cancelable Operating Leases		Royalty Agreements		Total
2004 (remainder of year)	$	—	$	—	$	9,074	$	1,223	$	10,297
2005		—		—		15,901		210		16,111
2006		—		—		10,729		210		10,939
2007		—		300,000		7,856		210		308,066
2008		500,000		—		5,807		160		505,967
Thereafter		—		—		25,027		100		25,127
Total	$	500,000	$	300,000	$	74,394	$	2,113	$	876,507

(a) Assuming we do not retire additional 2000 Notes during 2004 and interest rates stay constant, we will make interest payments net of our interest rate swap of approximately $3.3 million during the remainder of 2004, approximately $6.6 million in 2005 and 2006, and approximately $3.3 million during 2007. The face value of our 2000 Notes differs from our book value. See Note 7 to the condensed consolidated financial statements for a full description of our long-term debt activities and related accounting policy.

In July 2000, we issued $500.0 million in Convertible Subordinated Notes due on July 1, 2007. The 2000 Notes bear interest at a rate of 4.75% per annum and are payable semiannually on January 1 and July 1 of each year. The 2000 Notes are subordinated in right of payment to all of our future senior debt. The 2000 Notes are convertible into shares of our common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. The entire outstanding principal amount of the 2000 Notes will become due and payable at maturity. We may redeem the 2000 Notes, in whole or in part, at any time on or after July 1, 2003. Accrued interest to the redemption date will be paid by us in any such redemption. We did not redeem any portion of the 2000 Notes at June 30, 2004. From December 2001 through June 30, 2002, we retired $200.0 million face value of the 2000 Notes. The face value of the 2000 Notes was $300.0 million at June 30, 2004 and December 31, 2003.

In 2002, we entered into an interest rate swap arrangement of $300.0 million, with a maturity date of July 2007, to hedge the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) of our 2000 Notes. The value of the interest rate swap is determined using various inputs, including forward interest rates, and time to maturity. Our interest rate swap was recorded as an asset in our consolidated balance sheets as of June 30, 2004 and December 31, 2003, but it has decreased in value over the past six months. If market changes continue to negatively impact the value of the swap, the swap may become a liability in our consolidated balance sheet. In the event we chose to terminate the swap before maturity, and the swap value was unfavorable, we would be obligated to pay to our counterparty in cash, the market value of the swap at termination date. Also, see Notes 7 and 14 to the condensed consolidated financial statements for additional information regarding our 2000 and 2003 Notes and the related interest rate swap activities.

In April 2003, we issued $500.0 million of Zero Coupon Convertible Notes due on May 1, 2008 in a private offering. The 2003 Notes do not bear interest, have a zero yield to maturity and may be convertible into our common stock. Holders of the 2003 Notes may convert their 2003 Notes prior to maturity only if the sale price of our common stock reaches specified thresholds or if specified corporate transactions have occurred. Upon conversion, we have the right to deliver cash instead of shares of our common stock. We may not redeem the 2003 Notes prior to their maturity. See Note 7 to the condensed consolidated financial statements for further details on the conversion provisions for the 2003 Notes.

Historically, a significant amount of our income and cash flow was generated in Israel where tax rate incentives have been extended to encourage foreign investment. We may have to pay significantly more income taxes if these tax rate incentives are not renewed upon expiration or tax rates applicable to us are increased or if we choose to repatriate cash balances from Israel to other foreign jurisdictions. In addition, our future tax provisions will depend on the mix of our worldwide income and the tax rates in effect for various tax jurisdictions.

As of June 30, 2004, we did not have any purchase commitments other than obligations incurred in the normal course of business. These amounts are accrued when services or goods are received.

For the six months ended June 30, 2004 and 2003, our source of funding was mainly from cash generated by our operations. Since our operating results may fluctuate significantly, a decrease in customer demand or a decrease in the acceptance of our future products and services may impact our ability to generate positive cash flow from operations.

We continue to derive a significant portion of our overall business growth through the growth of our application management product offerings which are primarily offered on a subscription basis. The shift in the mix of license types does not impact our collections cycle as we typically invoice the customers up front for the full license amount and cash is generally received within 30-60 days from the invoice date in the U.S., APAC, and Japan (slightly longer in EMEA). Our quarterly operating results are affected by

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the mix of license types entered into in connection with the sale of products. As revenue associated with our subscription licenses is generally recognized ratably over the term of the license, the shift in mix will also result in deferred revenue becoming a larger component of our cash provided by operations. We believe that the shift to a subscription revenue model will continue in the future as we have continued to expand the number of offerings structured as subscription based contracts. Further, generally, if a perpetual license is sold at the same time as a subscription based license to the same customer, then the two become bundled together and are recognized over the term of the contract. This shift may cause us to experience a decrease or a lower rate of growth in recognized revenue in a given period, as well as continued growth in deferred revenue. Deferred revenue at June 30, 2004 was $327.3 million compared to $280.6 million at December 31, 2003. The increase included subscription fees of $22.9 million and maintenance fees of $15.2 million. However, we expect the mix of licenses to continue to fluctuate.

In the future, we expect cash will continue to be generated from our operations. We expect to spend additional cash of approximately $4.0 million to $5.0 million on leasehold improvements and IT infrastructure for our new leased campus, and other related costs during the remainder of 2004. Except for cash spent for our new leased campus, we do not expect the level of cash used in investing activities to acquire property and equipment in 2004 to change significantly from 2003. We currently plan to reinvest our cash generated from operations in new short- and long-term investments in high quality financial, government, and corporate securities or other investments, consistent with past investment practices, and therefore net cash used in investing activities may increase. Cash could be used in the future for acquisitions or strategic investments. For example, we expect to pay approximately $51.5 million in cash, including $0.7 million of direct merger costs to acquire Appilog. Cash could also be used to repurchase additional equity or retire or redeem additional debt. For example, since the inception of our new stock repurchase program through August 6, 2004, cash used to repurchase our common stock under our new stock repurchase program was $109.3 million. There are no transactions, arrangements, or other relationships with non-consolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of our requirements for capital resources.

Assuming there is no significant change in our business, we believe that our current cash and investment balances and cash flow from operations will be sufficient to fund our cash needs for at least the next twelve months.

Subsequent Events

On May 12, 2004, we entered into a definitive agreement to acquire all of the outstanding shares of Appilog and assume all outstanding vested stock options. The acquisition was completed on July 1, 2004. The total purchase price of approximately $61.9 million consists of $50.8 million in cash, $0.7 million in direct merger costs, and $10.4 million related to stock options exchanged. The purchase price will be allocated to the tangible and intangible assets acquired and liabilities assumed based on their respective fair values at the acquisition date.

On July 27, 2004, our Board of Directors approved a new program to repurchase up to $400.0 million of our common stock over the next two years. The specific timing and amount of repurchases will vary based on market conditions, securities law limitations, and other factors. Since the inception of our new stock repurchase program through August 6, 2004, we have repurchased 3,072,000 shares of our common stock at an average price of $35.59 per share for an aggregate purchase price of $109.3 million.

Our former Vice President of Tax, Uzi Sasson, filed a complaint on August 4, 2004, alleging that we wrongfully terminated his employment. We believe these claims were without merit and intend to vigorously defend the lawsuit.

Critical Accounting Policies and Estimates

The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our financial statements. The U.S. Securities and Exchange Commission has defined the most critical accounting policies as the ones that are most important to the portrayal of our financial condition and results, and require us to make our most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain.

Our critical accounting policies are as follows:

• revenue recognition;

• estimating valuation allowances and accrued liabilities;

• valuation of long-lived and intangible assets;

• valuation of goodwill;

• accounting for income taxes;

• accounting for investments in non-consolidated companies;

• accounting for stock options; and

• estimating forward contract terms.

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We discuss these policies further, as well as the estimates and judgments involved. We also have other key accounting policies. We believe that these other policies either do not generally require us to make estimates and judgments that are as difficult or as subjective, or it is less likely that they would have a material impact on our reported results of operations for a given period.

Revenue recognition

Our revenue recognition policy is detailed in Note 1 to the condensed consolidated financial statements. We have made significant judgments related to revenue recognition; specifically, in connection with each transaction involving our arrangements, we must evaluate whether our fee is “fixed or determinable” and we must assess whether “collectibility is probable.” These judgments are discussed below.

Fee is fixed or determinable

With respect to each arrangement, we must make a judgment as to whether the arrangement fee is fixed or determinable. If the fee is fixed or determinable, then revenue is recognized upon delivery of software or over the period of arrangements with our customers (assuming other revenue recognition criteria are met). If the fee is not fixed or determinable, then the revenue recognized in each quarter (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees had been fixed or determinable.

A determination that an arrangement fee is fixed or determinable also depends upon the payment terms relating to such an arrangement. Our customary payment terms are generally within 30-60 days of the invoice date in the U.S., APAC, and Japan (slightly longer in EMEA). Arrangements with payment terms extending beyond the customary payment terms are considered not to be fixed or determinable. A determination of whether the arrangement fee is fixed or determinable is particularly relevant to revenue recognition on perpetual licenses. The amount and timing of our revenue recognized in any period may differ materially if we make different judgments.

Collectibility is probable

To recognize revenue, we must make a judgment of the collectibility of the arrangement fee. Our judgment of the collectibility is applied on a customer-by-customer basis. We generally sell to customers for which there is a history of successful collection. If we determine that collection of a fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon receipt of cash. The amount and timing of revenue recognized in any period may differ materially if we make different judgments.

Estimating valuation allowances and accrued liabilities

The preparation of financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Use of estimates and assumptions include, but are not limited to, the sales reserve and prepaid commissions.

We must make estimates of potential future credits, warranty cost of product and services, and write-off of bad debts related to current period product revenues. We analyze historical returns, historical bad debts, current economic trends, average deal size, changes in customer demand, and acceptance of our products when evaluating the adequacy of the sales reserves. Revenue for the period is reduced to reflect the provision for sales returns. As a percentage of current period revenues, charges against sales reserves were insignificant for the three and six months ended June 30, 2004. Significant management judgments and estimates are made and used in connection with establishing the sales reserve in any accounting period. Material differences may result in the amount and timing of our revenues for any period if we make different judgments or use different estimates. At June 30, 2004 and December 31, 2003, sales reserves were $5.5 million and $6.1 million, respectively.

We are required to make estimates of the future sales commission expense associated with our revenues that will be recognized in future periods. We analyze historical commission rates, composition of the future revenues, and expected timing of revenue recognition of such future amounts. We make significant judgments and estimates in connection with establishing the prepaid commission in any accounting period. Material differences may result in the amount and timing of our sales commission expense for any period if we make different judgments or use different estimates. At June 30, 2004 and December 31, 2003, prepaid commissions were $28.4 million and $23.4 million, respectively.

Valuation of long-lived and intangible assets

We assess the impairment of long-lived assets and certain identifiable intangible assets to be held and used whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

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• a significant decrease in the market price of a long-lived asset (asset group);

• a significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition;

• a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator;

• an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group);

• a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group); and

• a current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.

We determine the recoverability of long-lived assets and certain identifiable intangible assets based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Such estimation process is highly subjective and involves significant management judgment. Determination of impairment loss for long-lived assets and certain identifiable intangible assets that management expects to hold and use is based on the fair value of the asset. Long-lived assets and certain identifiable intangible assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. In the second quarter of 2004, we recorded an impairment charge of $6.7 million associated with one of the two buildings we own that has been placed for sale. If our estimates or the related assumptions change in the future, we may be required to record an impairment charge on long-lived assets and certain intangible assets to reduce the carrying amount of these assets. Net intangible assets and long-lived assets were $110.1 million and $118.3 million at June 30, 2004 and December 31, 2003, respectively.

Valuation of goodwill

We assess the impairment of goodwill on an annual basis, and potentially more frequently if events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

• significant underperformance relative to expected historical or projected future operating results;

• significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

• significant negative industry or economic trends;

• significant decline in our stock price for a sustained period; and

• our market capitalization relative to net book value.

When we determine that the carrying value of goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure this impairment based on a projected discounted cash flow. We performed an annual impairment review during the fourth quarter in both 2003 and 2002. We did not record an impairment charge based on our reviews. If our estimates or the related assumptions change in the future, we may be required to record an impairment charge on goodwill to reduce its carrying amount to its estimated fair value.

Accounting for income taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax expense in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations. In addition, to the extent that we are unable to continue to reinvest a substantial portion of our profits in our Israeli operations, we may be subject to additional tax rate increases in the future. Our taxes could increase if these tax rate incentives are not renewed upon expiration, tax rates applicable to us are increased, authorities challenge our tax strategy, or our tax strategy is impacted by new laws or rulings.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our net deferred tax assets. We have recorded a valuation allowance for the

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majority portion of the net operating losses related to the income tax benefits arising from the exercise of employees’ stock options. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance, which could materially impact our financial position and results of operations.

Accounting for investments in non-consolidated companies

From time to time, we hold equity investments in publicly traded companies, privately held companies, and private equity funds for business and strategic purposes. These investments are accounted for under the cost method, as we do not have the ability to exercise significant influence over these companies’ operations. We periodically monitor our equity investments for impairment and will record reductions in carrying values if and when necessary. For equity investments in privately held companies and private equity funds, the evaluation process is based on information that we request from these companies and funds. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, recent financing activities, financing needs, earnings/revenue outlook, operational performance, management/ownership changes, and competition. If we determine that the carrying value of an investment is at an amount above fair value, or if a company has completed a financing with new unrelated third party investors based on a valuation significantly lower than the carrying value of our investment and the decline is other-than-temporary, it is our policy to record a loss on investment in our consolidated statement of operations. Estimating the fair value of non-marketable equity investments in technology companies is inherently subjective and may contribute to significant volatility in our reported results of operations.

For equity investments in publicly traded companies, we record a loss on investment in our consolidated statement of operations when we determine the decline in fair value below the carrying value is other-than-temporary. The ultimate value realized on these equity investments is subject to market price volatility until they are sold. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, earnings/revenue outlook, operational performance, management/ownership changes, competition, and stock price performance. Our on-going review may result in additional impairment charges in the future which could significantly impact our results of operations.

At June 30, 2004, our equity investments in non-consolidated companies were composed of investments in privately held companies of $4.6 million, a private equity fund of $7.1 million, and a warrant to purchase common stock of Motive of $0.8 million. At June 30, 2004, our total capital contributions to the private equity fund were $7.9 million. We have committed to make additional capital contributions to this private equity fund up to $7.1 million in the future. If the companies in which we have made investments do not complete initial public offerings or are not acquired by publicly traded companies, we may not be able to sell these investments. In addition, even if we are able to sell these investments, we cannot assure that we will be able to sell them at a gain or even recover our investment. A decline in the U.S. stock market and the market prices of publicly traded technology companies will adversely affect our ability to realize gains or a return of our capital on many of these investments. For the three months ended June 30, 2004, we did not record any losses on our investments in privately held companies nor the private equity fund. Unrealized gain related to a change in the fair value of the Motive warrant was $0.1 million for the three months ended June 30, 2004. For the six months ended June 30, 2004, we recorded a loss of $0.5 million on one of our investments in privately held companies. The loss was partially offset by an unrealized gain of $0.4 million related to a change in fair value of the Motive warrant. For the three months ended June 30, 2003, we recorded a loss of $0.6 million on one of our investments in privately held companies and a loss of $0.2 million on our investment in the private equity fund. For the six months ended June 30, 2003, we recorded a loss of $1.1 million on two of our investments in privately held companies and a loss of $0.2 million on our investment in the private equity fund.

The warrant is treated as a derivative instrument due to a net settlement provision. The warrant is recorded at its fair value on each reporting period. We calculate the fair value of the warrant using the Black-Scholes option-pricing model. The option-pricing model requires the input of highly subjective assumption such as the expected stock price volatility. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. A decline in the U.S. stock market and the market price of Motive’s common stock could contribute to volatility in our reported results of operations.

Accounting for stock options

We account for stock-based compensation for our employees using the intrinsic value method presented in Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations, and comply with the disclosure provisions of Statement of Financial Accounting Standard (SFAS) No. 123, Accounting for Stock-Based Compensation, and with the disclosure provisions of SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure Amendment of SFAS No. 123. Under APB No. 25, compensation expense is based on the difference, as of the date of the grant, between the fair value of our stock and the exercise price. No stock-based compensation has been recorded for stock options granted to our employees because we have granted stock options to our employees equal to the market price of the underlying stock on the date of grant. In accordance with Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB No. 25, we account for the fair value of stock options assumed in a purchase business combination at the date of acquisition at their fair value calculated using the Black-Scholes option-pricing model. The fair value of assumed options is included as a component of the purchase price. The intrinsic value attributable to unvested options is recorded as unearned stock-based compensation and amortized over the remaining vesting period of the stock options.

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In 2001 and 2003, we recorded unearned stock-based compensation primarily due to assumed stock options in conjunction with our acquisitions of Freshwater, Performant, and Kintana. We amortize unearned stock-based compensation using the straight-line method over the remaining vesting periods of the related options. If we amortize unearned stock-based compensation using the graded vesting method, which results in higher expense being recognized in the earlier period, our financial position and results of operations could be different.

On March 31, 2004, the Financial Accounting Standards Board (FASB) issued an exposure draft on proposed standard for the accounting of stock options. The proposed standard requires public companies to value employee stock options and stock issued under employee stock purchase plans using the fair value based method on the grant date and record stock-based compensation expense. The fair value based models that companies are allowed to use could be different from the Black-Scholes option-pricing model, which is currently used by us to calculate the pro forma effect on net income and earnings per share if we had applied SFAS No. 123 to employee option grants. (See Note 1 to our condensed consolidated financial statements for the disclosure of the pro forma net income (loss) and earnings (loss) per share for the three and six months ended June 30, 2004 and 2003, if we had applied SFAS No. 123.) However, the actual impact to our results of operations upon adoption of the proposed standard could be materially different from the pro forma information included in Note 1 to our condensed consolidated financial statements due to differences in the option-pricing model used, estimates and assumptions required, and options to be included in the calculation upon adoption. The fair value based models require the input of highly subjective assumptions and do not necessarily provide a reliable single measure of the fair value of our stock options. We closely monitor the status of this proposed standard and will evaluate the impact on our financial position and results of operations at such time when the final standard is issued.

Estimating forward contract terms

To mitigate our exposure on foreign currencies fluctuations, we enter into forward contracts to manage foreign currency exposures related to certain foreign currency denominated intercompany balances attributable to subsidiaries and foreign offices in the Americas, EMEA, APAC, and Japan against fluctuations in exchange rates. We have not entered into forward contracts for speculative or trading purposes. We enter into forward contracts based on our estimation of when revenue will be earned and cash will be collected. If the timing between when revenue is earned and cash is collected is different from our estimates, we will recognize gains or losses on forward contracts as a result of our hedging ineffectiveness. Based on any gains and losses our financial position and results of operations may be significantly impacted.

Recent accounting pronouncement

In November 2003, the EITF reached a consensus on disclosure guidance previously discussed under EITF Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The consensus provided for certain disclosure requirements that were effective for fiscal years ending after December 15, 2003. We adopted the disclosure requirements during the year ended December 31, 2003.

In March 2004, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF Issue No. 03-01. The consensus clarified the meaning of other-than-temporary impairment and its application to debt and equity investments accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and other investments accounted for under the cost method. The recognition and measurement guidance for which the consensus was reached in March 2004 is to be applied to other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. The consensus reached in March 2004 also provided for certain disclosure requirements associated with cost method investments that were effective for fiscal years ending after June 15, 2004. We do not believe that the consensus on the recognition and measurement guidance will have an impact on our results of operations.

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Risk Factors

In addition to the other information included in this Quarterly Report on Form 10-Q, you should carefully consider the risks described below before deciding to invest in us or maintain or increase your investment. The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties not presently known to us or that we currently deem not significant may also affect our business operations. If any of these risks actually occur, our business, financial condition, or results of operations could be seriously harmed. In that event, the market price of our common stock could decline and you may lose all or part of your investment.

Our future success may be impaired and our operating results will suffer if we cannot respond to rapid market and technological changes by introducing new products and services and continually improving the performance, features, and reliability of our existing products and services and responding to competitive offerings. The market for our software products and services is characterized by:

• rapidly changing technology;

• frequent introduction of new products and services and enhancements to existing products and services by our competitors;

• increasing complexity and interdependence of our applications;

• changes in industry standards and practices;

• ability to attract and retain key personnel; and

• changes in customer requirements and demands.

To maintain our competitive position, we must continue to enhance our existing products, including our software products and services for our application management and application delivery, and IT governance solutions. We must also continue to develop new products and services, functionality, and technology that address the increasingly sophisticated and varied needs of our customers and prospective customers. The development of new products and services, and enhancement of existing products and services, entail significant technical and business risks and require substantial lead-time and significant investments in product development. In addition, many of the markets in which we operate are seasonal. If we fail to anticipate new technology developments, customer requirements, or industry standards, or if we are unable to develop new products and services that adequately address these new developments, requirements, and standards in a timely manner, our products and services may become obsolete, our ability to compete may be impaired, our revenue could decline, and our operating results may suffer.

We expect our quarterly revenue and operating results to fluctuate, and it is difficult to predict our future revenue and operating results. Our revenue and operating results have varied in the past and are likely to vary significantly from quarter to quarter in the future. These fluctuations are due to a number of factors, many of which are outside of our control, including:

• fluctuations in demand for, and sales of, our products and services;

• fluctuations in the number of large orders in a quarter, including changes in the length of term and subscription licenses;

• changes in the mix of perpetual, term, or subscription licenses sold in a quarter;

• changes in the mix of products or services sold in a quarter;

• our success in developing and introducing new products and services and the timing of new product and service introductions;

• our ability to introduce enhancements to our existing products and services in a timely manner;

• changes in economic conditions affecting our customers or our industry;

• uncertainties related to the integration of products, services, employees, and operations of acquired companies;

• the introduction of new or enhanced products and services by our competitors and changes in the pricing policies of these competitors;

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• the discretionary nature of our customers’ purchase and budget cycles and changes in their budgets for software and related purchases;

• the amount and timing of operating costs and capital expenditures relating to the expansion of our business;

• deferrals by our customers of orders in anticipation of new products or services or product enhancements; and

• the mix of our domestic and international sales, together with fluctuations in foreign currency exchange rates.

In addition, the timing of our software product revenues is difficult to predict and can vary substantially from product to product and customer to customer. We base our operating expenses on our expectations regarding future revenue levels. The timing of larger orders and customer buying patterns are difficult to forecast, therefore we may not learn of shortfalls in revenue or earnings or other failures to meet market expectations until late in a particular quarter. As a result, if total revenues for a particular quarter are below our expectations, we would not be able to proportionately reduce operating expenses for that quarter.

We have experienced seasonality in our orders and revenues which may result in seasonality in our earnings. The fourth quarter of the year typically has the highest orders and revenues for the year and higher orders and revenues than the first quarter of the following year. We believe that this seasonality results primarily from the budgeting cycles of our customers being typically higher in the third and fourth quarters, from our application management business being typically strongest in the fourth quarter and weakest in the first quarter, however, and to a lesser extent, from the structure of our sales commission program. In addition, the tendency of some of our customers to wait until the end of a fiscal quarter to finalize orders has resulted in higher order volumes towards the end of the quarter. We expect this seasonality to continue in the future. In the first quarter of 2004, we experienced higher orders and revenues than the fourth quarter of 2003. We do not believe that these results are indicative of a shift in the future seasonality trends that we have typically experienced in the past.

Due to these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. If our operating results are below the expectations of investors or securities analysts, the trading prices of our securities could decline.

Our revenue targets are dependent on a projected mix of orders in a particular quarter and any failure to achieve revenue targets because of a shift in the mix of orders could adversely affect our quarterly revenue and operating results. Our license revenue in any given quarter is dependent upon the volume of perpetual orders shipped during the quarter and the amount of subscription revenue amortized from deferred revenue and, to a small degree, the amount recognized on subscription orders received during the quarter. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain license mix of perpetual licenses and subscription licenses. The precise mix of orders is subject to substantial fluctuation in any given quarter or multiple quarter periods, and the actual mix of licenses sold affects the revenue we recognize in the period. If we achieve the target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we deliver more-than-expected subscription licenses) or may exceed them (if we deliver more-than-expected perpetual licenses). In addition, if we achieve the target license mix but the overall level of orders is below the target level, then we will not meet our revenue targets which will adversely affect our operating results. In 2002, we began to effect a change in the mix of software license types to a higher percentage of subscription licenses in our application management and application delivery products. We believe that this shift will continue in the future as we offer more products on a subscription basis and more of our customers license our products a subscription basis. Further, generally, if a perpetual license is sold at the same time as a subscription based license to the same customer, then the two become bundled together and are recognized over the term of the contract. This shift may cause us to experience a decrease in recognized revenue in a given period, as well as continued growth of deferred revenue. In addition, while subscription licenses represent a potential source of renewable license revenue, there is also the risk that customers will not renew their licenses at the end of a term.

We expect to face increasing competition in the future, which could cause reduced sales levels and result in price reductions, reduced gross margins, or loss of market share. The market for our business technology optimization products and services is extremely competitive, dynamic, and subject to frequent technological change. There are few substantial barriers of entry in our market. The Internet has further reduced these barriers of entry, allowing other companies to compete with us in our markets. As a result of the increased competition, our success will depend, in large part, on our ability to identify and respond to the needs of current and potential customers, and to new technological and market opportunities, before our competitors identify and respond to these needs and opportunities. We may fail to respond quickly enough to these needs and opportunities.

In the market for application delivery solutions, our principal competitors include Compuware, Empirix, IBM Software Group, and Segue Software. In the new and rapidly changing market for application management solutions, our principal competitors include established providers of systems, storage, and network management software such as BMC Software, Computer Associates, HP OpenView (a division of Hewlett-Packard), Tivoli (a division of IBM), and Veritas, and providers of managed services such as Keynote Systems. Additionally, we face potential competition in this market from existing providers of application delivery solutions such as Segue Software and Compuware. In the market for IT governance solutions, our principal competitors include enterprise application vendors such as SAP, PeopleSoft, Oracle, Lawson, and Changepoint (which was recently acquired by Compuware), as well as point tool vendors such as Niku and Primavera.

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We believe that the principal competitive factors affecting our market are:

• price and cost effectiveness;

• product functionality;

• product performance, including scalability and reliability;

• quality of support and service;

• company reputation;

• depth and breadth of BTO offerings;

• research and development leadership;

• financial stability; and

• global capabilities.

Although we believe that our products and services currently compete favorably with respect to these factors, the markets for application management, application delivery, and IT governance are new and rapidly evolving. We may not be able to maintain our competitive position, which could lead to a decrease in our revenues and adversely affect our operating results. The software industry is increasingly experiencing consolidation and this could increase the resources available to our competitors and the scope of their product offerings. For example, our former application delivery competitor Rational Software was acquired by IBM Software Group, which has substantially greater financial and other resources than we have. Our competitors and potential competitors may develop more advanced technology, undertake more extensive marketing campaigns, adopt more aggressive pricing policies, or make more attractive offers to distribution partners and to employees.

If we fail to maintain our existing distribution channels and develop additional channels in the future, our revenue could decline. We derive a portion of our business from sales of our products and services through distribution channels, such as global software vendors, systems integrators, or value-added resellers. We generally expect that sales of our products through these channels will continue to account for a substantial portion of our revenue for the foreseeable future. We may not experience increased revenue from new channels and may see a decrease from our existing channels, which could harm our business.

The loss of one or more of our systems integrators or value-added resellers, or any reduction or delay in their sales of our products and services could result in reductions in our revenue in future periods. In addition, our ability to increase our revenue in the future depends on our ability to expand our indirect distribution channels.

Our dependence on indirect distribution channels presents a number of risks, including:

• each of our global software vendors, systems integrators or value-added resellers can cease marketing our products and services with limited or no notice and with little or no penalty;

• our existing global software vendors, systems integrators, or value-added resellers may not be able to effectively sell any new products and services that we may introduce;

• we may not be able to replace existing or recruit additional global software vendors, systems integrators, or value-added resellers, if we lose any of our existing ones;

• our global software vendors, systems integrators, or value-added resellers may also offer competitive products and services;

• we may face conflicts between the activities of our indirect channels and our direct sales and marketing activities; and

• our global software vendors, systems integrators, or value-added resellers may not give priority to the marketing of our products and services as compared to our competitors’ products.

The continued growth of our business may be adversely affected if we fail to form and maintain strategic relationships and business alliances. Our development, marketing, and distribution strategies rely increasingly on our ability to form strategic relationships with software and other technology companies. These business relationships often consist of cooperative marketing

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programs, joint customer seminars, lead referrals, and cooperation in product development. Many of these relationships are not contractual and depend on the continued voluntary cooperation of each party with us. Divergence in strategy or change in focus by, or competitive product offerings by, any of these companies may interfere with our ability to develop, market, sell, or support our products, which in turn could harm our business. Further, if these companies enter into strategic alliances with other companies or are acquired, they could reduce their support of our products. Our existing relationships may be jeopardized if we enter into alliances with competitors of our strategic partners. In addition, one or more of these companies may use the information they gain from their relationship with us to develop or market competing products.

If we do not adequately manage and evolve our financial reporting and managerial systems and processes, our ability to manage and grow our business may be harmed. Our ability to successfully implement our business plan and comply with regulations, including Sarbanes-Oxley Act of 2002, requires an effective planning and management process. We expect that we will need to continue to improve existing, and implement new, operational and financial systems, procedures and controls to manage our business effectively in the future. Any delay in the implementation of, or disruption in the transition to, new or enhanced systems, procedures or controls, could harm our ability to accurately forecast sales demand, manage our supply chain and record and report financial and management information on a timely and accurate basis.

Our increasing efforts to sell enterprise-wide software products and services could expose us to revenue variations and higher operating costs. We increasingly focus our efforts on sales of enterprise-wide solutions, which consist of our entire Mercury Optimization Centers product suite and related professional services, and managed services, rather than on the sale of component products. As a result, each sale requires substantial time and effort from our sales and support staff as well as involvement by our professional services and managed services organizations and our systems integrator partners. Large individual sales, or even small delays in customer orders, can cause significant variation in our revenues and adversely affect our results of operations for a particular period. The timing of large orders is usually difficult to predict and, like many software and services companies, many of our customers typically complete transactions in the last month of a quarter.

If we are unable to manage rapid changes, our operating results could be adversely affected. We have, in the past, experienced significant growth in revenue, employees, and number of product and service offerings and we believe this growth may continue. This growth has placed a significant strain on our management and our financial, operational, marketing, and sales systems. We are implementing and plan to implement in the future a variety of new or expanded business and financial systems, procedures, and controls, including the improvement of our sales and customer support systems. The implementation of these systems, procedures, and controls may not be completed successfully, or may disrupt our operations or our data may not be transitioned properly. Any failure by us to properly manage these transitions could impair our ability to attract and service customers and could cause us to incur higher operating costs and experience delays in the execution of our business plan.

We have also in the past experienced reductions in revenue that required us to rapidly reduce costs. If we fail to reduce staffing levels when necessary, our costs would be excessive and our business and operating results could be adversely affected.

The success of our business depends on the efforts and abilities of our senior management and other key personnel. We depend on the continued services and performance of our senior management and other key personnel. We do not have long-term employment agreements with any of our key personnel. The loss of any of our executive officers or other key employees could hurt our business. The loss of senior personnel can result in significant disruption to our ongoing operations, and new senior personnel must spend a significant amount of time learning our business and our systems in addition to performing their regular duties. Additionally, our inability to attract new senior executives and key personnel could significantly impact our business results.

Our international sales and operations subject us to risks that can adversely affect our revenue and operating results. International sales have historically accounted for a significant percentage of our revenue and we anticipate that such sales will continue to be a significant percentage of our revenue. As a percentage of our total revenues, international sales were 38% and 37% for the three and six months ended June 30, 2004, respectively, and 37% for both the three and six months ended June 30, 2003. We face risks associated with our international operations, including:

• changes in tax laws and regulatory requirements;

• difficulties in staffing and managing foreign operations;

• reduced protection for intellectual property rights in some countries;

• the need to localize products for sale in international markets;

• longer payment cycles to collect accounts receivable in some countries;

• seasonal reductions in business activity in other parts of the world in which we operate;

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• changes in foreign currency exchange rates;

• geographical turmoil, including terrorism and wars;

• country or regional political and economic instability; and

• economic downturns in international markets.

Any of these risks could harm our international operations and reduce our international sales. For example, some countries in Europe, the Middle East and Africa already have laws and regulations related to technologies used on the Internet that are more strict than those currently in force in the U.S. Any or all of these factors could cause our business and operating results to be harmed.

Because our research and development operations are primarily located in Israel, we may be affected by volatile political, economic, and military conditions in that country and by restrictions imposed by that country on the transfer of technology. Our operations depend on the availability of highly skilled scientific and technical personnel in Israel. Our business also depends on trading relationships between Israel and other countries. In addition to the risks associated with international sales and operations generally, our operations could be adversely affected if major hostilities involving Israel should occur or if trade between Israel and its current trading partners were interrupted or curtailed.

These risks are compounded due to the restrictions on our ability to manufacture or transfer outside of Israel any technology developed under research and development grants from the government of Israel without the prior written consent of the government of Israel. If we are unable to obtain the consent of the government of Israel, we may not be able to take advantage of strategic manufacturing and other opportunities outside of Israel.

We are subject to the risk of increased taxes if tax rate incentives in Israel are altered or if there are other changes in tax laws or rulings. Historically, our operations resulted in a significant amount of income in Israel where tax rate incentives have been extended to encourage foreign investment. Our taxes could increase if these tax rate incentives are not renewed upon expiration or tax rates applicable to us are increased. Tax authorities could challenge the manner in which profits are allocated between our subsidiaries and us, and we may not prevail in any such challenge. If the profits recognized by our subsidiaries in jurisdictions where taxes are lower became subject to income taxes in other jurisdictions, our worldwide effective tax rate would increase. In addition, to the extent that we are unable to continue to reinvest a substantial portion of our profits in our Israeli operations, we may be subject to additional tax rate increases in the future.

Other factors that could increase our effective tax rate include the effect of changing economic conditions, business opportunities, and changes in tax laws and rulings. We have in the past and may continue in the future to retire amounts outstanding under our 2000 Notes. To the extent that these repurchases are completed below the par value of the 2000 Notes, we may generate a taxable gain from these repurchases. These gains may result in an increase in our effective tax rate. Merger and acquisition activities, if any, could result in nondeductible expenses, which may increase our effective tax rate. In addition, we intend to migrate the economic ownership of the technology acquired from Performant and Kintana to our Israeli subsidiary in 2004, which may lead to a temporary increase in our effective tax rate.

Our financial results may be positively or negatively impacted by foreign currency fluctuations. A substantial portion of our research and development activities are performed in Israel. In addition, our foreign operations are generally transacted through our international sales subsidiaries and offices in the Americas; Europe, the Middle East and Africa (EMEA); Asia Pacific (APAC); and Japan. The Americas includes Brazil, Canada, Mexico and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. As a result, these sales and related expenses are denominated in currencies other than the U.S. dollar. Because our financial results are reported in U.S. dollars, our results of operations may be positively or adversely impacted by fluctuations in the rates of exchange between the U.S. dollar and other currencies, including:

• a decrease in the value of currencies in certain countries of the Americas, EMEA, APAC, or Japan relative to the U.S. dollar, which would decrease our reported U.S. dollar revenue, as we generate revenue in these local currencies and report the related revenue in U.S. dollars;

• an increase in the value of currencies in certain countries of the Americas, EMEA, APAC, or Japan relative to the U.S. dollar, which would increase our sales and marketing costs in these countries and would increase research and development costs in Israel; and

• an increase in the value of currencies in certain countries of the Americas, EMEA, APAC, or Japan relative to the U.S. dollar, which would increase our reported U.S. dollar revenue, as we generate revenue in these local currencies and report the related revenue in U.S. dollars.

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We attempt to limit foreign exchange exposure through operational strategies and by using forward contracts to offset the effects of exchange rate changes on intercompany trade balances. This requires us to estimate when revenue will be earned and cash will be collected. We may not be successful in making these estimates. If these estimates are overstated or understated during periods of currency volatility, we could experience material currency gains or losses on forward contracts and our financial position and results of operations may be significantly impacted.

Acquisitions may be difficult to integrate, disrupt our business, dilute stockholder value, or divert the attention of our management and may result in financial results that are different than expected. In July 2004, we acquired Appilog, Inc. In August 2003, we acquired Kintana. In addition, in May 2003, we completed our acquisition of Performant and in May 2001, we acquired Freshwater Software. In the event of any future acquisitions, we could:

• issue stock that would dilute the ownership of our then-existing stockholders;

• incur debt;

• assume liabilities;

• incur charges for the impairment of the value of acquired assets; or

• incur amortization expense related to intangible assets.

If we fail to achieve the financial and strategic benefits of past and future acquisitions, our operating results will suffer.

Acquisitions involve numerous other risks, including:

• difficulties in integrating or coordinating the different research and development, sales programs, facilities, operations, technologies, or products;

• failure to achieve targeted synergies;

• unanticipated costs and liabilities;

• diversion of management’s attention from our core business;

• adverse effects on our existing business relationships with suppliers and customers or those of the acquired organization;

• difficulties in entering markets in which we have no or limited prior experience; and

• potential loss of key employees, particularly those of the acquired organizations.

In addition, for purchase acquisitions completed to date, the development of these technologies remains a significant risk due to the remaining efforts to achieve technical feasibility, changing customer markets, and uncertainty of new product standards. Efforts to develop these acquired technologies into commercially viable products consist of planning, designing, experimenting, and testing activities necessary to determine that the technologies can meet market expectations, including functionality and technical requirements. Failure to bring these products to market in a timely manner could result in a loss of market share or a lost opportunity to capitalize on emerging markets, and could have a material adverse impact on our business and operating results.

In the normal course of business, we frequently engage in discussions with parties relating to possible acquisitions. As a result of such transactions, our financial results may differ from the investment community’s expectations in a given quarter. Further, if market conditions or other factors lead us to change our strategic direction, we may not realize the expected value from such transactions. If we do not realize the expected benefits or synergies of such transactions, our consolidated financial position, results of operations, cash flows, and stock price could be negatively impacted.

If we are required to account for stock options under our employee stock plans as a compensation expense, our net income and our earnings per share would be significantly reduced or may reflect a loss. There has been an increasing public debate about the proper accounting treatment for equity-based compensation, such as employee stock options and employee stock purchase plan shares, and whether they should be treated as a compensation expense and, if so, how to properly value such charges. On March 31, 2004, the Financial Accounting Standards Board issued an exposure draft on a proposed standard for the accounting of stock options. The proposed standard requires public companies to value employee stock options and stock issued under employee stock purchase plans using the fair value based method on the grant date and record stock-based compensation expense. If we elected or were required to record an expense for our employee stock plans using the fair value based method, we would be required to recognize significant stock-based compensation charges. We currently calculate stock-based compensation expense using the Black-Scholes option-pricing model and disclose the pro forma impact on net income (loss) and net income (loss) per share in Note 1 to our condensed consolidated financial statements for the three and six months ended June 30, 2004 and 2003. Although we are not currently required to record any

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stock-based compensation expense using the fair value based model in connection with employee option grants that have an exercise price at or above fair market value and for shares issued under our employee stock purchase plan, it is possible that future accounting standards will require us to treat all stock-based compensation as a compensation expense in our consolidated statements of operations using the fair value based method.

Investments may become impaired and require us to take a charge against earnings. At June 30, 2004, our equity investments in non-consolidated companies were composed of investments in privately held companies of $4.6 million, a private equity fund of $7.1 million, and a warrant to purchase common stock of Motive of $0.8 million. At June 30, 2004, our total capital contributions to this private equity fund were $7.9 million. We have committed to make additional capital contributions to this private equity fund up to $7.1 million in the future. We may be required to incur charges for the impairment of value of our investments. For example, for the three months ended June 30, 2004, we did not record any losses on our investments in private companies nor the private equity fund. For the six months ended June 30, 2004, we recorded a loss of $0.5 million on one of our investments in privately held companies. Unrealized gain related to a change in fair value of the Motive warrant was $0.1 million and $0.4 million for the three and six months ended June 30, 2004, respectively. For the three and six months ended June 30, 2003, we recorded a loss of $0.6 million and $1.1 million on our investments in privately held companies, respectively, and a loss of $0.2 million on our investment in the private equity fund for both periods. In calculating the loss on our investments, we took into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors. We closely monitor the financial health of the private companies in which we hold minority equity investments. We may continue to make investments in other companies. If we determine in accordance with our standard accounting policies that an impairment has occurred, then additional losses would be recorded.

The Motive warrant is treated as a derivative instrument due to a net settlement provision. The warrant is recorded at its fair value on each reporting date by using the Black-Scholes option-pricing model. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. Estimating the fair value of the warrant requires management judgment and may have an impact on our financial positions and results of operations.

If we fail to adequately protect our proprietary rights and intellectual property, we may lose a valuable asset, experience reduced revenue, and incur costly litigation to protect our rights. Our success depends in large part on our proprietary technology. We rely on a combination of patents, copyrights, trademarks, service marks, trade secret, and contractual restrictions (including confidentiality provisions and licensing arrangements) to establish and protect our proprietary rights in our products and services. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Despite our precautions, it may be possible for unauthorized third parties to copy our products and services and use information that we regard as proprietary to create products and services that compete with ours. Some license provisions protecting against unauthorized use, copying, transfers, and disclosures of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries. Further, the laws of some countries do not protect proprietary rights to the same extent as the laws of the U.S. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase. If we fail to successfully enforce our intellectual property rights, our competitive position could suffer, which could harm our operating results. In addition, we are not significantly dependent on any of our patents as we do not generally license our patents to other companies and do not receive any revenue as a direct result of our patents.

In many cases, we enter into confidentiality or license agreements with our employees and consultants and with the customers and corporations with whom we have strategic relationships and business alliances. No assurance can be given that these agreements will be effective in controlling access to and distribution of our products and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our products.

Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversions of our management resources, which could result in lower revenue, higher operating costs, and adversely affect our operating results.

Third parties could assert that our products and services infringe their intellectual property rights, which could expose us to litigation that, with or without merit, could be costly to defend. We may from time to time be subject to claims of infringement of other parties’ proprietary rights. We could incur substantial costs in defending ourselves and our customers against these claims. Parties making these claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the U.S. and abroad and could result in an award of substantial damages against us. In the event of a claim of infringement, we may be required to obtain licenses from third parties, develop alternative technology, or to alter our products or processes or cease activities that infringe the intellectual property rights of third parties. If we are required to obtain licenses, we cannot be sure that we will be able to do so at a commercially reasonable cost, or at all. Defense of any lawsuit or failure to obtain required licenses could delay shipment of our products and increase our costs. In addition, any such lawsuit could result in our incurring significant costs or the diversion of the attention of our management.

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If we fail to obtain or maintain early access to third-party software, our future product development may suffer. Software developers have, in the past, provided us with early access to pre-generally available versions of their software in order to have input into the functionality and to ensure that we can adapt our software to exploit new functionality in these systems. Some companies, however, may adopt more restrictive policies in the future or impose unfavorable terms and conditions for such access. These restrictions may result in higher research and development costs for us in connection with the enhancement and modification of our existing products and the development of new products or may prevent us from being able to develop products which will work with such new systems, which could harm our business.

We have adopted anti-takeover defenses that could delay or prevent an acquisition of our company, including an acquisition that would be beneficial to our stockholders. We have adopted a Preferred Shares Rights Agreement (which we refer to as our Shareholder Rights Plan) on July 5, 1996, as amended. In connection with the Shareholder Rights Plan, our Board of Directors declared and paid a dividend of one preferred share purchase right for each share of our common stock outstanding on July 15, 1996. In addition, each share of common stock issued after July 15, 1996 was issued, or will be issued, with an accompanying preferred stock purchase right. Because the rights may substantially dilute the stock ownership of a person or group attempting to take us over without the approval of our Board of Directors, the Shareholder Rights Plan could make it more difficult for a third party to acquire us (or a significant percentage of our outstanding capital stock) without first negotiating with our Board of Directors regarding such acquisition.

Our Board of Directors also has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present plans to issue shares of preferred stock.

In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, which will prohibit us from engaging in a business combination with an interested stockholder for a period of three years after the date that the person became an interested stockholder unless, subject to certain exceptions, the business combination or the transaction in which the person became an interested stockholder is approved in a prescribed manner.

Furthermore, certain provisions of our Amended and Restated Certificate of Incorporation may have the effect of delaying or preventing changes in our control or management, which could adversely affect the market price of our common stock.

Leverage and debt service obligations for $800.0 million in outstanding Notes may adversely affect our cash flow. On April 29, 2003, we issued our 2003 Notes, with a principal amount of $500.0 million, in a private placement, and in July 2000, we completed the offering of the 2000 Notes with a principal amount of $500.0 million. From December 2001 through June 30, 2004, we retired $200.0 million face value of our 2000 Notes. We continue to carry a substantial amount of outstanding indebtedness, primarily the 2000 Notes and the 2003 Notes. There is the possibility that we may be unable to generate cash sufficient to pay the principal of, interest on, and other amounts in respect of our indebtedness when due. Our leverage could have significant negative consequences, including:

• increasing our vulnerability to general adverse economic and industry conditions;

• requiring the dedication of a substantial portion of our expected cash flow from operations to service our indebtedness, thereby reducing the amount of our expected cash flow available for other purposes, including capital expenditures and acquisitions; and

• limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete.

In November 2002, we entered into an interest rate swap with Goldman Sachs Capital Markets, L.P. (GSCM) with respect to $300.0 million of our 2000 Notes. This interest rate swap could expose us to greater interest expense for our 2000 Notes.

In addition, the 2003 Notes would be included in our diluted net income per share calculation if our common stock price reaches a specified threshold or if specified corporate transactions have occurred and if we elect to settle in stock instead of cash. In this case, 9,673,050 shares would be included in the diluted weighted average common shares and equivalents. In June 2004, the Emerging Issues Task Force issued a draft on Statement No. 04-08, Accounting Issues Related to Certain Features of Contingently Debt and the Effect on Diluted Earnings per Share, to address the threshold question of whether a market price contingency needs to be substantive for the dilutive effect of contingently convertible debt to be excluded from diluted earnings per share. If the proposed accounting standard is finalized and the conversion feature of our 2003 Notes is determined to be nonsubstantive, we will be required to include 9,673,050 shares in the diluted weighted average common shares and equivalents to calculate our diluted net income per share in the future periods, as required, by the proposed accounting standard.

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Finally, our newly approved stock repurchase program approved by the Board of Directors on July 27, 2004, pursuant to which we may repurchase up to $400.0 million of our common stock may leave us with less cash to repay our 2000 Notes and 2003 Notes.

Economic, political, and market conditions may adversely affect demand for our products and services. Our customers’ decisions to purchase our products and services are discretionary and subject to their internal budgets and purchasing processes. We believe that the slowdown in the economy and the weakening of business conditions have caused and may continue to cause customers to reassess their immediate technology needs, lengthen their purchasing decision-making processes, require more senior level internal approvals of purchases, and defer purchasing decisions, and accordingly, have reduced and could reduce demand in the future for our products and services. In addition, the war on terrorism and the potential for other hostilities in various parts of the world have caused political uncertainties and volatility in the financial markets. Under these circumstances, there is a risk that our existing and potential customers may decrease spending for our products and services. If demand for our products and services is reduced, our revenue growth rates and operating results will be adversely affected.

The price of our common stock may fluctuate significantly, which may result in losses for investors and possible lawsuits. The market price for our common stock has been and may continue to be volatile. For example, during the 52-week period ended July 30, 2004, the closing sale prices of our common stock as reported on the NASDAQ National Market ranged from a high of $54.00 to a low of $35.07. We expect our stock price to be subject to fluctuations as a result of a variety of factors, including factors beyond our control. These factors include:

• actual or anticipated variations in our quarterly operating results;

• announcements of technological innovations or new products or services by us or our competitors;

• announcements relating to strategic relationships, acquisitions or investments;

• changes in financial estimates or other statements by securities analysts;

• changes in general economic conditions;

• terrorist attacks, and the effects of war;

• conditions or trends affecting the software industry and the Internet;

• changes in the rating of our notes or other securities; and

• changes in the economic performance and/or market valuations of other software and high-technology companies.

Because of this volatility, we may fail to meet the expectations of our stockholders or of securities analysts at some time in the future, and the trading prices of our securities could decline as a result. In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the trading prices of equity securities of many high-technology companies. These fluctuations have often been unrelated or disproportionate to the operating performance of these companies. Any negative change in the public’s perception of software or internet software companies could depress our stock price regardless of our operating results. Because the 2000 Notes and 2003 Notes are convertible into shares of our common stock, volatility or depressed prices for our common stock could have a similar effect on the trading price of these Notes. Holders who receive common stock upon conversion also will be subject to the risk of volatility and depressed prices of our common stock. In addition, the existence of these Notes may encourage short selling in our common stock by market participants because the conversion of these Notes could depress the price of our common stock.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Our exposure to market rate risk includes risk of change in interest rate, foreign exchange rate fluctuations, and loss in equity investments.

Interest Rate Risk:

We mitigate market risk associated with our investments by placing our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer or issue. In addition, we have classified all of our debt securities investments as “held to maturity.” Marketable equity securities are classified as available-for-sale short-term investments. At June 30, 2004, we did not hold any marketable equity securities. At June 30, 2004, $574.0 million, or 41% of our cash, cash equivalents, and investment portfolio have original maturities of less than 90 days, and an additional $167.7 million, or 12% carried original maturities of less than one year. All investments mature, by policy, in less than three years. Information about our investment portfolio in debt securities is presented in the table below, which states notional amounts and related weighted-average interest rates. Amounts represent maturities from the reporting date to the dates shown below for each twelve-month periods (in thousands):

	June 30,									Total			Fair Value
	2005			2006			2007
Investments maturing within 30 days at June 30, 2004:
Fixed rate	$	316,159		$	—		$	—		$	316,159		$	316,161
Weighted average rate		1.36	%		—			—			1.36	%		—
Investments maturing 30 days after June 30, 2004:
Fixed rate	$	309,990		$	159,926		$	488,702		$	958,618		$	955,072
Weighted average rate		1.67	%		2.30	%		2.40	%		2.15	%		—
Total investments	$	626,149		$	159,926		$	488,702		$	1,274,777		$	1,271,233
Weighted average rate		1.54	%		2.30	%		2.40	%		1.97	%		—

Our long-term investments include $604.4 million of government agency instruments, which have callable provisions and accordingly may be redeemed by the agencies should interest rates fall below the coupon rate of the investments.

The fair value of our 2000 Notes fluctuates based upon changes in the price of our common stock, changes in interest rates, and changes in our creditworthiness. The fair market value of our 2000 Notes at June 30, 2004 was $297.0 million while the face value and book value was $300.0 million and $304.8 million, respectively. To mitigate the risk of fluctuation in the fair value of our 2000 Notes, we entered into an interest rate swap arrangement. The fair value of our 2003 Notes fluctuates based upon changes in the price of our common stock and changes in our creditworthiness. The fair market value of the 2003 Notes at June 30, 2004 was $556.9 million while the face value and the book value was $500.0 million. See Note 7 to the condensed consolidated financial statements for transactions regarding our 2000 and 2003 Notes.

In November 2002, we merged our January and February 2002 interest rate swaps with Goldman Sachs Capital Markets, L.P. (GSCM) into a single interest rate swap with GSCM to improve the overall effectiveness of our interest rate swap arrangement. The November interest rate swap of $300.0 million, with a maturity date of July 2007, is designated as an effective hedge of the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) of our 2000 Notes. The objective of the swap is to convert the 4.75% fixed interest rate on our 2000 Notes to a variable interest rate based on the 3-month LIBOR plus 48.5 basis points. The gain or loss from changes in the fair value of the interest rate swap is expected to be highly effective at offsetting the gain or loss from changes in the fair value attributable to changes in the LIBOR throughout the life of our 2000 Notes. The interest rate swap creates a market exposure to changes in the LIBOR. If the LIBOR increases or decreases by 1%, our interest expense would increase or decrease by $750,000 quarterly on a pretax basis. The value of the interest rate swap is determined using various inputs, including forward interest rates, and time to maturity. Our interest rate swap was recorded as an asset in our consolidated balance sheets as of June 30, 2004 and December 31, 2003, but it has decreased in value over the past six months. If market changes continue to negatively impact the value of the swap, the swap may become a liability in our consolidated balance sheet. In the event we chose to terminate the swap before maturity, and the swap value was unfavorable, we would be obligated to pay to our counterparty in cash, the market value of the swap at termination date. According to the terms of the swap, we are required to provide initial collateral in the form of cash or cash equivalents to GSCM in the amount of $6.0 million as continuing security for our obligations under the swap (irrespective of movements in the value of the swap) and from time to time additional collateral can change hands between Mercury and GSCM as swap rates and equity prices fluctuate. We accounted for the initial collateral and any additional collateral as restricted cash on our consolidated balance sheets. If the price of our common stock exceeds the original conversion or redemption price of the 2000 Notes, we will be required to pay the fixed rate of 4.75% and receive a variable rate on the $300.0 million principal amount of the 2000 Notes. If we call the 2000 Notes at a premium (in whole or in part), or if any of the holders of the 2000 Notes elected to convert the 2000 Notes (in whole or in part), we will be required to pay a variable rate and receive the fixed rate of 4.75% on the principal amount of such called or converted our 2000 Notes.

We have credit exposure with respect to GSCM as counterparty under the swap. However, we believe that the risk of such credit exposure is limited because GSCM is an affiliate of a major U.S. investment bank and because its obligation under the swap is guaranteed by the Goldman Sachs Group L.P.

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Also, see Notes 7 and 14 to the condensed consolidated financial statements for additional information regarding our 2000 Notes and the interest rate swap activities.

Foreign exchange rate risk

A portion of our business is conducted in currencies other than the U.S. dollar. Our operating expenses in each of these countries are in the local currencies, which mitigates a significant portion of the exposure related to local currency revenue. We enter into foreign exchange forward contracts to minimize the short-term impact of foreign currency fluctuations on foreign currency denominated intercompany balances attributable to subsidiaries and foreign offices in the Americas; Europe, the Middle East, and Africa (EMEA); Asia Pacific (APAC); and Japan. The Americas includes Brazil, Canada, Mexico, and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. We had outstanding forward contracts with notional amounts totaling $22.0 million and $31.5 million at June 30, 2004 and December 31, 2003, respectively. The forward contracts in effect at June 30, 2004 mature on July 30, 2004 and were hedges of certain foreign currency transaction exposures in the Australian Dollar, British Pound, Danish Kroner, Euro, Hong Kong Dollar, Indian Rupee, Japanese Yen, Korean Won, Norwegian Kroner, Singapore Dollar, South African Rand, and Swiss Franc.

We also utilize forward exchange contracts of one fiscal-month duration to offset various non-functional currency exposures. Currencies hedged under this program include the Canadian Dollar, Hong Kong Dollar, Israeli Shekel, and Singapore Dollar. We had outstanding forward contracts with notional amounts totaling $20.9 million and $42.6 million at June 30, 2004 and December 31, 2003, respectively.

Gains or losses on forward contracts are recognized as “Other income (expense), net” in our consolidated statement of operations in the same period as gains or losses on the underlying transactions. Net gains or losses on forward contracts and the underlying transactions did not have any material impact to our financial position. We do not believe an immediate increase of 10% in the exchange rates of the U.S. dollar to other foreign currencies would have a material impact on our operating results or cash flows.

Investment risk

From time to time, we have equity investments in public companies, privately held companies, and private equity funds for business and strategic purposes. At June 30, 2004, our investments in privately held companies and a private equity fund were $4.6 million and $7.1 million, respectively. Through June 30, 2004, we have made capital contributions to the private equity fund totaling $7.9 million and we have committed to pay up to $7.1 million in the future.

If the privately held companies in which we have made investments do not complete initial public offerings or are not acquired by publicly traded companies, we may not be able to sell these investments. In addition, even if we are able to sell these investments, we cannot assure that we will be able to sell them at a gain or even recover our investment. A decline in the U.S. stock market and the market prices of publicly traded technology companies will adversely affect our ability to realize gains or a return of our capital on our investments in these public and private companies. We have a policy to review our equity investments portfolio. If we determine that the decline in value in one of our equity investments is other-than-temporary, we record a loss on investment in our consolidated statement of operations to write down these equity investments to the market value.

For the three months ended June 30, 2004, we did not record any losses on our investments in privately held companies nor the private equity fund. For the six months ended June 30, 2004, we recorded a loss of $0.5 million on one of our investments in privately held companies. In calculating the loss on our investments, we took into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors.

In addition, we have a warrant to purchase common stock of Motive, Inc. The warrant is treated as a derivative instrument due to a net settlement provision. The Motive warrant is marked to market at each reporting date using the Black-Scholes option-pricing model. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. Any significant fluctuations in the common stock price of Motive may have an impact on our financial positions and results of operations. The fair value of the warrant was $0.8 million and $0.4 million as of June 30, 2004 and December 31, 2003, respectively.

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Item 4. Controls and Procedures

(a) Disclosure controls and procedures. Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this quarterly report, have concluded that as of the end of the period covered by this report, our disclosure controls and procedures were adequate and designed to ensure that material information related to us and our consolidated subsidiaries would be made known to them by others within these entities.

(b) Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rule 13a-15 or 15d-15 that occurred during the period covered by this quarterly report, or to our knowledge in other factors, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II

Item 4. Submission of Matters to a Vote of Stockholders

(a) The 2004 Annual Meeting of the Stockholders (“the Meeting”) of Mercury Interactive Corporation was held at the Four Seasons New York, 57 East 57th Street, New York, New York 10022 at 10:00 a.m., Eastern Time, on Wednesday, May 19, 2004.

(b) At the Meeting, the following six persons were elected to the Company’s Board of Directors, constituting all members of the Board of Directors.

Nominee	For	Withheld
Amnon Landan	76,403,725	2,881,219
Igal Kohavi	74,826,916	4,458,028
Clyde Ostler	67,124,780	12,160,164
Yair Shamir	70,929,770	8,355,174
Giora Yaron	71,235,862	8,049,082
Anthony Zingale	66,573,773	12,711,171

(c) The following additional proposals were considered at the Meeting with their results according to the respective vote of the stockholders:

PROPOSAL 2—Ratify and approve an amendment to Mercury’s Restated Certificate of Incorporation to increase the authorized number of shares of Mercury common stock to 560,000,000 shares.

For	Against	Abstentions (1)	Broker Non- Votes (1)
56,812,268	22,055,893	416,783	0

PROPOSAL 3—Ratify the appointment of PricewaterhouseCoopers LLP as independent auditors for the fiscal year ending December 31, 2004.

For	Against	Abstentions (1)	Broker Non- Votes (1)
78,230,660	666,587	387,697	0

(1) Both abstentions and broker non-votes are counted as present for the purpose of determining the presence of a quorum. Broker non-votes occur when shares held by a broker on behalf of a beneficial owner are not voted with respect to a particular proposal, which generally occurs when the broker has not received voting instructions from the beneficial owner and lacks the discretionary authority to vote the shares itself.

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Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

2.1	Agreement and Plan of Merger dated as of May 12, 2004 among Appilog, Inc., Appilog Logview Ltd., Mercury Interactive Corporation, Alaska Merger Corporation and Amnon Shoham as Stockholders’ Representative
2.2	Amendment No. 1 dated as of June 24, 2004 to the Agreement and Plan of Merger dated as of May 12, 2004 among Appilog, Inc., Appilog Logview Ltd., Mercury Interactive Corporation, Alaska Merger Corporation and Amnon Shoham as Stockholders’ Representative
3.1	Certificate of Amendment of Restated Certificate of Incorporation
3.2	Corrected Certificate of Amendment of Restated Certificate of Incorporation
31.1	Certification of the Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of the Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b) Reports on Form 8-K

We filed or furnished the following Current Reports on Form 8-K during the quarter ended June 30, 2004:

• Current Report on Form 8-K dated April 22, 2004, announcing financial results for the quarter ended March 31, 2004 and attached a press release related thereto.

• Current Report on Form 8-K dated May 12, 2004, announcing the signing of a definitive agreement to acquire Appilog, Inc. and attached a press release related thereto.

48

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, Mercury Interactive Corporation, a corporation organized and existing under the laws of the State of Delaware, has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

MERCURY INTERACTIVE CORPORATION

(Registrant)

Dated: August 9, 2004

By:	/s/ Douglas P. Smith
	Douglas P. Smith, Executive Vice President and Chief Financial Officer Principal Financial Officer
By:	/s/ Bryan J. LeBlanc
	Bryan J. LeBlanc, Vice President, Finance and Operations Principal Accounting Officer

49

EX-2.1

Exhibit 2.1

[EXECUTION COPY]

AGREEMENT AND PLAN OF MERGER

dated as of

May 12, 2004

Among

APPILOG, INC.,

APPILOG LOGVIEW LTD.

MERCURY INTERACTIVE CORPORATION,

ALASKA MERGER CORPORATION,

and

AMNON SHOHAM, as STOCKHOLDERS’ REPRESENTATIVE

TABLE OF CONTENTS

		PAGE
ARTICLE 1
DEFINITIONS
Section 1.01 .	Definitions	2
ARTICLE 2
THE MERGERS
Section 2.01 .	Mergers	10
Section 2.02 .	Conversion of Shares=	10
Section 2.03 .	Surrender and Payment	11
Section 2.04 .	Dissenting Shares	12
Section 2.05 .	Stock Options	13
Section 2.06 .	Adjustments	13
Section 2.07 .	Withholding Rights	14
Section 2.08 .	Escrow	14
Section 2.09 .	Lost Certificates	14
ARTICLE 3
THE SURVIVING CORPORATION
Section 3.01 .	Certificate of Incorporation	15
Section 3.02 .	Bylaws	15
Section 3.03 .	Directors and Officers	15
ARTICLE 4
REPRESENTATIONS AND WARRANTIES OF THE COMPANY AND THE COMPANY SUBSIDIARY
Section 4.01 .	Corporate Existence and Power	15
Section 4.02 .	Corporate Authorization; Stockholder Consents	15
Section 4.03 .	Governmental Authorization	16
Section 4.04 .	Non-Contravention	17
Section 4.05 .	Capitalization	17
Section 4.06 .	Subsidiaries	19
Section 4.07 .	Financial Statements	20
Section 4.08 .	Absence of Certain Changes	21
Section 4.09 .	No Undisclosed Liabilities	22
Section 4.10 .	Compliance with Laws and Court Orders	23
Section 4.11 .	Agreements, Contracts and Commitments	23
Section 4.12 .	Litigation	25
Section 4.13 .	Finders’ Fees	26
Section 4.14 .	Tax Representations	26

Section 4.15 .	Employee Matters and Employment Benefit Plans	28
Section 4.16 .	Title of Properties; Absence of Liens and Encumbrances; Condition of Equipment	31
Section 4.17 .	Products	32
Section 4.18 .	Intellectual Property	32
Section 4.19 .	Insurance Coverage	39
Section 4.20 .	Licenses and Permits	39
Section 4.21 .	Receivables	39
Section 4.22 .	Environmental Matters	40
Section 4.23 .	Certain Interests	40
Section 4.24 .	Customers; Suppliers	41
Section 4.25 .	Books and Records	41
Section 4.26 .	Directors and Officers	42
Section 4.27 .	Grants, Incentives, Subsidies	42
Section 4.28 .	Information Statement	43
ARTICLE 5
REPRESENTATIONS AND WARRANTIES OF PARENT
Section 5.01 .	Corporate Existence and Power	43
Section 5.02 .	Corporate Authorization	43
Section 5.03 .	Governmental Authorization	43
Section 5.04 .	Non-Contravention	44
Section 5.05 .	Litigation	44
Section 5.06 .	Form S-8	44
ARTICLE 6
COVENANTS OF THE COMPANY AND THE COMPANY SUBSIDIARY
Section 6.01 .	Conduct of the Company and the Company Subsidiary	45
Section 6.02 .	Stockholder Approval	48
Section 6.03 .	No Solicitation; Other Offers	48
Section 6.04 .	Access to Information	49
Section 6.05 .	Tax Matters	49
Section 6.06 .	Notices of Certain Events	50
Section 6.07 .	Consents and Notices	50
Section 6.08 .	Company Cash Amount.	50
Section 6.09 .	Excise Tax Matters	51
Section 6.10 .	Capitalization Information	51
Section 6.11 .	Stock Options	51
Section 6.12 .	Allocation of Consideration	52
Section 6.13 .	Amendment of Stock Plan Agreements	52
ARTICLE 7
COVENANTS OF PARENT
Section 7.01 .	Obligations of Merger Sub	52

ii

Section 7.02 .	Benefits	52
Section 7.03 .	Indemnification	52
Section 7.04 .	Form S-8	53
Section 7.05 .	Certain Filings	53
Section 7.06 .	Severance Cost Notification	53
ARTICLE 8
COVENANTS OF PARENT AND THE COMPANY
Section 8.01 .	Reasonable Efforts	54
Section 8.02 .	Certain Filings	54
Section 8.03 .	Public Announcements	54
Section 8.04 .	Further Assurances	54
Section 8.05 .	Notification of Certain Matters	54
ARTICLE 9
CONDITIONS TO THE MERGER
Section 9.01 .	Conditions to Obligations of Each Party	55
Section 9.02 .	Conditions to the Obligations of Parent and Merger Sub	56
Section 9.03 .	Conditions to Obligations of the Company	58
ARTICLE 10
SURVIVAL OF REPRESENTATION AND WARRANTIES; INDEMNIFICATION
Section 10.01 .	Survival of Representation and Warranties	58
Section 10.02 .	Indemnification	59
Section 10.03 .	Defense of Claims	62
Section 10.04 .	Stockholders’ Representative	63
ARTICLE 11
TERMINATION
Section 11.01 .	Termination	64
Section 11.02 .	Effect of Termination	65
ARTICLE 12
MISCELLANEOUS
Section 12.01 .	Notices	65
Section 12.02 .	Amendments; No Waivers	66
Section 12.03 .	Expenses	67
Section 12.04 .	Successors and Assigns	67
Section 12.05 .	Governing Law	67
Section 12.06 .	Jurisdiction	67
Section 12.07 .	WAIVER OF JURY TRIAL	67
Section 12.08 .	Counterparts; Effectiveness; Benefit	67

iii

Section 12.09 .	Entire Agreement	68
Section 12.10 .	Captions	68
Section 12.11 .	Severability	68
Section 12.12 .	Specific Performance	68
Section 12.13 .	No Implied Representation	68
Company Disclosure Schedule

iv

INDEX TO EXHIBITS

Exhibit A	Form of Stockholder Consent
Exhibit B-1	Form of Non-Competition and Non-Solicitation Agreement (for U.S. employees)
Exhibit B-2	Form of Non-Competition and Non-Solicitation Agreement (for Israeli employees)
Exhibit C	Form of Escrow Agreement
Exhibit D	Form of Stockholders’ Representative Agreement
Exhibit E-1	Form of Opinion of Testa, Hurwitz & Thibeault, LLP
Exhibit E-2	Form of Opinion of Meitar Liquornik Geva & Leshem Brandwein

INDEX TO ANNEXES

Annex A	List of Stockholders Executing Written Consents
Annex B-1	List of U.S Persons Executing Non-Competition and Non-Solicitation Agreement
Annex B-2	List of Israeli Persons Executing Non-Competition and Non-Solicitation Agreement

AGREEMENT AND PLAN OF MERGER

AGREEMENT AND PLAN OF MERGER (this “Agreement”) dated as of May 12, 2004, among Appilog, Inc., a Delaware corporation (the “Company”), Appilog Logview Ltd., registered with the Israeli Registrar of Companies as Number 51-304272-1 (“Company Subsidiary”), Mercury Interactive Corporation, a Delaware corporation (“Parent”), Alaska Merger Corporation, a Delaware corporation and a wholly-owned subsidiary of Parent (“Merger Sub”), and Amnon Shoham, as Stockholders’ Representative.

WHEREAS, upon the terms and subject to the conditions of this Agreement and in accordance with Delaware Law, Parent and the Company will enter into a business combination transaction pursuant to which Merger Sub will merge with and into the Company (the “Merger”);

WHEREAS, the Board of Directors of the Company (i) has determined that the business combination transaction is consistent with and in furtherance of the long-term business strategy of the Company and fair to, and in the best interests of, the Company and its stockholders and has approved and adopted this Agreement and the transactions contemplated by this Agreement and (ii) has recommended the approval and adoption of this Agreement by the stockholders of the Company;

WHEREAS, (i) the Board of Directors of Parent has approved and adopted this Agreement and the transactions contemplated by this Agreement and (ii) the Board of Directors of Merger Sub has approved and adopted this Agreement and the transactions contemplated by this Agreement and has recommended the approval and adoption of this Agreement by Parent as its sole stockholder;

WHEREAS, as a condition and inducement to Parent’s and Merger Sub’s willingness to enter into this Agreement, immediately hereafter, each Stockholder listed on Annex A hereto shall execute a written consent in the form of Exhibit A approving this Agreement and the Merger (such consents collectively, the “Stockholder Consents”);

WHEREAS, concurrently with the execution of this Agreement, and as a condition and inducement to Parent’s and Merger Sub’s willingness to enter into this Agreement, each of the individuals listed on Annex B-1 hereto shall enter into a Non-Competition and Non-Solicitation Agreement in the form attached hereto as Exhibit B-1, and each of the individuals listed on Annex B-2 hereto shall enter into a Non-Competition and Non-Solicitation Agreement in the form attached hereto as Exhibit B-2 (collectively, the “Non-Competition and Non-Solicitation Agreements”); and

WHEREAS, the Company, on the one hand, and Parent and Merger Sub, on the other hand, desire to make certain representations, warranties, covenants and other agreements in connection with the Merger.

NOW, THEREFORE, in consideration of the foregoing and the mutual covenants and agreements herein contained, and intending to be legally bound hereby, Parent, Merger Sub and the Company hereby agree as follows:

ARTICLE 1

DEFINITIONS

Section 1.01. Definitions. (a) The following terms, as used herein, have the following meanings:

“Accrued Company Expenses” means, as of the date of Closing, the sum of (i) the amount of fees and expenses (including, without limitation, legal, accounting, investment banking, finders and advisory fees and expenses), employee bonuses and related expenses, severance payments and any other expenses, in each case, incurred by the Company in connection with this Agreement and the transactions contemplated hereby but not paid as of such date; provided that, to the extent the aggregate fees and expenses owed to Broadview International LLC in connection with this Agreement and the transactions contemplated hereby are less than the amount of fees and expenses that would be owed pursuant to the terms of the Letter Agreement dated December 19, 2003 between Broadview International LLC and the Company, one-half of the amount of such difference shall not be included in “Accrued Company Expenses”, (ii) the amount of any payables owed by the Company or the Company Subsidiary as of June 1, 2004 which, if paid in the ordinary course of business consistent with the terms of the appropriate invoices, would have been paid as of June 1, 2004, (iii) one-half of all amounts collected by the Company on or after the date of this Agreement, and (iv) the aggregate of all amounts payable by the Company in connection with any extension of any directors and officers liability insurance policy or the purchase of any such new policy for any director or officer of the Company.

“Acquisition Proposal” means, other than the transactions contemplated by this Agreement, any offer, proposal or inquiry by a Third Party relating to, or any indication of interest by a Third Party in, (i) any acquisition or purchase, direct or indirect, of any amount in excess of 10% of the consolidated assets of the Company and the Company Subsidiary or any amount in excess of 10% of any class of equity or voting securities of the Company or the Company Subsidiary, (ii) any tender offer (including a self-tender offer) or exchange offer that, if consummated, would result in any Third Party beneficially owning any amount in excess of 10% of any class of equity or voting securities of the Company or the Company Subsidiary or (iii) a merger, consolidation, share exchange, business combination, sale of substantially all the assets of the Company, reorganization, recapitalization, liquidation, dissolution or other similar transaction involving the Company.

“Additional Options” means additional option grants that may be made by the Company after the date hereof and prior to the Effective Time pursuant to Section 6.11 or with the prior written consent of Parent pursuant to Section 6.01(b).

2

“Affiliate” means, with respect to any Person, any other Person directly or indirectly controlling, controlled by or under common control with such Person.

“Aggregate Series A Cash Amount” means the product of (i) the Series A Cash Amount and (ii) the Outstanding Series A Preferred.

“Aggregate Series A Equivalent Common Shares” means a number of shares equal to the product of (i) the Series A Equivalent Common Shares and (ii) the Outstanding Series A Preferred.

“Aggregate Series B Cash Amount” means the product of (i) the Series B Cash Amount and (ii) the Outstanding Series B Preferred.

“Aggregate Series B Equivalent Common Shares” means a number of shares equal to the product of (i) the Series B Equivalent Common Shares and (ii) the Outstanding Series B Preferred.

“Business Day” means a day other than a Saturday, Sunday or any day on which commercial banks in San Francisco, California are authorized or required by law to close.

“Code” means the Internal Revenue Code of 1986.

“Common Cash Amount” means an amount equal to the Total Cash Consideration less the sum of (i) the Aggregate Series A Cash Amount and (ii) the Aggregate Series B Cash Amount.

“Common Equivalent Share Cash Amount” means an amount of cash equal to a fraction, the numerator of which is the Common Cash Amount and the denominator of which is the sum of (i) the Outstanding Common, (ii) the Aggregate Series A Equivalent Common Shares and (ii) the Aggregate Series B Equivalent Common Shares.

“Company Balance Sheet” means the balance sheet of the Company as of December 31, 2003 and the footnotes thereto.

“Company Balance Sheet Date” means December 31, 2003.

“Company Cash” means, as of the date of the Closing, the amount of cash and cash equivalents of the Company as of such date, provided that if such date is after June 1, 2004, “Company Cash” shall mean the sum of the Company Cash as of June 1, 2004 plus the amount of payables which become owed by the Company for the first time after June 1, 2004 which have been paid by the Company as of such date in the ordinary course of business consistent with the terms of the appropriate invoices.

“Company Charter” means the Third Amended and Restated Certificate of Incorporation of the Company dated December 22, 2003.

“Company Common Stock” means the shares of Common Stock, $0.0001 par value per share, of the Company.

3

“Delaware Law” means the General Corporation Law of the State of Delaware.

“Effective Date” means the date on which the Effective Time occurs.

“Environmental Laws” means any federal, state, local or foreign law (including, without limitation, common law), treaty, judicial decision, regulation, rule, judgment, order, decree, injunction, permit or governmental restriction or requirement or any agreement with any governmental authority or other third party, relating to human health and safety, the environment or to pollutants, contaminants, wastes or chemicals or any toxic, radioactive, ignitable, corrosive, reactive or otherwise hazardous substances, wastes or materials.

“Environmental Permits” means all permits, licenses, franchises, certificates, approvals and other similar authorizations of governmental authorities relating to or required by Environmental Laws and affecting, or relating in any way to, the business of the Company or the Company Subsidiary as currently conducted.

“ERISA” means the Employee Retirement Income Security Act of 1974.

“ERISA Affiliate” of any entity means any other entity that, together with such entity, would be treated as a single employer under Section 414 of the Code.

“Escrow Amount” means an amount in cash equal to the product of (a) 0.2 and (b) the Total Cash Consideration, subject to reduction as set forth in Schedule 1.01 of the Company Disclosure Schedule.

“Escrow Holdback” means, for each Stockholder, such Stockholder’s Pro Rata Share of the Escrow Amount.

“Intellectual Property Rights” means (i) inventions reduced to practice or made the subject of one or more pending patent applications, (ii) national and multinational statutory invention registrations, patents and patent applications (including all reissues, divisions, continuations, continuations-in-part, extensions and reexaminations thereof) registered or applied for in the United States and all other nations throughout the world, (iii) trademarks, service marks, trade dress, logos, and trade names (whether or not registered) in the United States and all other nations throughout the world, including all registrations and applications for registration of the foregoing and all goodwill associated therewith, (iv) copyrights (whether or not registered) and registrations and applications for registration thereof in the United States and all other nations throughout the world, including all moral rights, renewals, extensions, reversions or restorations associated with such copyrights, now or hereafter provided by law, regardless of the medium of fixation or means of expression, (v) rights in computer software (including source code, object code, firmware, operating systems and specifications), (vi) non-patentable inventions the confidentiality of which have been maintained, rights in trade secrets and, to the extent protectable as trade secrets or proprietary information, business information (including confidential pricing and cost information, business and marketing plans and customer and supplier lists) and know-how (including confidential manufacturing and production

4

processes and techniques and research and development information), (vii) rights in industrial designs (whether or not registered), (viii) rights in databases and data collections, (ix) all rights to obtain and rights to apply for patents, and to register trademarks and copyrights, (x) all rights in all of the foregoing provided by treaties, conventions and common law and (xi) all rights to sue or recover and retain damages and costs and attorneys’ fees for past, present and future infringement or misappropriation of any of the foregoing.

“Interim Balance Sheet” means the unaudited balance sheet of the Company for the period ending March 31, 2004.

“Interim Balance Sheet Date” means March 31, 2004.

“Knowledge” of any Person that is not an individual means the actual knowledge of such Person’s officers after reasonable inquiry of the relevant principal employees of the Company.

“Licensed Intellectual Property Rights” means all Intellectual Property Rights owned by a Person other than the Company or the Company Subsidiary and licensed or sublicensed to either the Company or the Company Subsidiary or for which the Company or the Company Subsidiary is the recipient of a covenant not to sue.

“Lien” means, with respect to any property or asset, any mortgage, lien, pledge, charge, security interest, encumbrance or other adverse claim, limitation or restriction of any kind in respect of such property or asset other than (i) non-exclusive licenses of Intellectual Property Rights granted to end user customers by the Company or the Company Subsidiary in the ordinary course, (ii) Liens for Taxes not yet due and payable, (iii) municipal and zoning ordinances, easements for public utilities and such imperfections of title and encumbrances, if any, that do not materially interfere with the present use of the Property. For purposes of this Agreement, a Person shall be deemed to own subject to a Lien any property or asset that it has acquired or holds subject to the interest of a vendor or lessor under any conditional sale agreement, capital lease or other title retention agreement relating to such property or asset.

“Mandatory Approvals Receipt Date” means the date as of which the Mandatory Approvals shall have been received.

“Material Adverse Effect” means, with respect to any Person, a material adverse effect on the condition (financial or otherwise), business (including the continued operation thereof in accordance with past practice), assets or results of operations of such Person and its Subsidiaries, taken as a whole; provided, however, that none of the following shall be deemed in themselves, either alone or in combination, to constitute, and none of the following shall be taken into account in determining whether there has been or will be, a Material Adverse Effect: (i) any failure by the Person to meet internal projections or forecasts; (ii) any adverse change, effect, event, occurrence, state of facts or development to the extent attributable to the announcement or pendency of the Merger (including any cancellations of or delays in customer orders, any reduction in sales, any

5

disruption in supplier, distributor, partner or similar relationships or any loss of employees); (iii) any adverse change, effect, event, occurrence, state of facts or development attributable to conditions affecting the industries in which the Person participates, the U.S. economy as a whole or foreign economies in any locations where the Person has material operations or sales or suppliers or customers; or (iv) any adverse change, effect, event, occurrence, state of facts or development resulting from or relating to compliance with the terms of, or the taking of any action required by, this Agreement.

“Merger Consideration” means the consideration payable to holders of Company Common Stock and Preferred Stock pursuant to Sections 2.02 (a)-(c) below.

“1933 Act” means the Securities Act of 1933, as amended.

“1934 Act” means the Securities Exchange Act of 1934.

“officer” of any Person means any executive officer of such Person.

“Option Exchange Ratio” means a fraction, the numerator of which is the Common Equivalent Share Cash Amount and the denominator of which is the Parent Average Price Per Share, rounded to the nearest ten-thousandth.

“Outstanding Common” means the shares of Company Common Stock issued and outstanding at the Effective Time.

“Outstanding Options” means all of the stock options to purchase shares of Company Common Stock outstanding at the Effective Time, excluding the Additional Options.

“Outstanding Preferred” means the Outstanding Series A Preferred and the Outstanding Series B Preferred, collectively.

“Outstanding Series A Preferred” means the shares of Series A Convertible Preferred Stock issued and outstanding at the Effective Time.

“Outstanding Series B Preferred” means the shares of Series B Convertible Preferred Stock issued and outstanding at the Effective Time.

“Owned Intellectual Property Rights” means all Intellectual Property Rights owned by either the Company or the Company Subsidiary.

“Parent Average Price Per Share” means the average closing price of Parent Common Stock as printed in the Wall Street Journal for each of the 10 trading days up to and including the second trading day preceding such date.

“Parent Common Stock” means shares of common stock, $0.002 par value, of Parent, including any associated preferred stock purchase rights.

6

“Person” means an individual, corporation, partnership, limited liability company, association, trust or other entity or organization, including a government or political subdivision or an agency or instrumentality thereof.

“Post-Closing Tax Period” means any Tax period beginning after the Effective Date; and, with respect to a Tax period that begins on or before the Effective Date and ends thereafter, the portion of such Tax period beginning after the Effective Date.

“Pre-Closing Tax Period” means any Tax period ending on or before the Effective Date; and, with respect to a Tax period that begins on or before the Effective Date and ends thereafter, the portion of such Tax period ending on the Effective Date.

“Preferred Stock” means collectively the shares of Series A Preferred Stock and the Series B Preferred Stock.

“Pro Rata Share” means, with respect to a holder of Shares, the quotient obtained by dividing (A) the Merger Consideration received by that holder by (B) the aggregate Merger Consideration received by all holders of Shares.

“SEC” means the United States Securities and Exchange Commission.

“Series A Cash Amount” means $1.076.

“Series A Equivalent Common Shares” means, with respect to each share of Outstanding Series A Preferred, 2.64593187 shares of Company Common Stock issuable upon conversion of such share of Outstanding Series A Preferred in accordance with the Company Charter.

“Series A Preferred Stock” means the Series A Convertible Preferred Stock, $0.0001 par value per share, of the Company.

“Series B Cash Amount” means $0.17461777.

“Series B Equivalent Common Shares” means, with respect to each share of Outstanding Series B Preferred, 1.62787239 shares of Company Common Stock issuable upon conversion of such share of Outstanding Series B Preferred in accordance with the Company Charter.

“Series B Preferred Stock” means the Series B Convertible Preferred Stock, $0.0001 par value per share, of the Company.

“Shares” means the Company Common Stock and the Preferred Stock, collectively.

“Stockholders’ Representative” means Amnon Shoham.

7

“Stockholders’ Representative Agreement” means the agreement between the Company and the Stockholders’ Representative, dated May 12, 2004, in the form attached hereto as Exhibit D.

“Subsidiary” means, with respect to any Person, any entity of which securities or other ownership interests having ordinary voting power to elect a majority of the board of directors or other persons performing similar functions are at any time directly or indirectly owned by such Person.

“Tax” means (i) any tax, governmental fee or other like assessment or charge of any kind whatsoever (including, but not limited to, withholding on amounts paid to or by any Person), together with any interest, penalty, addition to tax or additional amount imposed by any governmental authority (a “Taxing Authority”) responsible for the imposition of any such tax (domestic or foreign), and any liability for any of the foregoing as transferee, (ii) in the case of the Company or the Company Subsidiary, liability for the payment of any amount of the type described in clause (i) as a result of being or having been before the Effective Time a member of an affiliated, consolidated, combined or unitary group, or a party to any agreement or arrangement, as a result of which liability of the Company or the Company Subsidiary to a Taxing Authority is determined or taken into account with reference to the activities of any other Person, and (iii) liability of the Company or the Company Subsidiary for the payment of any amount as a result of being party to any Tax Sharing Agreement or with respect to the payment of any amount imposed on any person of the type described in (i) or (ii) as a result of any existing express or implied agreement or arrangement (including, but not limited to, an indemnification agreement or arrangement).

“Tax Asset” means any net operating loss, net capital loss, investment tax credit, foreign tax credit, charitable deduction or any other credit or tax attribute that could be carried forward or back to reduce Taxes (including without limitation deductions and credits related to alternative minimum Taxes).

“Tax Sharing Agreements” means all existing agreements or arrangements (whether or not written) binding the Company or the Company Subsidiary that provide for the allocation, apportionment, sharing or assignment of any item of income, gain, deduction, credit or loss or any Tax liability or benefit, in each case, for the purpose of determining any person’s Tax liability.

“Third Party” means any Person as defined in this Agreement or in Section 13(d) of the 1934 Act, other than Parent or any of its Affiliates.

“Total Cash Consideration” means an amount equal to the sum of (a) $49,000,000 and (b) the Final Company Cash Amount.

“Transaction Expenses” means the reasonably documented fees and expenses incurred by the Company’s legal counsel, auditors, investment bankers, financial advisors and consultants incurred in connection with this Agreement and the transactions contemplated hereby.

8

“Warrant” means each unexpired and unexercised outstanding warrant to purchase Company Common Stock or Series B Preferred Stock, as applicable.

Any reference in this Agreement to a statute shall be to such statute, as amended from time to time, and to the rules and regulations promulgated thereunder.

(b) Each of the following terms is defined in the Section set forth opposite such term:

Term	Section
Antitrust Authority	Section 4.03
Basket Amount	Section 10.02
Capital Gain Route	Section 4.05
Certificates	Section 2.03
Change of Recommendation	Section 6.03
Chief Scientist	Section 4.03
Closing	Section 2.01
Company Disclosure Schedule	Article 4
Company Products	Section 4.18
Company Registered Intellectual Property Rights	Section 4.18
Company Securities	Section 4.05
Company Stock Options	Section 2.05
Company Stock Plan	Section 2.05
Company Subsidiary Securities	Section 4.06
Contested Claim	Section 10.02
Damages	Section 10.02
Effective Time	Section 2.01
Employee Agreements	Section 4.18
Employee Plans	Section 4.15
End Date	Section 11.01
Escrow Account	Section 2.08
Escrow Agent	Section 2.08
Escrow Agreement	Section 2.08
Escrow Fund	Section 2.08
Estimated Company Cash Amount	Section 6.08
Exchange Agent	Section 2.03
Final Award	Section 10.02
Final Company Cash Amount	Section 6.08
GAAP	Section 4.07
Governmental Authority	Section 9.01
Indemnified Parties	Section 7.03
Indemnifying Party	Section 10.02
Information Statement	Section 6.02
Investment Center	Section 4.03
ISO	Section 4.05
Israeli Tax Authorities	Section 4.03
J.A.M.S.	Section 10.02

9

Term	Section
Loss	Section 10.02
Mandatory Approvals	Section 6.07
Material Agreement	Section 4.11
Merger	Recitals
Multiemployer Plan	Section 4.15
NDA	Section 6.04
Non-Competition and Non-Solicitation Agreement	Recitals
Open Source Materials	Section 4.18
Ordinance	Section 2.05
Parent Indemnified Parties	Section 10.02
Permits	Section 4.20
Registration Rights Agreement	Section 4.15
Return	Section 4.14
Rules	Section 2.05
Schedule	Article 4
Stockholder	Section 2.03
Stockholder Consents	Recitals
Surviving Corporation	Section 2.01
Third Party Combined Products	Section 4.18

ARTICLE 2

THE MERGERS

Section 2.01. Mergers. (a) At the Effective Time, Merger Sub shall be merged with and into the Company in accordance with Delaware Law, whereupon the separate existence of Merger Sub shall cease, and the Company shall be the surviving corporation (the “Surviving Corporation”).

(b) As soon as practicable (but in no event later than 2 Business Days) after satisfaction or, to the extent permitted hereunder, waiver, of all conditions to the Merger set forth in Article 9, the Company and Merger Sub will file an agreement of merger with the Secretary of State of the State of Delaware and make all other filings or recordings required by Delaware Law in connection with the Merger. The Merger shall become effective at such time (the “Effective Time”) as the agreement of merger is accepted by the Secretary of State of the State of Delaware or at such later time as is specified in the agreement of merger. Immediately prior to the filing of the agreement of merger with the Secretary of State of the State of Delaware, a closing (the “Closing”) will be held at the offices of Davis Polk & Wardwell, 1600 El Camino Real, Menlo Park, California 94025 (or such other place as the parties may agree).

Section 2.02. Conversion of Shares. At the Effective Time:

(a) each share of Outstanding Series B Preferred shall be converted into the right to receive an amount of cash, without interest, equal to the sum of (i) the Series B Cash Amount and (ii) the product of (A) the Series B Equivalent Common Shares and (B) the Common Equivalent Share Cash Amount;

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(b) each share of Outstanding Series A Preferred shall be converted into the right to receive an amount of cash, without interest, equal to the sum of (i) the Series A Cash Amount and (ii) the product of (A) the Series A Equivalent Common Shares and (B) the Common Equivalent Share Cash Amount;

(c) each share of Outstanding Common shall be converted into the right to receive an amount of cash, without interest, equal to the Common Equivalent Share Cash Amount;

(d) each Share held by the Company as treasury stock or owned by Parent or any of its Subsidiaries immediately prior to the Effective Time shall be canceled, and no payment shall be made with respect thereto; and

(e) each share of common stock of Merger Sub outstanding immediately prior to the Effective Time shall be converted into and become one share of common stock of the Surviving Corporation with the same rights, powers and privileges as the shares so converted and shall constitute the only outstanding shares of capital stock of the Surviving Corporation.

Notwithstanding the foregoing, the parties hereto acknowledge and agree that the Escrow Amount shall be deducted from the cash payable to each Stockholder based on such Stockholder’s Pro Rata Share of the Escrow Amount as set forth in Section 2.08. The aggregate amount of consideration payable to each Stockholder pursuant to Sections 2.02(a), 2.02(b), and 2.02(c) shall be rounded to the nearest cent.

Section 2.03. Surrender and Payment. (a) Prior to the Effective Time, Parent shall appoint an agent (the “Exchange Agent”) for the purpose of exchanging certificates representing Shares (the “Certificates”) for the Merger Consideration (less the Escrow Holdback). At the Effective Time or promptly thereafter (but in no event later than 1 Business Day), Parent will transfer to the Exchange Agent, as needed, the Merger Consideration (less the Escrow Holdback) to be paid in respect of the Shares. At the Effective Time or promptly thereafter, the Company’s stockholders (each, a “Stockholder” and collectively, the “Stockholders”) will surrender the Certificates to the Exchange Agent for cancellation together with a letter of transmittal and instructions (the “Letter of Transmittal”), which shall specify that the delivery shall be effected, and risk of loss and title shall pass, only upon proper delivery of the Certificates to the Exchange Agent, for use in such exchange.

(b) Each holder of Shares that have been converted into the right to receive the Merger Consideration less the Escrow Holdback will be entitled to receive, upon surrender to the Exchange Agent of a Certificate, together with a properly completed Letter of Transmittal, the Merger Consideration less the Escrow Holdback payable for each Share represented by such Certificate. All such funds shall be paid to the holders of Shares by check or, upon the request of any such holder and the payment by such holder

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of any applicable fee required by the Exchange Agent, by wire transfer to an account specified in such holder’s respective Letter of Transmittal. Until so surrendered, each such Certificate shall represent after the Effective Time for all purposes only the right to receive such Merger Consideration less the Escrow Holdback.

(c) If any portion of the Merger Consideration less the Escrow Holdback is to be paid to a Person other than the Person in whose name the surrendered Certificate is registered, it shall be a condition to such payment that the Certificate so surrendered shall be properly endorsed or otherwise be in proper form for transfer and that the Person requesting such payment shall pay to the Exchange Agent any transfer or other taxes required as a result of such payment to a Person other than the registered holder of such Certificate or establish to the satisfaction of the Exchange Agent that such tax has been paid or is not payable.

(d) After the Effective Time, there shall be no further registration of transfers of Shares. If, after the Effective Time, Certificates are presented to the Surviving Corporation, they shall be canceled and exchanged for the Merger Consideration less the Escrow Holdback provided for, and in accordance with the procedures set forth, in this Article 2.

(e) Any portion of the Merger Consideration (less the Escrow Holdback) made available to the Exchange Agent pursuant to Section 2.03(a) (and any interest or other income earned thereon) that remains unclaimed by the holders of Shares on the first anniversary of the Effective Date shall be returned to Parent, upon demand, and any such holder who has not exchanged Shares for the Merger Consideration less the Escrow Holdback in accordance with this Section 2.03 prior to that time shall thereafter look only to Parent for payment of the Merger Consideration less the Escrow Holdback in respect of such Shares without any interest thereon. Notwithstanding the foregoing, Parent shall not be liable to any holder of Shares for any amount paid to a public official pursuant to applicable abandoned property, escheat or similar laws. Immediately prior to such time when amounts remaining unclaimed by holders of Shares would otherwise escheat to or become property of any governmental authority, such unclaimed amounts shall become, to the extent permitted by applicable law, the property of Parent free and clear of any claims or interest of any Persons previously entitled thereto.

(f) Any portion of the Merger Consideration made available to the Exchange Agent pursuant to Section 2.03(a) to pay for Shares for which appraisal rights have been perfected shall be returned to Parent, upon demand.

Section 2.04. Dissenting Shares. Notwithstanding Section 2.02, Shares outstanding immediately prior to the Effective Time and held by a holder who has not voted in favor of the Merger or consented thereto in writing and who has demanded appraisal for such Shares in accordance with Delaware Law shall not be converted into a right to receive the Merger Consideration, but the holder thereof shall only be entitled to such rights as are provided by Delaware Law, unless such holder fails to perfect, withdraws or otherwise loses its right to appraisal. If, after the Effective Time, such holder fails to perfect, withdraws or loses its right to appraisal, such Shares shall be

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treated as if they had been converted as of the Effective Time into a right to receive the Merger Consideration less the Escrow Holdback. The Company shall give Parent prompt notice of any demands received by the Company for appraisal of Shares, and Parent shall have the right to participate in all negotiations and proceedings with respect to such demands. Except with the prior written consent of Parent, the Company shall not make any payment with respect to, or settle or offer to settle, any such demands.

Section 2.05. Stock Options. (a) All outstanding options to purchase Company capital stock (“Company Stock Options”) outstanding at the Effective Time under the Appilog, Inc. 2003 Stock Option Plan (the “Company Stock Plan”) shall, at the Effective Time and by virtue of the Merger and without any action on the part of the holder thereof, be assumed by Parent. To the extent necessary, the applicable option agreements shall be amended to provide that the Company Stock Options (other than the Additional Options) shall become fully vested as of the Effective Time. Subject to the immediately preceding sentence, each Company Stock Option so assumed by Parent under this Agreement shall continue to have, and be subject to, substantially similar terms and conditions to those set forth in the Company Stock Plan or as provided in the respective option agreement immediately prior to the Effective Time, except that (i) each Company Stock Option will be exercisable for that number of whole shares of Parent Common Stock equal to the product of the number of shares of Company Common Stock that were issuable upon exercise of such Company Stock Option immediately prior to the Effective Time multiplied by the Option Exchange Ratio, rounded down to the nearest whole number of shares of Parent Common Stock; and (ii) the per share exercise price for the shares of Parent Common Stock issuable upon exercise of such assumed Company Stock Option will be equal to the quotient determined by dividing the exercise price per share of Company capital stock at which such Company Option was exercisable immediately prior to the Effective Time by the Option Exchange Ratio, rounded up to the nearest whole cent. It is the intention of the parties hereto that the Company Stock Options (other than those Additional Options which shall be issued to employees located in the United States) assumed by Parent following the Effective Time pursuant to this Section will, to the extent permitted by applicable law, qualify as incentive stock options as defined in Section 422 of the Code, to the extent any such Company Stock Options qualified as incentive stock options immediately prior to the Effective Time or as options granted pursuant to the provisions of section 102 of the Israeli Income Tax Ordinance (new version) 1961 (the “Ordinance”) and any regulations, rules, orders or procedures promulgated thereunder, including the Income Tax Rules (Tax benefits in Stock Issuance to Employees) 5763-2003 (the “Rules”), as appropriate.

(b) As soon as practicable after the Effective Time, Parent shall deliver to each holder of an outstanding Company Stock Option an appropriate notice setting forth such holder’s rights pursuant thereto. Parent shall take all corporate action necessary to reserve for issuance a sufficient number of shares of Parent Common Stock for delivery upon exercise of assumed Company Stock Options pursuant to the terms set forth in this Section.

Section 2.06. Adjustments. If, during the period between the date of this Agreement and the Effective Time, any change in the outstanding Shares shall occur,

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including by reason of any reclassification, recapitalization, stock split or combination, exchange or readjustment of Shares, or stock dividend thereon with a record date during such period, the Merger Consideration, the Escrow Holdback, and any other amounts payable pursuant to this Agreement shall be appropriately adjusted.

Section 2.07. Withholding Rights. Each of the Surviving Corporation and Parent shall be entitled to deduct and withhold from the consideration otherwise payable to any Person pursuant to this Article 2 such amounts as it is required to deduct and withhold with respect to the making of such payment under any provision of federal, state, local or foreign tax law; provided, however, that the Surviving Corporation and/or Parent, as the case may be, shall not be entitled to withhold any amounts pursuant to this Section 2.07 if the Surviving Corporation, Parent or the Exchange Agent, as the case may be, has received, prior to Closing, such certificates or forms as are sufficient, under applicable law, to establish that withholding is not required. If the Surviving Corporation or Parent, as the case may be, so withholds amounts, such amounts shall be treated for all purposes of this Agreement as having been paid to the holder of the Shares in respect of which the Surviving Corporation or Parent, as the case may be, made such deduction and withholding.

Section 2.08. Escrow. At the Effective Time, Parent shall withhold from the Merger Consideration otherwise payable with respect to Shares, an aggregate amount of cash equal to the Escrow Amount. The Escrow Amount shall be allocated to each holder of Shares based on such holder’s Pro Rata Share of the Escrow Amount. Prior to or simultaneously with the Effective Time, the Stockholders’ Representative and Parent shall enter into an escrow agreement (the “Escrow Agreement”) substantially in the form of Exhibit C hereto with an escrow agent (the “Escrow Agent”) selected by Parent and reasonably acceptable to the Stockholders’ Representative. Pursuant to the terms of the Escrow Agreement, at the Effective Time Parent shall deposit the Escrow Amount into an escrow account (the “Escrow Account”), which account is to be managed by the Escrow Agent. Distributions of any money from the Escrow Account shall be governed by the terms and conditions of the Escrow Agreement (any money in the Escrow Account being referred to as the “Escrow Fund”). The parties acknowledge and agree that (i) any amount distributed by the Escrow Agent from the Escrow Account to the Stockholders pursuant to the terms of the Escrow Agreement shall be treated, for U.S. federal income tax purposes, as additional consideration paid to the Stockholders for their Shares pursuant to the Merger as and when such amount is distributed, and (ii) a portion of each such distribution shall be treated as a payment of interest in accordance with Section 483 of the Code.

Section 2.09. Lost Certificates. If any Certificate shall have been lost, stolen or destroyed, upon the making of an affidavit of that fact by the Person claiming such Certificate to be lost, stolen or destroyed and, if required by the Surviving Corporation, the posting by such Person of a bond, in such reasonable amount as the Surviving Corporation may direct, as indemnity against any claim that may be made against it with respect to such Certificate, the Exchange Agent will pay, in exchange for such lost, stolen or destroyed Certificate, the Merger Consideration (less the Escrow Holdback) to be paid in respect of the Shares represented by such Certificate, as contemplated by this Article 2.

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ARTICLE 3

THE SURVIVING CORPORATION

Section 3.01. Certificate of Incorporation. The certificate of incorporation of the Surviving Corporation shall be amended at the Effective Time to be identical to the Certificate of Incorporation of Merger Sub as in effect immediately prior to the Effective Time.

Section 3.02. Bylaws. The bylaws of Merger Sub in effect at the Effective Time shall be the bylaws of the Surviving Corporation until amended in accordance with applicable law.

Section 3.03. Directors and Officers. From and after the Effective Time, until successors are duly elected or appointed and qualified in accordance with applicable law, (i) the directors of Merger Sub at the Effective Time shall be the directors of the Surviving Corporation and (ii) the officers of Merger Sub at the Effective Time shall be the officers of the Surviving Corporation.

ARTICLE 4

REPRESENTATIONS AND WARRANTIES OF THE COMPANY AND THE COMPANY SUBSIDIARY

The Company hereby represents and warrants to Parent that each of the statements contained in this Article 4 are true and complete, and the Company Subsidiary hereby represents and warrants to Parent that each of the statements contained in this Article 4 that are related to the Company Subsidiary are true and complete, except as otherwise provided herein and except as specifically disclosed in the schedules attached hereto (each, a “Schedule” and together, the “Company Disclosure Schedule”).

Section 4.01. Corporate Existence and Power. The Company is a corporation duly incorporated, validly existing and in good standing under the laws of the State of Delaware and has all corporate powers and authority to own, lease and operate its properties and assets and to carry on its business as now conducted and as currently proposed by it to be conducted. Schedule 4.01(a) contains a complete and accurate list of every jurisdiction in which the Company is qualified to do business. The Company is duly qualified to do business as a foreign corporation and is in good standing in each jurisdiction where failure to be so qualified would have a Material Adverse Effect on the Company. The Company has heretofore made available to Parent true and complete copies of the Company Charter and bylaws of the Company as currently in full force and effect. The Company is not in violation of any of the provisions of the Company Charter or bylaws. The Company shall amend its certificate of incorporation immediately prior to the Effective Time as set forth in Schedule 4.01(b).

Section 4.02. Corporate Authorization; Stockholder Consents. (a) The execution, delivery and performance by the Company of this Agreement and the Stockholders’ Representative Agreement and the consummation by the Company of the transactions contemplated hereby and thereby are within the Company’s corporate

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powers and have been duly authorized by the Company’s Board of Directors. This Agreement has been duly executed and delivered by the Company, and assuming due authorization, execution and delivery by the other parties hereto, this Agreement constitutes a valid and binding obligation of the Company enforceable in accordance with its terms, except as its enforceability may be subject to the effect, if any, of (i) applicable bankruptcy and other similar laws affecting the rights of creditors generally and (ii) rules of law governing specific performance, injunctive relief and other equitable remedies. The Stockholders’ Representative Agreement, when duly executed and delivered by the Company, and assuming the due authorization, execution and delivery by the other parties thereto, will constitute a valid and binding obligation of the Company enforceable in accordance with its terms, except as its enforceability may be subject to the effect, if any, of (i) applicable bankruptcy and other similar laws affecting the rights of creditors generally and (ii) rules of law governing specific performance, injunctive relief and other equitable remedies.

(b) At a meeting duly called and held (or by unanimous written consent in accordance with Delaware Law and the Company Charter and bylaws of the Company) the Company’s Board of Directors has (i) unanimously determined that this Agreement is advisable, and that the Merger is fair to and in the best interests of the Stockholders and (ii) unanimously approved and adopted this Agreement and the Merger.

(c) The only votes of the holders of any class or series of Company capital stock necessary to consummate the Merger and the transactions provided for herein are (i) the approval of the holders of at least a majority of the Outstanding Common, Outstanding Series A Preferred, and Outstanding Series B Preferred, voting together as a single class on a common equivalent basis in accordance with the Charter and (ii) the approval of the holders of at least two-thirds of the Outstanding Series A Preferred and the Outstanding Series B Preferred, voting together as a single class on a common equivalent basis in accordance with the Charter. The approvals specified in the preceding sentence will be satisfied by the execution and delivery of the Stockholder Consents by the Stockholders listed on Annex A, who represent the owners of a number of Shares sufficient to satisfy the approvals specified in the first sentence of this Section 4.02(c) and to satisfy the requirements of Delaware Law and the Company Charter with respect to the Merger and the transactions contemplated pursuant to this Agreement.

Section 4.03. Governmental Authorization. The execution, delivery and performance by the Company of this Agreement and the Stockholders’ Representative Agreement and the consummation by the Company of the transactions contemplated hereby and thereby require no action on the part of the Company or the Company Subsidiary by or in respect of, or filing with or approval of, any governmental body, agency, official or authority, domestic, foreign or supranational, other than (i) the filing of a certificate of merger with respect to the Merger with the Delaware Secretary of State and appropriate documents with the relevant authorities of other states in which the Company is qualified to do business, (ii) such filings and approvals as may be required with the Israel Investment Center of the Israeli Ministry of Trade and Industry (the “Investment Center”), (iii) such filings and approvals as may be required with the Office of the Chief Scientist of the Ministry of Trade and Industry of the State of Israel

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(the “Chief Scientist”), (iv) such filings and approvals as may be required with the General Director of the Antitrust Authority in Israel (the “Antitrust Authority”), and (v) such filings and approvals as may be required with the Israeli Income Tax Authorities (the “Israeli Tax Authorities”) as specified in Section 6.07 below.

Section 4.04. Non-Contravention. (a) The execution, delivery and performance by the Company of this Agreement and the Stockholders’ Representative Agreement and the consummation of the transactions contemplated hereby and thereby do not and will not (i) contravene, conflict with, or result in any violation or breach of any provision of the Company Charter, bylaws or other governing instruments of the Company or the Company Subsidiary, (ii) assuming compliance with the matters referred to in Section 4.03, contravene, conflict with, or result in a violation or breach of any provision of any material law, statute, ordinance, rule, regulation, judgment, injunction, order, ruling or decree applicable to the Company or the Company Subsidiary, (iii) except as set forth in Section 4.04 of the Company Disclosure Schedule, require any material consent or similar action by any Person under, constitute a default, or an event that, with or without notice or lapse of time or both, could become a default, under, or cause or permit the termination, cancellation, acceleration or other change of any material right or obligation or the loss of any material benefit to which the Company or the Company Subsidiary is entitled under any provision of any Material Agreement or any contract, lease, license, franchise, permit, certificate, approval or other similar authorization affecting, or relating in any way to, the assets or business of the Company and the Company Subsidiary or (iv) result in the creation or imposition of any Lien on any asset of the Company or the Company Subsidiary, except for such contraventions, conflicts and violations referred to in clause (ii) and for such failures to obtain any such consent or other action, defaults, terminations, cancellations, accelerations, changes, losses or Liens referred to in clauses (iii) and (iv) that would not be reasonably expected, individually or in the aggregate, to be material to the Company or to materially impair the ability of the Company to consummate the actions contemplated by this Agreement.

(b) The conversion of each share of Outstanding Series B Preferred, Outstanding Series A Preferred and Outstanding Common in accordance with Section 2.02 conforms in all respects to the requirements, preferences and other provisions of the Company Charter.

Section 4.05. Capitalization. (a) As of the date hereof, the authorized capital stock of the Company consists of 208,568,882 shares consisting of (i) 150,000,000 shares of Company Common Stock and (ii) 58,568,882 shares of Preferred Stock consisting of (A) 3,877,999 shares of Series A Preferred Stock and (B) 54,690,883 shares of Series B Preferred Stock. As of the date hereof, there are outstanding (i) 4,422,001 shares of Common Stock (ii) 3,877,999 shares of Series A Preferred Stock, and (iii) 52,256,996 shares of Series B Preferred Stock. As of the date hereof, there are outstanding Warrants to purchase 3,962,058 shares of Company Common Stock and 2,433,888 shares of Series B Preferred Stock. As of the date hereof, each share of Series A Preferred Stock is convertible into a number of shares of Company Common Stock equal to the Series A Equivalent Common Shares and each share of Series B Preferred Stock is convertible into a number of shares of Company Common Stock equal to the Series B Equivalent

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Common Shares. The Company capital stock and Warrants are, as of the date of this Agreement, held by the Persons and in the amounts set forth in Schedule 4.05, with the latest known addresses of such Persons indicated thereon. All holders of the Company capital stock and Warrants are the lawful owners of record of all the issued and outstanding shares of capital stock and Warrants of the Company as indicated opposite to their name in Schedule 4.05 and, except as set forth on Schedule 4.05(a), of all rights thereto, to the Company’s Knowledge, free and clear of all liens, claims, charges, encumbrances, restrictions, rights, options to purchase, proxies, voting trust and other voting agreements, calls or commitments of every kind, and none of the said entities owns any other stock, options or other rights to subscribe for, purchase or acquire any capital stock of the Company from the Company or, to the Knowledge of the Company, from each other. The Company Subsidiary owns no Company capital stock or Warrants. All outstanding shares of the Company are duly authorized, validly issued, fully paid and non-assessable and not subject to preemptive rights created by statute, the Company Charter or bylaws of the Company or any agreement to which the Company is a party or by which it is bound and have been issued in compliance with federal and state and any other applicable local securities laws. Each Warrant was duly and validly issued and was issued in compliance with federal and state and any other applicable local securities laws, and except as set forth on Schedule 4.05(a), the Company capital stock issuable upon exercise of each Warrant has been duly reserved and, upon exercise, would be validly issued, fully paid and non-assessable. Each Warrant that is unexercised prior to the Effective Time shall not be exercisable at or after the Effective Time and anything to the contrary in such Warrant is void and of no force or effect. There are no declared or accrued unpaid dividends with respect to any shares of the Company Common Stock or the Company Preferred Stock. The Company has no other capital stock authorized, issued or outstanding. The Company has heretofore delivered to Parent true and complete copies of each Warrant and any and all agreements to grant a warrant. Since its incorporation, there has been no declaration or payment by the Company of dividends, or any distribution by the Company of any assets of any kind to any of its stockholders in redemption of or as the purchase price for any Company Securities.

(b) The Company has reserved 68,162,592 shares of Company Common Stock for issuance to employees, directors and consultants pursuant to the Company Stock Plan, of which 27,987,874 shares are subject to outstanding unexercised options as of the date hereof, and 40,174,718 shares remain available for future grant as of the date hereof. Schedule 4.05(b)(i) of the Company Disclosure Schedule sets forth each Company Stock Option outstanding, the grant date and number of shares of Company Common Stock subject to such option, the exercise price of such option, the date on which such option expires and whether and to what extent such option in intended to qualify as an incentive stock option as defined in Section 422 of the Code (an “ISO”) or qualification under the Capital Gain Route as defined in section 102 of the Ordinance (the “Capital Gain Route”). Each option identified as an ISO met all of the requirements of the Code with respect to ISOs as of the date of grant. Each option granted to Israeli employees under the Capital Gain Route meets all of the requirements of the Ordinance and the Rules. Each Company Stock Option was duly and validly issued and was issued in compliance with federal and state and any other applicable local securities laws, the Company capital

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stock issuable upon exercise of each Company Stock Option has been duly reserved and, upon exercise, will be validly issued, fully paid and non-assessable. The Company has provided to Parent the name and address of the holder of each such option. Except for the Company Stock Options, the Warrants, the Outstanding Series A Preferred, and the Outstanding Series B Preferred, there are no options, warrants, calls, rights, commitments or agreements of any character, written or oral, to which the Company is a party or by which it is bound obligating the Company to issue, deliver, sell, repurchase or redeem, or cause to be issued, delivered, sold, repurchased or redeemed, any securities of the Company or obligating the Company to grant, extend, accelerate the vesting of, change the price of, otherwise amend or enter into any such option, warrant, call, right, commitment or agreement, and the Company has not promised any person (including any former employee) any such options or other securities. No outstanding Company capital stock is subject to vesting or forfeiture or rights of repurchase by the Company. There are no outstanding or authorized stock appreciation, dividend equivalent, phantom stock, profit participation, or other similar rights with respect to the Company or any of its securities. There are no voting trusts, proxies, or other agreements or understandings with respect to the voting stock of the Company or any other matters involving any securities of the Company. The Company has heretofore delivered or made available to Parent true and complete copies of each Company Stock Option and any and all agreements to grant a Company Stock Option.

(c) Except as set forth in this Section 4.05, there are no outstanding (i) shares of capital stock or voting securities of the Company, (ii) securities of the Company convertible into or exchangeable for shares of capital stock or voting securities of the Company or (iii) options, warrants, preemptive rights, contracts, commitments or other rights to subscribe for, purchase or acquire from the Company, or other obligations of the Company to issue, any capital stock, voting securities or securities convertible into or exchangeable for capital stock or voting securities of the Company (the items in clauses (i), (ii) and (iii) being referred to collectively as the “Company Securities”). There are no outstanding obligations of the Company or the Company Subsidiary to repurchase, redeem or otherwise acquire any of the Company Securities.

(d) (i) The authorization and issuance of each of the Series A Preferred Stock, the Series B Preferred Stock and the Warrants and (ii) the authorization of all actions taken in connection with the issuance of each of the Series A Preferred Stock and Series B Preferred Stock (including, without limitation, the approval of any applicable amended and restated certificates of incorporation), in each case, did not (A) contravene, conflict with, or result in any violation or breach of any provision of the certificate of incorporation, bylaws or other governing instruments or agreements (including without limitation, any stockholder or registration rights agreement) of the Company as then in effect, or (B) contravene, conflict with, or result in any violation or breach of any law or statute applicable to the Company (including without limitation, Delaware Law) as such law or statute was in effect at the time of such authorization and issuance.

Section 4.06. Subsidiaries. (a) The Company does not own or control, directly or indirectly, any interest in any Person other than the Company Subsidiary and is not a participant in any partnership or joint venture, and does not own, directly or indirectly,

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any assets comprising the business or obligations of any other Person. The Company Subsidiary is a corporation duly incorporated, validly existing and in good standing under the laws of the State of Israel, has all corporate powers and authority to own, lease and operate its properties and assets and to carry on its business as now conducted and as currently proposed to be conducted. The Company Subsidiary is duly qualified to do business as a foreign corporation and is in good standing in each jurisdiction where failure to be so qualified would have, individually or the aggregate, a Material Adverse Effect on the Company and the Company Subsidiary, taken as a whole. The Company Subsidiary is not in violation of any of the provisions of its articles of association or bylaws. Schedule 4.06(a)(1) sets forth all jurisdictions in which it is authorized to do business. The Articles of Association of the Company Subsidiary as in effect of the date hereof and as shall be in effect at the Closing are attached hereto as Schedule 4.06(a)(2).

(b) All of the outstanding shares of capital stock of, or other voting securities or ownership interests in, the Company Subsidiary are directly owned by the Company, free and clear of any Lien and free of any other limitation or restriction (including any restriction on the right to vote, sell or otherwise dispose of such capital stock or other voting securities or ownership interests). No Person other than the Company has any right to participate in, or receive any payment based on any amount relating to, the revenue, income, value or net worth of the Company Subsidiary or any component or portion thereof, or any increase or decrease in any of the foregoing. There are no outstanding (i) securities of the Company or Company Subsidiary convertible into or exchangeable for shares of capital stock or other voting securities or ownership interests in the Company Subsidiary or (ii) options, warrants, preemptive rights, contracts, commitments or other rights to acquire from the Company or the Company Subsidiary, or other obligations of the Company or the Company Subsidiary to issue, any capital stock or other voting securities or ownership interests in, or any securities convertible into or exchangeable for any capital stock or other voting securities or ownership interests in, the Company Subsidiary (the items in clauses (i) and (ii) being referred to collectively as the “Company Subsidiary Securities”). There are no outstanding obligations of the Company or the Company Subsidiary to repurchase, redeem or otherwise acquire any of the Company Subsidiary Securities.

Section 4.07. Financial Statements. The audited balance sheets as of December 31, 2003, 2002 and 2001 and related audited statements of income and cash flows for each of the years ended December 31, 2003, 2002 and 2001 and unaudited consolidated interim financial statements for the three months ended March 31, 2004 of the Company provided to Parent and attached hereto as Schedule 4.07 fairly present, in conformity with United States generally accepted accounting principles (“GAAP”) applied on a consistent basis (except as may be indicated in the notes thereto), the consolidated financial position of the Company and the Company Subsidiary as of the dates thereof and their consolidated results of operations and cash flows for the periods then ended (subject only to normal year-end adjustments and an absence of footnotes in the case of any unaudited interim financial statements).

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Section 4.08. Absence of Certain Changes. Since the Company Balance Sheet Date, the business of the Company and the Company Subsidiary has been conducted in the ordinary course consistent with past practices and, other than as provided for in this Agreement, there has not been:

(a) any event, occurrence, development or state of circumstances or facts that has had or would reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect on the Company or the Company Subsidiary;

(b) any declaration, setting aside or payment of any dividend or other distribution with respect to any shares of capital stock of the Company, or any repurchase, redemption or other acquisition by the Company or the Company Subsidiary of any outstanding shares of capital stock or other securities of, or other ownership interests in, the Company or the Company Subsidiary;

(c) any amendment of any material term of any outstanding security of the Company or the Company Subsidiary, other than as contemplated by this Agreement;

(d) as of the date of this Agreement, any incurrence, assumption or guarantee by the Company or the Company Subsidiary of any indebtedness for borrowed money;

(e) any creation or other incurrence by the Company or the Company Subsidiary of any material Lien on any material asset;

(f) any making of any loan, advance or capital contributions to or investment in any Person, except for reasonable advances to employees and consultants for travel and business expenses in the ordinary course of business consistent with past practices;

(g) any damage, destruction or other casualty loss (whether or not covered by insurance) affecting the business or assets of the Company or the Company Subsidiary that has had or could reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect on the Company or the Company Subsidiary;

(h) any transaction or commitment made, or any contract or agreement entered into, by the Company or the Company Subsidiary relating to its assets or business (including the acquisition or disposition of its assets) or any relinquishment by the Company or the Company Subsidiary of any contract or other right, in either case, material to the Company and the Company Subsidiary, taken as a whole, other than in the ordinary course of business.

(i) any change in any method of accounting, method of tax accounting or accounting principles or practice by the Company or the Company Subsidiary, except for any such change required by reason of a concurrent change in GAAP;

(j) any (i) grant of any severance or termination pay to (or amendment to any existing arrangement with) any director, officer or employee of the Company or the Company Subsidiary, (ii) increase in benefits payable to any director, officer or employee of the Company or the Company Subsidiary under any existing severance or termination pay policies or employment agreements, (iii) entering into any employment, deferred

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compensation or other similar agreement (or any amendment to any such existing agreement) with any director, officer or employee of the Company or the Company Subsidiary, (iv) establishment, adoption or amendment (except as required by applicable law) of any collective bargaining, bonus, profit-sharing, thrift, pension, retirement, deferred compensation, compensation, stock option, restricted stock or other benefit plan or arrangement covering any director, officer or employee of the Company or the Company Subsidiary, or (v) increase in compensation, bonus or other benefits payable to any director, officer or employee of the Company or the Company Subsidiary; in each such case other than as required by applicable law;

(k) any material labor dispute, other than routine individual grievances, or any activity or proceeding by a labor union or representative thereof to organize any employees of the Company or the Company Subsidiary, which employees were not subject to a collective bargaining agreement at the Company Balance Sheet Date, or any lockouts, strikes, slowdowns, work stoppages or threats thereof by or with respect to such employees;

(l) any material Tax election made or changed, any annual Tax accounting period changed, any method of Tax accounting adopted or changed, any material amended Tax Returns or claims for Tax refunds filed, any material closing agreement entered into, any material Tax claim, audit or assessment settled, or any right to claim a material Tax refund, offset or other reduction in Tax liability surrendered; or

(m) material change in its practices relating to pricing or royalties set or charged by the Company to its customers or licensees or, any notification made to the Company of a material change in pricing or royalties set or charged by licensors to the Company;

(n) any material capital expenditure, or commitment for a capital expenditure, for additions or improvements to property, plant and equipment that, other than as set forth in the Company’s capital spending plan which has been made available to Parent; or

(o) agreement by the Company or any officer thereof or any written agreement by an employee of the Company in their capacities as such to do any of the things described in the preceding clauses (a) through (n) (other than negotiations with Parent and its representatives regarding the transactions contemplated by this Agreement).

Section 4.09. No Undisclosed Liabilities. There are no liabilities or obligations of the Company or the Company Subsidiary of any kind whatsoever, whether accrued, contingent, absolute, determined, determinable or otherwise, and there is no existing condition, situation or set of circumstances that would reasonably be expected to result in such a liability or obligation, other than:

(a) liabilities or obligations disclosed and provided for in the Company Balance Sheet or in the notes thereto or incurred in the ordinary course of business since the Company Balance Sheet Date; and

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(b) liabilities or obligations incurred in the ordinary course of business consistent with past practices since the Company Balance Sheet Date that would not reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect on the Company or the Company Subsidiary.

Section 4.10. Compliance with Laws and Court Orders. Each of the Company and the Company Subsidiary is and has at all times since its date of organization been in material compliance with, and to the Knowledge of the Company is not under investigation with respect to and has not been threatened to be charged with or given notice of any material violation of, any applicable law, statute, ordinance, rule, regulation, judgment, injunction, order or decree.

Section 4.11. Agreements, Contracts and Commitments. (a) Neither the Company nor the Company Subsidiary is a party to or bound by:

(i) any lease or sublease (whether of real or personal property);

(ii) any agreement for the purchase or license of materials, supplies, goods, services, equipment or other tangible or intangible assets providing for either (A) annual payments by the Company or the Company Subsidiary of $10,000 or more or (B) aggregate payments by the Company or the Company Subsidiary of $25,000 or more;

(iii) any license, sales, distribution or other similar agreement (other than agreements with end user customers entered into in the ordinary course of business) providing for the sale or license by the Company or any the Company Subsidiary of software, materials, supplies, goods, services, equipment or other assets that provides for either (A) annual payments to the Company or the Company Subsidiary of $10,000 or more or (B) aggregate payments to the Company and the Company Subsidiary of $25,000 or more;

(iv) any sales or similar agreement which entitles any customer to a rebate or right of set-off, to return any product to the Company after acceptance thereof or to delay the acceptance thereof, or which varies in any material respect from the Company’s standard form contracts (except for contracts which, individually or in the aggregate, are not material to the business of the Company or the Company Subsidiary);

(v) any agreement with a supplier containing any provision permitting any party other than the Company or the Company Subsidiary to renegotiate the price or other terms, or containing any pay-back or other similar provision, upon the occurrence of a failure by the Company or the Company Subsidiary to meet its obligations under the agreement when due or the occurrence of any other event (except for contracts which, individually or in the aggregate, are not material to the business of the Company or the Company Subsidiary);

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(vi) any partnership, joint venture, alliance, agency, dealer, sales representative, marketing, distribution, original equipment manufacturer, value added reseller, remarketer, joint marketing, channel partner or other similar agreement or arrangement;

(vii) any agreement, contract or commitment relating to the acquisition or disposition of any business (whether by merger, sale of stock, sale of assets or otherwise);

(viii) any mortgages, indentures, loans or credit agreements, security agreements or other written agreements or instruments relating to the borrowing of money or the extension of credit or the deferred purchase price of property (in any case, whether incurred, assumed, guaranteed or secured by any asset);

(ix) any agreement under which the Company or the Company Subsidiary has advanced or agreed to advance money;

(x) except for end-user licenses granted to customers by the Company or the Company Subsidiary in the ordinary course of business consistent with past practices, any material option (other than employee stock options), license or franchise;

(xi) any software development agreement or other agreement for development or authorship of products and services for the Company or the Company Subsidiary;

(xii) any agreement that limits in any material respect the freedom of the Company or the Company Subsidiary to compete in any line of business or with any Person or in any geographic area or which could reasonably be expected to so limit the freedom of the Company or the Company Subsidiary after the Effective Time;

(xiii) any agreement with any Affiliate of the Company (or the Company Subsidiary), with any director or officer of the Company or the Company Subsidiary, or with any “associate” or any member of the “immediate family” (as such terms are respectively defined in Rules 12b-2 and 16a-1 of the 1934 Act) of any such director or officer; or

(xiv) other than Employee Agreements and standard offer letters, any employment or consulting agreement, contract or commitment with an employee or individual consultant or salesperson or consulting or sales agreement, contract or commitment with a firm or other organization;

(xv) any agreement with severance, change in control or similar arrangements, that will result in any obligation (absolute or contingent) of the Company or the Company Subsidiary to make any payment as a result of the consummation of the Merger, termination of employment or both;

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(xvi) any agreement or plan, including, without limitation, any stock option plan, stock appreciation rights plan or stock purchase plan, any of the benefits of which will be increased, or the vesting of benefits of which will be accelerated, as a result of the consummation of the Merger or the value of any of the benefits of which will be calculated on the basis of the Merger; or

(xvii) any other agreement, commitment, arrangement or plan not made in the ordinary course of business that is material to the Company and the Company Subsidiary, taken as a whole other than agreements with end user customers entered into in the ordinary course of business, involving annual payments to the Company and the Company Subsidiary in excess of $25,000.

(b) Each agreement, contract, plan, lease, arrangement or commitment disclosed or required to be disclosed pursuant to this Section 4.11 is referred to as a “Material Agreement” and is a valid and binding agreement of the Company or the Company Subsidiary, as the case may be, and is in full force and effect with respect to the Company or the Company Subsidiary and, to the Knowledge of the Company, each other party thereto, and none of the Company, the Company Subsidiary or, to the Knowledge of the Company, any other party thereto is in default or breach in any material respect under the terms of any such Material Agreement, and, to the Knowledge of the Company, no event or circumstance has occurred that, with notice or lapse of time or both, would reasonably be expected to constitute a material event of default thereunder. Any “acceptance requirement”, “acceptance criteria” or other similar provision in any Material Agreement has been met by the Company or the Company Subsidiary, as applicable. The Company has no present expectation or intention of not fully performing all its respective material obligations under each such Material Agreement. True and complete copies of each such Material Agreement, have been made available to Parent.

Section 4.12. Litigation. There is no action, suit, investigation or proceeding (or, to the Knowledge of the Company, any reasonable basis therefor) pending against, or, to the Knowledge of the Company, threatened against or affecting, the Company or the Company Subsidiary, or, to the Knowledge of the Company pending or threatened against or affecting any present officer, director or employee of the Company or the Company Subsidiary (including, without limitation, any action pending or threatened involving the prior employment of any of the Company’s or the Company Subsidiary’s employees or use by any of them in connection with the Company’s or the Company Subsidiary’s business of any information, property or techniques allegedly proprietary to any of their former employers) in each case if determined adversely could reasonably be expected to result in a material liability to the Company, the Company Subsidiary or any of their respective properties or that in any manner challenges or seeks to prevent, enjoin, alter or materially delay the Merger or any of the other transactions contemplated hereby before any court or arbitrator or before or by any governmental body, agency or official, domestic, foreign or supranational. Neither the Company nor the Company Subsidiary is a party to or subject to the provisions of any order, writ, injunction, judgment award or decree of any court tribunal or arbitrator or governmental authority agency or instrumentality. There is no action, suit or proceeding initiated by the Company or the

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Company Subsidiary currently pending or that the Company or the Company Subsidiary intends to initiate, including, without limitation, any action involving the prior employment of any of the Company’s or the Company Subsidiary’s officers or employees or their use in connection with the Company’s business of any information or techniques that may be proprietary to any of their former employers.

Section 4.13. Finders’ Fees. Other than Broadview International LLC, there is no investment banker, broker, finder or other intermediary that has been retained by or is authorized to act on behalf of the Company or the Company Subsidiary who might be entitled to any fee or commission from the Company or any of its Affiliates in connection with the transactions contemplated by this Agreement. A copy of the Company’s engagement agreement with Broadview International LLC has been provided to Parent.

Section 4.14. Tax Representations. The Company represents and warrants to Parent as of the date hereof and as of the Effective Time that:

(a) Filing and Payment. Except as set forth on Schedule 4.14(a), (i) all Tax returns, statements, reports, elections, declarations, disclosures, schedules and forms (including estimated tax or information returns and reports) filed or required to be filed with any Taxing Authority with respect to any Pre-Closing Tax Period by or on behalf of the Company or the Company Subsidiary (collectively, the “Returns”), have, to the extent required to be filed on or before the date hereof, been filed when due in accordance with all applicable laws; (ii) as of the time of filing, the Returns were true and complete in all material respects; and (iii) all Taxes shown as due and payable on the Returns that have been filed have been timely paid, or withheld and remitted to the appropriate Taxing Authority.

(b) Financial Records. Except as set forth on Schedule 4.14(b), (i) the charges, accruals and reserves for Taxes with respect to the Company and the Company Subsidiary reflected on the books of the Company and the Company Subsidiary (excluding any provision for deferred income taxes reflecting either differences between the treatment of items for accounting and income tax purposes or carry forwards) are adequate to cover Tax liabilities accruing through the end of the last period for which the Company and the Company Subsidiary ordinarily record items on their respective books; and (ii) since the end of the last period for which the Company and the Company Subsidiary ordinarily record items on their respective books, neither the Company nor the Company Subsidiary has incurred any material Tax liabilities, other than in the ordinary course of business.

(c) Procedure and Compliance. Except as set forth on Schedule 4.14(c), (i) neither the Company nor the Company Subsidiary has granted any extension or waiver of the statute of limitations period applicable to any Return, which period (after giving effect to such extension or waiver) has not yet expired; (ii) there is no claim, audit, action, suit, proceeding, or investigation now pending or, to the Knowledge of the Company, threatened against or with respect to the Company or the Company Subsidiary in respect of any Tax or Tax Asset; and (iii) no adjustment that would materially increase the Tax liability, or materially reduce any Tax Asset, of the Company or the Company

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Subsidiary has been made, proposed or to the Knowledge of the Company threatened by a Taxing Authority during any audit of a Pre-Closing Tax Period which could reasonably be expected to be made, proposed or threatened in an audit of any subsequent Pre-Closing Tax Period or Post-Closing Tax Period.

(d) Taxing Jurisdictions. Schedule 4.14(d) contains a list of all jurisdictions (whether foreign or domestic) to which any Tax is properly payable by the Company or the Company Subsidiary.

(e) Tax Sharing, Consolidation and Similar Arrangements. Except as set forth on Schedule 4.14(e), (i) neither the Company nor the Company Subsidiary has been a member of an affiliated, consolidated, combined or unitary group other than one of which the Company was the common parent, or made any election or participated in any arrangement whereby any Tax liability or any Tax Asset of the Company or the Company Subsidiary was determined or taken into account for Tax purposes with reference to or in conjunction with any Tax liability or any Tax Asset of any other Person; (ii) neither the Company nor the Company Subsidiary is party to any Tax Sharing Agreement or to any other agreement or arrangement referred to in clause (ii) or (iii) of the definition of “Tax”; (iii) no amount of the type described in clause (ii) or (iii) of the definition of “Tax” is currently payable by either the Company or the Company Subsidiary, regardless of whether such Tax is imposed on the Company or the Company Subsidiary; (iv) neither the Company nor the Company Subsidiary has entered into any agreement or arrangement with any Taxing Authority with regard to the Tax liability of the Company or the Company Subsidiary affecting any Tax period for which the applicable statute of limitations, after giving effect to extensions or waivers, has not expired; and (v) any transaction or arrangement between the Company and the Company Subsidiary has been reported in accordance with the requirements of Section 482 of the Code and the Treasury Regulations promulgated thereunder, or any similar provision of state, local or foreign law.

(f) Certain Elections, Agreements and Arrangements. Except as set forth on Schedule 4.14(f), (i) neither the Company nor the Company Subsidiary is a party to any understanding or arrangement described in Section 6111(d) or Section 6662(d)(2)(C)(iii) of the Code, or has “participated” in a “reportable transaction” within the meaning of Treasury Regulations Section 1.6011-4 with respect to which the Company or the Company Subsidiary would be required to file a disclosure statement pursuant to Treasury Regulation Section 1.6011-4(a); (ii) during the five-year period ending on the date hereof, neither the Company nor the Company Subsidiary was a distributing corporation or a controlled corporation in a transaction intended to be governed by Section 355 of the Code; (iii) no election has been made under Treasury Regulations Section 1.7701-3 or any similar provision of Tax law to treat the Company or the Company Subsidiary as an association, corporation or partnership; and (iv) neither the Company nor the Company Subsidiary is disregarded as an entity for Tax purposes.

(g) Post-Closing Attributes. Except as set forth on Schedule 4.14(g), (i) neither the Company nor the Company Subsidiary will be required to include any adjustment in taxable income for any Post-Closing Tax Period under Section 481(c) of the Code (or any

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similar provision of the Tax laws of any jurisdiction) as a result of a change in method of accounting for a Pre-Closing Tax Period; (ii) neither the Company nor the Company Subsidiary has an overall foreign loss; and (iii) neither the Company nor the Company Subsidiary will be required to include for a Post-Closing Tax Period taxable income attributable to income economically realized in a Pre-Closing Tax Period, including any distributions in a Pre-Closing Tax Period from an entity that is fiscally transparent for Tax purposes and any income that would be includible in a Post-Closing Tax Period as a result of the installment method or the look-back method (as defined in Section 460(b) of the Code).

(h) Property and Leases. Except as set forth on Schedule 4.14(h), (i) neither the Company nor the Company Subsidiary owns an interest in real property in any jurisdiction in which a Tax is imposed, or the value of the interest is reassessed, on the transfer of an interest in real property and which treats the transfer of an interest in an entity that owns an interest in real property as a transfer of the interest in real property; and (ii) none of the property owned by the Company or the Company Subsidiary is “tax-exempt use property” within the meaning of Section 168(h) of the Code.

(i) Israeli Tax Benefit Eligibility. The transactions contemplated by this Agreement will not affect the eligibility of the Company or the Company Subsidiary for any tax benefits or exemptions received in the State of Israel under the Law for the Encouragement of Capital Investments, 5719-1959.

Section 4.15. Employee Matters and Employment Benefit Plans. (a) Schedule 4.15(a) contains a correct and complete list identifying each “employee benefit plan”, as defined in Section 3(3) of ERISA, each employment, severance or similar contract, plan, arrangement or policy and each other plan or arrangement (written or oral) providing for compensation, bonuses, profit-sharing, stock option or other stock related rights or other forms of incentive or deferred compensation, vacation benefits, insurance (including any self-insured arrangements), health or medical benefits, employee assistance program, disability or sick leave benefits, workers’ compensation, supplemental unemployment benefits, severance benefits and post-employment or retirement benefits (including compensation, pension, health, medical or life insurance benefits) which is maintained, administered or contributed to by the Company or any of its Affiliates or covers any employee or former employee of the Company or the Company Subsidiary (collectively, the “Employee Plans”). Copies of such Employee Plans (and, if applicable, related trust or funding agreements or insurance policies) and all amendments thereto and written interpretations thereof have been made available to Parent together with, if applicable, the most recent annual report (Form 5500 including, if applicable, Schedule B thereto) and tax return (Form 990) prepared in connection with any such plan or trust.

(b) Neither the Company nor any ERISA Affiliate nor any predecessor thereof sponsors, maintains or contributes to, or has in the past sponsored, maintained or contributed to, any Employee Plan subject to Title IV of ERISA or any other employee pension benefit plan (as defined in Section 3(2) of ERISA).

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(c) Neither the Company nor any ERISA Affiliate nor any predecessor thereof contributes to, or has in the past contributed to, any multiemployer plan, as defined in Section 3(37) of ERISA (a “Multiemployer Plan”).

(d) Each Employee Plan that is intended to be qualified under Section 401(a) of the Code is so qualified and has been so qualified during the period since its adoption. The Company has made available to Parent copies of the most recent Internal Revenue Service determination or opinion letters with respect to each such Employee Plan or has a remaining period of time to apply for such determination or opinion letter. Each Employee Plan has been maintained in material compliance with its terms and with the requirements prescribed by any and all statutes, orders, rules and regulations, including but not limited to ERISA and the Code, which are applicable to such Employee Plan. No material events have occurred with respect to any Employee Plan that could result in payment or assessment by or against the Company of any material excise taxes under Sections 4972, 4975, 4976, 4977, 4979, 4980B, 4980D, 4980E or 5000 of the Code.

(e) The consummation of the transactions contemplated by this Agreement will not (either alone or together with any other event) entitle any employee, former employee or independent contractor of the Company or the Company Subsidiary to severance pay, bonus or retirement or accelerate the time of payment or vesting or trigger any payment of funding (through a grantor trust or otherwise) of compensation or benefits under, increase the amount payable or trigger any other material obligation pursuant to, any Employee Plan or any other employment or benefit arrangement.

(f) There is no contract, plan or arrangement (written or otherwise) covering any employee or former employee of the Company or the Company Subsidiary that could give rise to the payment of any amount that would not be deductible pursuant to the terms of Section 280G of the Code.

(g) Neither the Company nor the Company Subsidiary has any liability in respect of post-employment or post-retirement health, medical or life insurance benefits for retired, former or current employees of the Company or the Company Subsidiary except as required under Section 4980B of the Code or similar local law. No condition exists that would prevent the Company or the Company Subsidiary from amending or terminating any Employee Plan providing health or medical benefits in respect of any active employee of the Company or the Company Subsidiary.

(h) All contributions and payments accrued under each Employee Plan, determined in accordance with prior funding and accrual practices, as adjusted to include proportional accruals for the period ending as of the date hereof, have been discharged and paid on or prior to the date hereof except to the extent reflected as a liability on the Company Balance Sheet.

(i) There has been no amendment to, written interpretation or announcement (whether or not written) by the Company or any of its Affiliates relating to, or change in employee participation or coverage under, an Employee Plan which could increase materially the expense of maintaining such Employee Plan above the level of the expense incurred in respect thereof for the fiscal year ended December 31, 2003.

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(j) Except for extension orders of common application to all employees in Israel, neither the Company nor any the Company Subsidiary is a party to or subject to, or is currently negotiating in connection with entering into, any collective bargaining agreement or other contract or understanding with a labor union or organization. To the Knowledge of the Company, no labor union has requested, sought or attempted to represent any employees, representatives or agents of the Company or the Company Subsidiary, and neither the Company nor the Company Subsidiary has any Knowledge of any other labor organizations activity involving any such employee, representative or agent.

(k) There is no action, suit, investigation, audit or proceeding pending against or involving or, to the Knowledge of the Company, threatened against or involving, any Employee Plan before any court or arbitrator or any state, federal or local governmental body, agency or official.

(l) The Company and the Company Subsidiary are and have been in compliance in all material respects with all applicable laws, regulation, agreements, arrangements (collective or personal), promises and obligations respecting employees and employment practices, including without limitation, terms and conditions of employment and wages and hours, and are not engaged in any unfair labor practice. There has not been and there was not, to the Knowledge of the Company, threatened any proceeding against or affecting the Company Subsidiary relating to the alleged violation of any applicable laws or agreements, undertakings, promises or any other obligations relating to labor relations or employment matters. There is no unfair labor practice complaint pending or, to the Knowledge of the Company, threatened against the Company or the Company Subsidiary before the National Labor Relations Board or comparable federal, state, local or foreign agency or authority.

(m) The Company has made available to Parent a true and complete list of the names, titles (if applicable), annual salaries or wage rates and other compensation of all employees of the Company and the Company Subsidiary. The Company has no Knowledge that any of its officers or any other key employee (as previously identified to Parent and listed on Schedule 4.15(m) hereto) of the Company and the Company Subsidiary currently intends to resign or retire as a result of the transactions contemplated by this Agreement. The Company has made available to Parent a true and complete list of the names and titles (if applicable) of all former employees of the Company and the Company Subsidiary and all offer letters with respect to such former employees.

(n) Each employee of the Company or the Company Subsidiary has executed a Proprietary Information and Non-Competition Agreement in the form contemplated by the Amended and Restated Investors’ and Registration Rights Agreement, dated as of June 19, 2003, among Alaska and the other parties thereto (the “Registration Rights Agreement”). To the extent required by the Registration Rights Agreement, Shmuel Assa and each officer, employee or consultant of the Company has executed such agreements required by Section 1.8 (Stock Restriction Agreements) of the Registration Rights Agreement.

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(o) There are no loans outstanding from the Company or the Company Subsidiary to any current or former employee or director.

(p) The Company Subsidiary has made all necessary provisions relating to its liabilities to its employees with respect to managers’ insurance policies (‘Bituach Menahalim’), severance payments, pension funds, studying funds (‘Keren Hishtalmut’) and any other provisions pursuant to any contractual obligation of the Company Subsidiary. A list of accrued vacation days and convalescence days of the Company Subsidiary’s employees is attached hereto as Schedule 4.15(p). As of the date hereof, the Company Subsidiary’s aggregate financial obligation to pay for such accrued vacation and convalescence days amounts to NIS 309,000, and the Company Subsidiary has made the adequate reserve to cover for such amount in its financial statements.

(q) The Company Subsidiary is not liable for the payment of any compensation, damages, taxes, fines, penalties, or other amounts, however designated, for failure to comply with any of its legal or contractual requirements with respect to employees.

(r) The Company Subsidiary has made all appropriate payments to the tax authorities, the Institute of National Insurance, health tax and to any other relevant authority, and all payments to the employees were made in accordance therewith, including without limitation adequate payments for overtime, sick days, vacation days and convalescence pay.

(s) The Company and the Company Subsidiary have fulfilled and complied with all obligations under and requirements of the Ordinance with respect to allocation of options to Israeli employees under the Company Stock Plan including without limitation the timely filing of all reports and requests, and the application for and obtaining of all consents and approvals, required to be filed, applied for or obtained, as applicable, under any of the foregoing or under any applicable law, statute, regulation or otherwise in connection with any allocation of options to Israeli employees.

Section 4.16. Title of Properties; Absence of Liens and Encumbrances; Condition of Equipment. (a) The Company and the Company Subsidiary do not own any real property, and have never owned any real property. Schedule 4.16 sets forth a list of all real property currently leased by the Company or the Company Subsidiary, the name of the lessor and the date of the lease and each amendment thereto and, with respect to any current lease, the aggregate annual rental and/or other fees payable under any such lease and the term and renewal provisions of such lease. All such leases are in full force and effect and enforceable by the Company or the Company Subsidiary, and there is not, under any of such leases, any existing material default by the Company or the Company Subsidiary or, to the Knowledge of the Company, by the other party thereto or material event of default (or event which with notice or lapse of time, or both, would constitute such a default). The Company has heretofore made available to Parent true and complete copies of all such leases.

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(b) The Company or the Company Subsidiary has good and marketable title to, or, in the case of leased properties and tangible assets, valid leasehold interests in, all of the tangible assets shown on the Company Balance Sheet, free and clear of any Liens, except as reflected in the Company Balance Sheet.

(c) All material items of equipment included in such assets shown on the Company Balance Sheet are, in the aggregate and in all material respects, in good operating condition, regularly and properly maintained, subject to normal wear and tear.

Section 4.17. Products. Schedule 4.17 lists (by name and version number) all products, software or service offerings of the Company and the Company Subsidiary (collectively, “Company Products”) that have been produced, licensed, sold, distributed or otherwise disposed of since the Company’s inception, and (ii) identifies, for each such Company Product, whether the Company provides support or maintenance for such Company Product. Each of the Company Products is, and at all times up to and including the sale thereof, conforms in all material respects to any promises or affirmations of fact made on the container or label for such product or in connection with its sale. To the Knowledge of the Company, none of the Company’s or the Company Subsidiary’s products contains defects that would reasonably be expected to materially impair such product’s value or use by customers.

Section 4.18. Intellectual Property. (a) Schedule 4.18(a)(i) contains a true and complete list of patents, registered copyrights, registered trademarks, registered service marks, Internet domain names and any applications for registrations for any of the foregoing included in the Owned Intellectual Property Rights or exclusively licensed to the Company or the Company Subsidiary (collectively, the “Company Registered Intellectual Property Rights”), specifying as to each such Intellectual Property Right, as applicable, (i) the owner of such Intellectual Property Right, (ii) the jurisdictions by or in which such Intellectual Property Right has been issued or registered or in which an application for such issuance or registration has been filed and (iii) the registration or application numbers thereof. Schedule 4.18(a)(ii) contains a true and complete list of all inter-parties proceedings or actions before any court, tribunal (including the United States Patent and Trademark Office (the “PTO”) or equivalent authority anywhere in the world) involving the Company or the Company Subsidiary. The Company Registered Intellectual Property Rights (other than applications for Company Registered Intellectual Property Rights) are valid and subsisting. To the Company’s Knowledge, there is no reason that would prevent any of the applications for the Company Registered Intellectual Property Rights from issuing with a scope at least as broad as currently claimed. All necessary documents and certificates in connection with the Company Registered Intellectual Property Rights have been filed with the relevant patent, copyright, trademark or other authorities in the United States and foreign jurisdictions, for the purposes of perfecting, prosecuting and maintaining such Company Registered Intellectual Property Rights. There are no actions that must be taken by the Company or the Company Subsidiary within 180 days of the date hereof, including the payment of any registration, maintenance or renewal fees or the filing of any responses to PTO office actions, documents, applications or certificates for the purposes of obtaining, maintaining, perfecting or preserving or renewing any Company Registered Intellectual Property

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Rights. Neither the Company nor the Company Subsidiary has claimed “small business status,” or other special status in the application for or registration of any Company Registered Intellectual Property Rights.

(b) Schedule 4.18(b) contains a true and complete list of any Licensed Intellectual Property Rights (excluding licenses for generally available commercial software for less than $500 per copy and not included in the Company Products but including all licenses for software that is distributed as “free software”, “open source software” or under a similar licensing or distribution model), specifying the (x) the date of any license or agreement and (y) the identity of all parties thereto.

(c) Schedule 4.18(c) contains a true and complete list of all licenses or sublicenses (including covenants not to sue) by the Company or the Company Subsidiary of the Owned Intellectual Property Rights (other than end user licenses entered into in the ordinary course of the business of the Company or the Company Subsidiary in the standard form provided to Parent), specifying (x) the date of any license or agreement and (y) the identity of all parties thereto.

(d) The Licensed Intellectual Property Rights and the Owned Intellectual Property Rights together constitute all of the Intellectual Property Rights necessary to conduct the business of the Company and the Company Subsidiary as currently conducted and as currently contemplated to be conducted by the Company or the Company Subsidiary, disregarding the effect of the transactions contemplated by this Agreement. There exist no restrictions on the disclosure, use or transfer of the Owned Intellectual Property Rights each of which may be carried out without payment of any kind to any Third Party (other than as set forth in Schedule 4.18(v)). No third party has any rights to use any of the Owned Intellectual Property Rights, other than (i) non-exclusive licenses granted by the Company or the Company Subsidiary to end users in the ordinary course of business in the standard form provided to Parent and (ii) the distribution agreements set forth in Schedule 4.18(d). All Owned Intellectual Property Rights are owned exclusively by the Company or the Company Subsidiary. The consummation of the transactions contemplated by this Agreement will not alter, impair or extinguish any of the Company’s rights, as of the date hereof, in Owned Intellectual Property Rights or Licensed Intellectual Property Rights.

(e) The Company and the Company Subsidiary have no Knowledge of any facts or circumstances that would render any Owned Intellectual Property Rights or Licensed Intellectual Property Rights (other than nonexclusively licensed Licensed Intellectual Property Rights) invalid or unenforceable.

(f) Except pursuant to written agreements entered into by the Company or the Company Subsidiary with end users in the ordinary course of business (copies of which have been made available to Parent) or to the distribution agreements set forth on Schedule 4.18(d), and except as set forth on Schedule 4.18(f)(A), there are no contracts, licenses or agreements between the Company or the Company Subsidiary and any other person wherein or whereby the Company or the Company Subsidiary has agreed to, or assumed, any obligation or duty to warrant, indemnify, reimburse, hold harmless,

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guaranty or otherwise assume or incur any obligation or liability in connection with the Company’s Intellectual Property Rights or Company Products. Schedule 4.18(f)(B) lists all warranty claims (including any pending claims) made by any Third Party related to the Company Products and the nature of such claims.

(g) No Person who has provided or licensed any Intellectual Property Rights to the Company or the Company Subsidiary has ownership rights or license rights to improvements, enhancements or other modifications or derivatives made by or for the Company or the Company Subsidiary.

(h) Neither the Company nor the Company Subsidiary has infringed, misappropriated or otherwise violated any Intellectual Property Right (other than patent rights) of any Third Party. To the Knowledge of the Company, neither the Company nor the Company Subsidiary has infringed, misappropriated or otherwise violated any patent rights of any Third Party. There is no claim, action, suit, investigation or proceeding pending or, to the Company’s Knowledge, threatened against the Company or the Company Subsidiary (i) based upon, or challenging or seeking to deny or restrict, the rights of the Company or the Company Subsidiary in any of the Owned Intellectual Property Rights and the Licensed Intellectual Property Rights, (ii) alleging that the use by the Company and the Company Subsidiary of the Owned Intellectual Property Rights or the Licensed Intellectual Property Rights or any services provided, processes used or products manufactured, used, imported, sold, marketed or licensed by the Company or the Company Subsidiary do or may misappropriate, infringe or otherwise violate any Intellectual Property Right of any Third Party or breach any obligation owed to a Third Party with respect to such party’s Intellectual Property Rights or (iii) alleging that the Company or the Company Subsidiary has infringed, misappropriated or otherwise violated any Intellectual Property Right of any Third Party. Neither the Company nor the Company Subsidiary has received any offer for a license of intellectual property, including but not limited to patent rights, from any Third Party in connection with an allegation by such Third Party that the Company or the Company Subsidiary has misappropriated or infringed any of the Intellectual Property Rights of such Third Party. Neither the Company nor the Company Subsidiary has received any written opinion of counsel that any Third Party patent would be directly or indirectly infringed by the operation of the business of the Company as previously conducted, currently conducted or contemplated to be conducted by the Company and the Company Subsidiary, including with respect to any Company Product.

(i) The Owned Intellectual Property Rights, and the use, reproduction, modification, distribution, licensing, sublicensing, offering for sale or sale of any Owned Intellectual Property Rights by the Company or its licensees, does not and will not infringe or misappropriate any copyright, trade secret, trademark, service mark, trade name, trade dress, or moral right of any Person or, to the Knowledge of the Company, the patent of any Person. To the Knowledge of the Company, the Licensed Intellectual Property Rights that form a part of any Company Product offered for sale or license, and the use, reproduction, modification, distribution, licensing, sublicensing, or sale of such Licensed Intellectual Property Rights by the Company or its licensees in accordance with the license agreements for such Licensed Intellectual Property Rights, as set forth on Schedule 4.18(b), does not and will not, infringe or misappropriate any copyright, patent, trade secret, trademark, service mark, trade name, trade dress, or moral right of any Person.

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(j) Except as set forth in Schedule 4.18(j), none of the Owned Intellectual Property Rights has been adjudged invalid or unenforceable in whole or part, and all such Owned Intellectual Property Rights are valid and enforceable.

(k) The Company and the Company Subsidiary hold all right, title and interest in and to all Owned Intellectual Property Rights and all of the Company’s and the Company Subsidiary’s rights in the Licensed Intellectual Property Rights, free and clear of any Lien (other than restrictions contained in license agreements for the Licensed Intellectual Property Rights as set forth on Schedule 4.18(b)). In each case where a patent or patent application, trademark registration or trademark application, service mark registration or service mark application, or copyright registration or copyright application included in the Owned Intellectual Property is held by assignment, the assignment has been duly recorded with the governmental authority from which the patent or registration issued or before which the application or application for registration is pending. Other than filing applications for copyright registration, the Company and the Company Subsidiary have taken all actions reasonably necessary to maintain and protect any material Owned Intellectual Property Rights, including payment of applicable maintenance fees and filing of applicable statements of use.

(l) To the Knowledge of the Company, based on reasonable investigation, no Person has infringed, misappropriated, breached or otherwise violated any Owned Intellectual Property Right or Licensed Intellectual Property Rights (other than nonexclusively licensed Licensed Intellectual Property Rights).

(m) All software source code listings that are part of any material Owned Intellectual Property Rights are documented in accordance with prevailing industry standards.

(n) Except as set forth on Schedule 4.18(n), none of the registered trademarks or service marks, applications for trademarks and applications for service marks included in the Owned Intellectual Property Rights that are material to the business or operation of the Company or the Company Subsidiary have been the subject of an opposition or cancellation procedure. None of the patents and patent applications included in the Owned Intellectual Property Rights that are material to the business or operation of the Company or the Company Subsidiary have been the subject of an interference, protest, public use proceeding or Third Party reexamination request.

(o) The Company and the Company Subsidiary have taken reasonable steps in accordance with normal industry practice to maintain the confidentiality of (i) all of the Company’s and the Company Subsidiary’s confidential information and trade secrets and (ii) information received from Third Parties which the Company or the Company Subsidiary is obligated to treat as confidential. None of the Intellectual Property Rights of the Company or the Company Subsidiary, the value of which to the Company or the

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Company Subsidiary is contingent upon maintaining the confidentiality thereof, has been disclosed other than pursuant to written confidentiality agreements, true and complete copies of which have been provided to Parent. The Company and the Company Subsidiary have taken reasonable steps in accordance with normal industry practice to obtain ownership of all works of authorship and inventions made by its employees, consultants and contractors. Without limiting the foregoing, the Company has, and enforces, a policy requiring each employee who contributes to the development of the Company’s Intellectual Property Rights to execute proprietary information, confidentiality and assignment agreements substantially in the form of the Company’s standard forms (the forms of which have been provided to Parent) (“Employee Agreements”), and no current or former employee of the Company or the Company Subsidiary has refused to sign the Employee Agreements.

(p) Except as set forth on Schedule 4.18(p), no Person other than the Company or the Company Subsidiary possesses any current or contingent rights to any source code that is part of the Owned Intellectual Property Rights. Neither the Company, Company Subsidiary nor any other Person acting, respectively, on their behalf has disclosed, delivered or licensed to any Person, agreed to disclose, deliver or license to any Person, or permitted the disclosure or delivery to any escrow agent or other Person of, any source code that is part of the Owned Intellectual Property Rights. No event has occurred, and no circumstance or condition exists, that (with or without notice or lapse of time, or both) will, or would reasonably be expected to, result in the disclosure or delivery by the Company, Company Subsidiary or any Person acting, respectively, on their behalf to any Person of any source code that is part of the Owned Intellectual Property Rights. Schedule 4.18(p) of the Company Disclosure Schedule identifies each contract pursuant to which the Company and Company Subsidiary has deposited, or is or may be required to deposit, with an escrow-holder or any other Person, any source code that is part of the Owned Intellectual Property Rights, and describes whether the execution of this Agreement or the consummation any of the other transactions hereunder, in and of itself, would reasonably be expected to result in the release from escrow of any such source code.

(q) Schedule 4.18(q) lists all parties (excluding employees of Company or Company Subsidiary whose work product was created by them entirely within the scope of their employment by Company and constitutes works made for hire owned by Company but including contractors and consultants) who have created any portion of the Owned Intellectual Property Rights. Company has secured from all parties who have created any portion of the Owned Intellectual Property Rights valid and enforceable written assignments or licenses of any such work or other rights to Company and has made available true and complete copies of such assignments or licenses to Parent or its counsel.

(r) Schedule 4.18(r) includes a true and complete list of support and maintenance agreements relating to Owned Intellectual Property to which Company is a party including the identity of the parties and the respective dates of such agreements (other than, in each case, support or maintenance provided by the Company to end users in the ordinary course of business pursuant to the standard form previously provided to Parent). Schedule 4.18(r) includes a true and complete list of all outstanding support and maintenance obligations, as of the date hereof, under each of the aforementioned agreements.

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(s) None of the Company Products contains any computer code: (i) designed to intentionally harm in any manner the operation of such software, or any other associated software, firmware, hardware, computer system or network (sometimes referred to as “viruses” or “worms”); (ii) that would intentionally disable such software or impair in any way its operation based on the elapsing of a period of time or advancement of a particular date (sometimes referred to as “time bombs,” “time locks,” or “drop dead” devices); (iii) that would permit the Company or any Third Party to access such software to intentionally cause any harmful, malicious procedures, routines or mechanisms which would cause the software to cease functioning or to damage or corrupt data, storage media, programs, equipment or communications or (iv) containing any bug, problem, flaw or similar issue that may materially adversely affect the value, functionality or fitness for the intended purposes of such Company Products. Notwithstanding the foregoing, there are no material defects (including any viruses) in any Company Products, and there are no errors in any technical documentation, specifications, manuals, user guides, promotional material, internal notes and memos, drawings, flow charts, diagrams, source language statements, demo disks, benchmark test results, and other written materials related to, associated with or used or produced in the development of such Company software products, which defects or errors would reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect on Parent.

(t) Subject to Section 4.27, no government funding, facilities of a university, college, other educational institution or research center or funding from third parties was used in the development of any Company Intellectual Property included in the Acquired Assets. No current or former employee, consultant or independent contractor of the Company or the Company Subsidiary, who was involved in, or who contributed to, the creation or development of any Owned Intellectual Property Rights, has performed services for the government or a university, college, or other educational institution or research center during a period of time during which such employee, consultant or independent contractor was also performing services for the Company or the Company Subsidiary.

(u) No (i) Company Product, technology, service or publication of the Company or the Company Subsidiary (ii) material published or distributed by the Company or the Company Subsidiary, or (iii) conduct or statement of the Company or the Company Subsidiary, constitutes obscene material, a defamatory statement or material, false advertising or otherwise violates in any material respect any law or regulation.

(v) Except as set forth in Schedule 4.18(v), there are no royalties, fees, honoraria or other payments payable by the Company or the Company Subsidiary to any person or entity by reason of the ownership, development, use, license, sale or disposition of the Owned Intellectual Property Rights, including any Company or Company Subsidiary product, other than salaries, sales commissions and other forms of compensation paid to employees and sales agents in the ordinary course of business.

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(w) Each of the Company and the Company Subsidiary has been and is in compliance with the Export Administration Act of 1979, as amended, and all regulations promulgated thereunder.

(x) Except as set forth in Schedule 4.18(x), the Company Products and the Owned Intellectual Property Rights do not contain any software code that (A) contains, or is derived in any manner (in whole or in part) from, any software that is distributed under any of the following licenses or distribution models, or licenses or distribution models similar to any of the following: GNU’s General Public License (GPL) or Lesser/Library GPL (LGPL); or (B) is licensed under any terms or conditions that impose any requirement that any software using, linked with, incorporating, distributed with, based on, derived from or accessing the software code: (i) be made available or distributed in source code form; (ii) be licensed for the purpose of making derivative works; (iii) be licensed under terms that allow reverse engineering, reverse assembly or disassembly of any kind; or (iv) be redistributable at no charge (any of the foregoing, referred to as “Open Source Materials”). Schedule 4.18(x) lists all Open Source Materials used by the Company or the Company Subsidiary in any way, and describes the manner in which such Open Source Materials were used. Such description shall include, without limitation, whether (and, if so, how) the Open Source Materials were embedded, linked (including dynamic linking), modified and/or distributed by the Company and the Company Subsidiary and whether and the extent to which each of the Open Source Materials was used to develop, distribute or design Company Products to link with (including dynamic linking at runtime) or access in any way (whether by calls, execution branching, interprocess control or other technique of any kind whatsoever) any Open Source Materials. The Company Products and the Owned Intellectual Property Rights do not contain any software code that (i) requires the disclosure or distribution of all or a portion of the source code for any Company Products or any third party code with which the Company Product have been combined by the Company or the Company Subsidiary (“Third Party Combined Products”), (ii) creates, or purports to create, obligations on licensors of Third Party Combined Products, (iii) grants, or purports to grant, to any third party any right to, or immunities under, intellectual property rights of licensors of Third Party Combined Products, or (iv) with respect to the GPL or similar licenses, causes, or could be interpreted or asserted as causing, the Company Products, any Third Party Combined Products, or any modifications to the Company Products or any Third Party Combined Products to become subject to the GPL or a similar license as a result of being combined with the software that is subject to the GPL or similar license. Except as set forth in Schedule 4.18(x), no Company Product or Company Intellectual Property is subject to the terms of license of any such Open Source Materials. The Company has not used software code that includes the Linux kernel version 2.4 or any later version.

(y) The Company and the Company Subsidiary has the right to use, pursuant to valid licenses, all software development tools, library functions, compilers and all other third-party software that are used in the operation of the Business or that are required to create, modify, compile, operate or support any software that is incorporated into any Company Product.

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Section 4.19. Insurance Coverage. Schedule 4.19 contains a complete and accurate list of, and the Company has made available to Parent true and complete copies of, all insurance policies relating to the assets, business, operations, employees, officers or directors of the Company and the Company Subsidiary. There is no claim by the Company or the Company Subsidiary pending under any of such policies as to which coverage has been denied or disputed by the underwriters of such policies or in respect of which such underwriters have reserved their rights. All premiums payable under all such policies have been timely paid (to the extent due) and the Company and the Company Subsidiary have otherwise complied fully with the material terms and conditions of all such policies. Such policies of insurance (or other policies providing substantially similar insurance coverage) have been in effect since 2001 and remain in full force and effect. The Company has no Knowledge of any threatened termination of, material premium increase with respect to, or material alteration of coverage under, any of such policies. To the Company’s Knowledge, such policies are of the type and in amounts customarily carried by Persons conducting businesses similar to those of the Company or the Company Subsidiary.

Section 4.20. Licenses and Permits. The Company and the Company Subsidiary hold all material licenses, franchises, permits, certificates, approvals or other similar authorizations that are reasonably necessary to conduct its business as currently conducted (the “Permits”). To the Knowledge of the Company, the Permits are valid and in full force and effect. Neither the Company nor the Company Subsidiary is in material default under, and neither the Company nor the Company Subsidiary has received any notice that any condition exists that with notice or lapse of time or both would reasonably be expected to constitute a material default under, the Permits. To the Knowledge of the Company, none of the Permits will be terminated or materially impaired or become terminable, in whole or in part, as a result of the transactions contemplated hereby.

Section 4.21. Receivables. (a) The Company has made available to Parent a list of all accounts receivable of the Company and the Company Subsidiary as of May 10, 2004, along with a statement of days elapsed since invoice.

(b) All accounts, notes receivable and other receivables arising out of or relating to the business of the Company and the Company Subsidiary as of the Company Balance Sheet Date or Interim Balance Sheet Date (i) have been included in the Company Balance Sheet and Interim Balance Sheet and all reserves for doubtful accounts reflected thereon were taken in accordance with GAAP applied on a consistent basis and (ii) to the Company’s Knowledge, are collectible in the ordinary course (subject to any reserves for doubtful accounts reflected in the Company Balance Sheet or Interim Balance Sheet). No person has any Lien on any such accounts receivable and, to the Company’s Knowledge, no request or agreement for deduction or discount has been made with respect to any such accounts receivable.

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Section 4.22. Environmental Matters. (a) (i) During the period that the Company and the Company Subsidiary have leased their respective properties or operated any facilities, no material notice, notification, demand, request for information, citation, summons or order has been received, no material complaint has been filed, no penalty has been assessed, and no material investigation, action, claim, suit, proceeding or review is pending or, to the Knowledge of the Company, is threatened by any governmental entity or other Person relating to or arising out of any Environmental Law;

(ii) during the period that the Company and the Company Subsidiary have leased their respective properties or operated any facilities, the Company and the Company Subsidiary are and have been in compliance in all material respects with all Environmental Laws and all Environmental Permits; and

(iii) there are no material liabilities of or relating to the Company or the Company Subsidiary of any kind whatsoever, whether accrued, contingent, absolute, determined, determinable or otherwise arising under or relating to any Environmental Law, and to the Knowledge of the Company there are no facts, conditions, situations or set of circumstances that could reasonably be expected to result in or be the basis for any material liability arising under or relating to any Environmental Law.

(b) There has been no environmental investigation, study, audit, test, review or other analysis conducted of which the Company has Knowledge in relation to the current or prior business of the Company or the Company Subsidiary or any property or facility now or previously owned or leased by the Company or the Company Subsidiary that has not been delivered to Parent at least five days prior to the date hereof.

(c) Neither the Company nor the Company Subsidiary owns, leases or operates or has owned, leased or operated any real property, or conducts or has conducted any operations, in New Jersey or Connecticut.

Section 4.23. Certain Interests. (a) To the Knowledge of the Company, none of the Stockholders of the Company or the Company Subsidiary or any officer or director of the Company or the Company Subsidiary and no member of such person’s “immediate family” (as such term is defined in Rule 16a-1 of the 1934 Act):

(i) has been an officer, director or stockholder of any significant supplier or customer of the Company, or of any company which holds, directly or indirectly, 50% or more of the outstanding shares of any such supplier or customer, provided, however, that the ownership of securities representing not more than 1% of the outstanding voting power of any supplier or customer, and which are listed on any national securities exchange or traded actively in the national over-the-counter market, shall not be deemed to be a “stockholder” as long as the person owning such securities has no other significant connection or relationship with such supplier or customer;

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(ii) is a party to or has a direct or indirect material financial interest in any license, partnership or alliance agreement with the Company or the Company Subsidiary other than pursuant to the Company’s sales, bonus or other compensation plan;

(iii) owns, directly or indirectly, in whole or in part, or has any other interest in any material tangible or intangible property which the Company or the Company Subsidiary owns (except for any such ownership or interest resulting from the ownership of securities in a public company or pursuant to its normal rights as a stockholder of the Company); or

(iv) has outstanding any indebtedness to the Company or the Company Subsidiary.

(b) Except for the payment of employee or director compensation in the ordinary course of business, the Company does not have any liability or any other material obligation of any nature whatsoever to any stockholder of the Company or any affiliate thereof or to any officer or director of the Company, or to the Knowledge of the Company, to any immediate relative or spouse (or immediate relative of such spouse) of any such officer or director.

Section 4.24. Customers; Suppliers. Schedule 4.24 sets forth the names of the 25 most significant customers (by dollar amount of sales) of the Company and the Company Subsidiary for the period from January 1, 2003 through March 31, 2004, and the dollar amount of sales for each such customer during such periods. Except as set forth in Schedule 4.24 of the Company Disclosure Schedule, to the Knowledge of the Company, there has been no material degradation in the quality of the relationship of the Company with any such significant customer, it being understood that such customers are typically under no obligation to purchase any additional products or services from the Company.

Section 4.25. Books and Records. (a) The books of account and other financial records of the Company have been maintained in accordance with sound business practices, including the maintenance of an adequate system of internal controls to provide reasonable assurances that: (i) transactions are executed in accordance with management’s general or specific authorization; and (ii) transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP. At the Closing, all of such books and records will be in the possession of the Company or its attorneys. The Company has made available all of such books, records and accounts to Parent or its representatives.

(b) The minute books of the Company and of the Company Subsidiary which have been provided to Parent contain accurate and complete copies of the minutes of every meeting of, and records of all corporate action taken by, the Company’s and the Company Subsidiary’s stockholders and Boards of Directors (and any committees thereof). No resolutions have been passed, enacted, consented to or adopted by the directors (or any committees thereof) or stockholders of the Company or the Company

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Subsidiary, except for those contained in such minute books. The corporate records of the Company and of the Company Subsidiary have been maintained in accordance with all applicable statutory requirements and are complete and accurate in all material respects.

Section 4.26. Directors and Officers. The officers and directors of the Company and the Company Subsidiary are set forth in Schedule 4.26(a). The Company has no agreement, obligation or commitment with respect to the election of any individual or individuals to the Board of Directors of the Company and there is no voting agreement or other arrangement among the Company’s stockholders. Except as set forth in Schedule 4.26(b), there are no agreements, commitments and understandings, whether written or oral, with respect to any compensation to be provided to any of the Company’s or the Company Subsidiary’s directors or officers.

Section 4.27. Grants, Incentives, Subsidies. (a) Schedule 4.27(a) sets forth a complete list of all grants, incentives and subsidies (collectively, “Grants”) from the government of the State of Israel or any agency thereof to the Company or the Company Subsidiary, including without limitation, an Approved Enterprise status and Grants from the Chief Scientist.

(b) The Company Subsidiary is entitled to certain tax benefits in the “Alternative Route” pursuant to letters of approval dated December 26, 2002 and March 11, 2004, and based on its status as an Approved Enterprise under the Law for the Encouragement of Capital Investments 5719-1959. The Company has made available to Parent, prior to the date hereof, true and correct copies of all applications, letters of approval, and supplements thereto, granted to the Company Subsidiary in connection with its Approved Enterprise status. The Company Subsidiary has complied with all the terms and provisions of its Approved Enterprise status and applicable laws and regulations in order to retain its status as an Approved Enterprise including, without limitation, the filing of all reports and requests, and the application for and obtaining of all consents and approvals, required to be filed, applied for or obtained, as applicable, under any of the foregoing or under any applicable law, statute, regulation or otherwise in connection with any transactions consummated by the Company Subsidiary or the Company at any time prior to the date hereof. To the Knowledge of the Company or the Company Subsidiary, there exists no fact, condition, situation or set of circumstances that would result in the revocation or modification of the Company Subsidiary’s “Approved Enterprise” status.

(c) The Company Subsidiary has received Grants in support of its research and development through the Chief Scientist pursuant to (i) letters of approval dated June 5, 2003 and August 5, 2003 and (ii) the Encouragement of Industrial Research and Development Law 5744 – 1984. The Company has made available to Parent, prior to the date hereof, true and correct copies of all letters of approval, and supplements thereto, granted to the Company Subsidiary by the Chief Scientist. The Company Subsidiary is in compliance with the terms and conditions of the Grants and has duly fulfilled all undertakings relating thereto including, without limitation, the filing of all reports and requests, and the application for and obtaining of all consents and approvals, required to

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be filed, applied for or obtained, as applicable, under any of the foregoing or under any applicable law, statute, regulation or otherwise in connection with any transactions consummated by the Company Subsidiary or the Company at any time prior to the date hereof. To the Knowledge of the Company or the Company Subsidiary, there exists no fact, condition, situation or set of circumstances that would result in the revocation or modification of any of the Grants.

(d) The Company Subsidiary has filed all of the required notices and reports to the Israeli Companies Registrar pursuant to the Companies Law 5759 – 1999 and the regulations promulgated thereunder and has paid all of its annual companies fees when due. No financial penalties have been imposed on the Company Subsidiary by the Israeli Companies Registrar and to the Knowledge of the Company or the Company Subsidiary, there exists no fact, condition, situation or set of circumstances that would result in the imposition of such financial penalties.

Section 4.28. Information Statement. The Information Statement shall include all information required to be provided to any Stockholder pursuant to Section 262 of Delaware Law. The Company will comply with all other requirements of Section 262 of Delaware Law.

ARTICLE 5

REPRESENTATIONS AND WARRANTIES OF PARENT

Parent represents and warrants to the Company that:

Section 5.01. Corporate Existence and Power. Each of Parent and Merger Sub is a corporation duly incorporated, validly existing and in good standing under the laws of its jurisdiction of incorporation and has all corporate powers and all governmental licenses, authorizations, permits, consents and approvals required to carry on its business as now conducted, except for those licenses, authorizations, permits, consents and approvals the absence of which would not have, individually or in the aggregate, a Material Adverse Effect on Parent. Since the date of its incorporation, Merger Sub has not engaged in any activities other than in connection with or as contemplated by this Agreement.

Section 5.02. Corporate Authorization. The execution, delivery and performance by Parent and Merger Sub of this Agreement and the Escrow Agreement and the consummation by Parent and Merger Sub of the transactions contemplated hereby and thereby are within the corporate powers of Parent and Merger Sub and have been duly authorized by all necessary corporate action. This Agreement and the Escrow Agreement constitute valid and binding agreements of each of Parent and Merger Sub enforceable against Parent and Merger Sub in accordance with their terms.

Section 5.03. Governmental Authorization. The execution, delivery and performance by Parent and Merger Sub of this Agreement and the consummation by Parent and Merger Sub of the transactions contemplated hereby require no action by or in

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respect of, or filing with, any governmental body, agency, official or authority, domestic, foreign or supranational, other than (i) the filing of a certificate of merger with respect to the Merger with the Secretary of State of the State of Delaware and appropriate documents with the relevant authorities of other states in which Parent is qualified to do business, (ii) compliance with any applicable takeover laws, whether state or foreign, and (ii) any actions or filings the absence of which could not be reasonably expected to, individually or in the aggregate, have a Material Adverse Effect on Parent or materially impair the ability of Parent and Merger Sub to consummate the transactions contemplated by this Agreement.

Section 5.04. Non-Contravention. The execution, delivery and performance by Parent, and Merger Sub of this Agreement and the consummation by Parent and Merger Sub of the transactions contemplated hereby do not and will not (i) contravene, conflict with, or result in any violation or breach of any provision of the certificate of incorporation or bylaws of Parent or the certificate of incorporation or bylaws of Merger Sub, (ii) assuming compliance with the matters referred to in Section 5.03, contravene, conflict with, or result in any violation or breach of any provision of any law, rule, regulation, judgment, injunction, order or decree, or (iii) require any material consent or other action by any Person under, constitute a material default, or an event that, with or without notice or lapse of time or both, could become a material default, under, or cause or permit the termination, cancellation, acceleration or other change of any right or obligation or the loss of any material benefit to which Parent or any of its Subsidiaries is entitled under any provision of any material agreement, or any material license, franchise, permit, certificate, approval or other similar authorization affecting, or relating to, the material assets or business of Parent except for such contraventions, conflicts and violations referred to in clause (ii) and for such failures to obtain any such consent or other action, defaults, terminations, cancellations, accelerations, changes or losses referred to in clause (iii) that would not be reasonably expected to, individually or in the aggregate, have a Material Adverse Effect on Parent or materially impair the ability of Parent and Merger Sub to consummate the transactions contemplated by this Agreement.

Section 5.05. Litigation. As of the date of this Agreement, there is no material action, suit, investigation or proceeding (or, to the Knowledge of Parent, any material basis therefor) pending against, or, to the Knowledge of Parent, threatened against or affecting Parent, that in any manner challenges or seeks to prevent, enjoin, alter or materially delay the Merger or any of the other transactions contemplated hereby before any court or arbitrator or before or by any governmental body, agency or official, domestic, foreign or supranational.

Section 5.06. Form S-8. Parent is eligible to file with the SEC a registration statement on Form S-8 (or any other successor or other appropriate form) for the registration of the shares of Parent Common Stock issuable pursuant to the exercise of the Company Stock Options assumed by Parent pursuant to Section 2.05.

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ARTICLE 6

COVENANTS OF THE COMPANY AND THE COMPANY SUBSIDIARY

Each of the Company and the Company Subsidiary agrees that:

Section 6.01. Conduct of the Company and the Company Subsidiary. Except as contemplated by this Agreement, or with the prior written consent of Parent, from the date hereof until the Effective Time, the Company and the Company Subsidiary shall conduct their business in the ordinary course consistent with past practice and in compliance in all material respects with all applicable laws and regulations, pay their debts and Taxes when due subject to good faith disputes over such debts or Taxes, pay or perform other material obligations when due, and use all commercially reasonable efforts consistent with past practices and policies to (i) preserve intact their present business organization, (ii) maintain the properties in good operating condition, (iii) keep available the services of their present officers, employees and contractors and (iv) preserve their relationships with customers, suppliers, licensors, licensees and others with which they have business dealings; provided that no guarantees are provided as to the foregoing. Except as otherwise permitted under this Agreement, the Company shall manage its working capital in the ordinary course of business, consistent with past business practices or as otherwise mutually determined by Parent and the Company. Without limiting the generality of the foregoing, from the date hereof until the Effective Time, without the prior written consent to Parent and except as contemplated by this Agreement, the Company shall not and shall not permit the Company Subsidiary to:

(a) adopt or propose any change to its certificate of incorporation or bylaws or to the Company Subsidiary’s Articles of Association or bylaws, other than as specifically permitted or contemplated by this Agreement;

(b) except for the issuance of Shares upon the exercise of Company Stock Options or Warrants outstanding as of the date of this Agreement in accordance with their terms or the conversion of its currently outstanding Preferred Stock, and the Additional Options to the extent directed by Parent, issue, sell, pledge, dispose of, grant, encumber, or authorize the issuance, sale, pledge, disposition, grant or encumbrance of, (i) any shares of its capital stock of any class, or any options, warrants, convertible securities or other rights of any kind to acquire any shares of such capital stock, or any other ownership interest (including, without limitation, any phantom interest), of the Company or the Company Subsidiary, or (ii) any material assets of the Company or the Company Subsidiary;

(c) declare, set aside, make or pay any dividend or other distribution, payable in cash, stock, property or otherwise, with respect to any of its capital stock other than dividends and other distributions paid by the Company Subsidiary to the Company or by the Company to the Company Subsidiary;

(d) reclassify, combine, split, subdivide or redeem, purchase, repurchase or otherwise acquire, directly or indirectly, any of its capital stock;

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(e) (i) acquire (including, without limitation, by merger, consolidation, or acquisition of stock or assets) any interest in any corporation, partnership, other business organization or any division thereof or any assets;

(ii) incur any indebtedness for borrowed money or issue any debt securities or assume, guarantee or endorse, or otherwise as an accommodation become responsible for, the obligations of any person, or make any loans or advances;

(iii) authorize or enter into any agreements or commitments with respect to capital expenditures which are, in the aggregate, in excess of $50,000;

(iv) hire, employ, contract or enter into any agreement with any new employees or independent contractors;

(v) shorten or lengthen the customary payment terms or other terms of any contracts with customers;

(vi) collect receivables owed from third parties, other than in the ordinary course of business consistent with past practice;

(vii) provide discounts to customers other than in the ordinary course of business consistent with past practice;

(viii) permit any outstanding obligations to remain due for more than 30 days after the date of the applicable invoice other than in the ordinary course of business consistent with the terms of the appropriate invoices;

(ix) incur any other liabilities other than in the ordinary course of business, consistent with past practice;

(x) enter into or amend any contract, agreement, commitment or arrangement that, if fully performed, would not be permitted under this Section 6.01(e).

(f) except as may be required by law, increase the compensation payable or to become payable to its officers or employees, or grant any severance or termination pay to, or enter into or amend any employment or severance agreement with, any director, officer or other employee of the Company or the Company Subsidiary, whether such act is done orally or in writing or with immediate or prospective effect, or establish, adopt, enter into or amend any collective bargaining, bonus, profit sharing, thrift, compensation, stock option, restricted stock, pension, retirement, deferred compensation, employment, termination, severance or other plan, agreement, trust, fund, policy or arrangement for the benefit of any director, officer or employee, provided that, the Company may take the actions provided for in Section 6.11 and Section 6.13;

(g) enter into any licensing, distribution, sponsorship, advertising, merchant program or other similar contracts, agreements, or obligations, other than, except as set forth in Schedule 6.01(g), contracts and agreements with customers in the ordinary course of business consistent with past practice;

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(h) transfer or license to any person or entity or otherwise extend, amend or modify in any material respect any Intellectual Property Rights of the Company, other than such items as are done in the ordinary course of business consistent with past practice;

(i) (A) except as provided in Section 2.05, take any action to cause, or fail to take any material action to prevent, the accelerated vesting and exercisability of the Company Stock Options except as provided herein, by the terms of such Company Stock Options or the employment agreement or arrangements of the employee disclosed to Parent or (B) otherwise amend any Company Stock Option to reduce the exercise price thereof;

(j) take any action, other than actions in the ordinary course of business and consistent with past practice, with respect to accounting policies or procedures except for any such action required by a concurrent change in GAAP;

(k) merge or consolidate with any other Person;

(l) sell, lease, license or otherwise dispose of any material subsidiary or material amount of assets, securities or property except pursuant to existing contracts or commitments which have been disclosed to Parent;

(m) enter into any lease, contract or agreement with regard to real property other than (i) renewals of existing leases on a month to month basis on terms similar to such existing leases and (ii) new month to month leases for sales offices entered into in the ordinary course consistent with past practices;

(n) enter into any non-compete agreement or other material restriction on any of their respective businesses following the Effective Time;

(o) enter into any agreement or commitment the effect of which would be to grant to a third party following the Merger any actual or potential right of license of any Intellectual Property Rights owned by the Company or the Company Subsidiary other than end-user customer contracts in the ordinary course of business;

(p) permit any insurance policy naming it as a beneficiary or a loss payee to be cancelled or terminated unless such insurance policy is replaced with a substantially equivalent policy;

(q) take any action that would reasonably be expected to make any representation and warranty of the Company hereunder inaccurate in any material respect at, or as of any time prior to, the Effective Time or omit to take any action reasonably expected to be necessary to prevent any such representation or warranty from being inaccurate in any material respect at any such time;

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(r) file any applications, notices or other documents with any governmental body which will adversely affect any of the Company’s or the Company Subsidiary’s approvals, authorizations, permits or statuses, including without limitation, the Grants from the Chief Scientist and the “Approved Enterprise” status; and

(s) agree or commit to do any of the foregoing.

Section 6.02. Stockholder Approval. (a) The Company shall use its best efforts to cause the Stockholders listed on Annex A to deliver the Stockholder Consents not later than 2 Business Days after the execution and delivery of this Agreement by the parties hereto.

(b) Notwithstanding the execution and delivery of the Stockholder Consents, the Company shall use commercially reasonable efforts to obtain the written consent of each Stockholder that shall not have delivered a Stockholder Consent immediately after the execution and delivery of this Agreement. As promptly as practicable after the execution and delivery of this Agreement by each of the parties hereto, the Company shall prepare, with the cooperation and assistance of Parent, an information statement (the “Information Statement”) which shall be reasonably acceptable to Parent and shall include information about this Agreement, the Merger and the other transactions contemplated hereby. The Company shall cause the Information Statement to be mailed to all the Stockholders. The Company shall comply with the requirements of Section 262 of Delaware Law.

Section 6.03. No Solicitation; Other Offers. (a) Unless and until this Agreement will have been terminated pursuant to Article 11, neither the Company nor the Company Subsidiary shall, nor shall the Company or the Company Subsidiary authorize, and the Company and the Company Subsidiary shall use all reasonable efforts to prevent, any of its or their officers, directors, employees, investment bankers, attorneys, accountants, consultants or other agents or advisors to, directly or indirectly, (i) solicit, initiate or take any action to facilitate or encourage the submission of any Acquisition Proposal, (ii) enter into or participate in any discussions or negotiations with, furnish any non-public information relating to the Company or the Company Subsidiary (other than as to the existence of these provisions) or afford access to the business, properties, assets, books or records of the Company or the Company Subsidiary to, otherwise knowingly cooperate in any way with, or knowingly assist, participate in, facilitate or encourage any effort by any Third Party to make an Acquisition Proposal, or (iii) enter into any agreement with respect to an Acquisition Proposal. The Company shall not submit to the vote of its stockholders any Acquisition Proposal other than this Agreement, or propose to do so until after the termination of this Agreement. If the Company receives an unsolicited submission of an Acquisition Proposal and the Company is not in violation of this Section 6.03 with respect to the submission of such Acquisition Proposal, the Company may inform the Stockholders of such Acquisition Proposal.

(b) The Company shall, and shall cause the Company Subsidiary and the advisors, employees and other agents of the Company and the Company Subsidiary to, cease immediately and cause to be terminated any and all existing activities, discussions

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or negotiations, if any, with any Third Party conducted prior to the date hereof with respect to any Acquisition Proposal and shall use all commercially reasonable efforts to cause any such Party (or its agents or advisors) in possession of confidential information about the Company that was furnished by or on behalf of the Company to return or destroy all such information.

Section 6.04. Access to Information. From the date hereof until the Effective Time and subject to applicable law and the Mutual Nondisclosure Agreement dated as of May 7, 2002 between the Company and Parent (the “NDA”), the Company shall (i) give Parent, its counsel, financial advisors, auditors and other authorized representatives reasonable access (during normal business hours and upon reasonable notice) to the offices, properties, books, work papers, assets, contracts and records of the Company and the Company Subsidiary (including access to perform physical examinations), (ii) furnish to Parent, its counsel, financial advisors, auditors and other authorized representatives such financial and operating data created by the Company in the ordinary course of its business and other information as such Persons may reasonably request and (iii) instruct the employees, counsel, financial advisors, auditors and other authorized representatives of the Company and the Company Subsidiary to cooperate with Parent in its investigation of the Company and the Company Subsidiary. The Company agrees to provide to Parent and its accountants, counsel and other representatives copies of internal financial statements (including returns and supporting documentation), when available, upon request as promptly as practicable consistent with the Company’s past practice. Any investigation pursuant to this Section shall be conducted in such manner as not to interfere unreasonably with the conduct of the business of the Company and the Company Subsidiary. No information or Knowledge obtained by Parent in any investigation pursuant to this Section shall affect, limit or be deemed to modify any representation or warranty made by the Company hereunder.

Section 6.05. Tax Matters. (a) From the date hereof until the Effective Time, without the prior written consent of Parent, neither the Company nor the Company Subsidiary shall make or change any material Tax election, change any annual Tax accounting period, adopt or change any method of Tax accounting, file any material amended Return, enter into any closing agreement, settle any Tax claim, audit or assessment, surrender any right to claim a material Tax refund, offset or other reduction in Tax liability, consent to any extension or waiver of the limitations period applicable to any Tax claim or assessment or take or omit to take any other action, if any such action or omission would have the effect of materially increasing the Tax liability or materially reducing any Tax Asset of the Company, the Company Subsidiary, Parent or any Affiliate of Parent.

(b) The Company and the Company Subsidiary shall establish or cause to be established in accordance with GAAP on or before the Effective Time an adequate accrual for all Taxes due with respect to any Pre-Closing Tax Period.

(c) Except as otherwise provided herein, all transfer, documentary, sales, use, stamp, registration, value added and other such Taxes and fees (including any penalties and interest) incurred in connection with the Merger, including any real property transfer

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tax and any similar Tax (“Transfer Taxes”) shall be paid by the Company when due, and the Company shall, at its own expense, file all necessary Tax returns or other documentation with respect to all such Transfer Taxes.

Section 6.06. Notices of Certain Events. The Company shall promptly notify Parent of:

(a) any notice or other communication from any Person in writing alleging that the consent of such Person is or may be required in connection with the transactions contemplated by this Agreement;

(b) any notice or other communication from any governmental or regulatory agency or authority in connection with the transactions contemplated by this Agreement; and

(c) any actions, suits, claims, investigations or proceedings commenced or, to its Knowledge, threatened against, relating to or involving or otherwise affecting the Company or the Company Subsidiary that, if pending on the date of this Agreement, could have been required to have been disclosed pursuant to Section 4.12, Section 4.14, Section 4.15, Section 4.18 or Section 4.22, as the case may be, or that relate to the consummation of the transactions contemplated by this Agreement.

Section 6.07. Consents and Notices. (a) As promptly as practicable after the execution of this Agreement, the Company shall use all commercially reasonable efforts to deliver such notices and filings and to obtain such consents, waivers, assignments, authorizations and approvals as may be required from third parties and Governmental Authorities in connection with the transactions contemplated hereby, including without limitation, (a) filings with and approvals of (i) the Chief Scientist, (ii) the Investment Center, (iii) the Israeli Tax Authorities (the filings and approvals specified in items (i), (ii) and (iii) of this clause (a) collectively, the “Mandatory Approvals”) and (iv) assist in making all filings related to the Antitrust Authority; and (b) notices to all holders of Warrants with respect to the Merger and the transactions contemplated hereby, which notices shall specify that Warrants shall only be exercisable until immediately prior to the Effective Time in accordance with their terms.

(b) Qualified Option Plan. As promptly as practicable after the date hereof, the Company shall use its best efforts to obtain approval of the Israeli Tax Authorities for the qualification of the Company Stock Options held for the benefit of the Company Subsidiary’s employees to be assumed by Parent pursuant to this Agreement: (i) as options granted under the Capital Gain Route pursuant to the provisions of section 102 of the Ordinance and any regulations, rules, orders or procedures promulgated thereunder, including the Rules and (ii) as not creating any tax liability by virtue of such assumption.

Section 6.08. Company Cash Amount.

(a) No later than two Business Days prior to the date of Closing, the Company shall deliver to Parent a certificate of an officer of the Company setting forth the

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Company’s good faith estimate of the amount equal to the excess of (i) the Company Cash over (ii) the amount of Accrued Company Expenses (such excess, the “Estimated Company Cash Amount”). Such certificate shall be accompanied by appropriate information and documentation supporting the Company’s estimate and reasonably satisfactory to Parent and the Company shall provide reasonable access to all records in its possession which were used in the preparation of the Estimated Company Cash Amount in accordance with Section 6.04.

(b) No later than one Business Day prior to the date of Closing, Parent shall either (i) provide written notice to the Company of its acceptance of the Estimated Company Cash Amount (including the amount of Accrued Company Expenses), which amount shall thereupon become final and binding as the Final Company Cash Amount or (ii) provide written notice to the Company of its disagreement with the Estimated Company Cash Amount. If Parent has delivered a notice of disagreement in accordance with clause (ii) of the preceding sentence, Parent and the Company shall negotiate in good faith to agree upon a Final Company Cash Amount. Upon resolution of such disagreement, Parent and the Company shall agree in writing upon a Final Company Cash Amount (including the amount of Accrued Company Expenses). As used herein, the term “Final Company Cash Amount” means the Company Cash Amount as determined in accordance with the first or second sentence, as the case may be, of this Section 6.08(b).

Section 6.09. Excise Tax Matters. Prior to the Effective Time, the Company shall endeavor to obtain the approval of more than 75% of the voting power of disinterested Stockholders with respect to all potential 280G benefits that are or may be payable to any disqualified individual in connection with or as a result of the Merger.

Section 6.10. Capitalization Information. The Company shall deliver to Parent on a date that is two Business Days prior to the Effective Time a complete and accurate schedule as of such date certified by an officer of the Company that sets forth as of such date and as of the Effective Time, in each case, the following: (i) the Outstanding Series A Preferred, (ii) the Outstanding Series B Preferred, (iii) the Outstanding Common, (iv) the number of Company Stock Options (including Additional Options), (v) the average exercise price of the Company Stock Options (including Additional Options) and (vi) the name of the holder of each Company Stock Options (including Additional Options), the grant date and number of shares of Company Common Stock subject to such option, the exercise price of such option, and the date on which such option expires.

Section 6.11. Stock Options. (a) The Company agrees to grant, immediately prior to the Effective Time, Additional Options to employees of the Company on such terms and in such amounts as requested by Parent provided such grants comply with the Company Stock Plan. At the request of Parent, the Company shall have used its reasonable best efforts to cause the stockholders of the Company to amend the Company Stock Plan to increase the number of shares of Company Common Stock subject thereto by 36,000,000 shares.

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(b) The Company shall use its reasonable best efforts to cause each holder of Company Stock Options (to the extent such holder has not signed a release of the type described in this sentence prior to the date hereof), including Additional Options, to sign a release in form and substance satisfactory to Parent which release shall provide that such holder is not entitled to any equity interest in the Company or the Company Subsidiary other than such holder’s Company Stock Options.

Section 6.12. Allocation of Consideration. (a) Schedule 6.12(a) sets forth a complete and accurate list of each holder of Company Common Stock and Preferred Stock. Such schedule shall be updated immediately prior to Closing and shall at such time state the amount of cash payable to such holder pursuant to Sections 2.02(a), 2.02(b) and 2.02(c)

Section 6.13. Amendment of Stock Plan Agreements. (a) To the extent necessary, the Company shall take all necessary actions to provide that the Outstanding Options (other than the Additional Options) shall become fully vested as of the Effective Time.

(b) Prior to any grant of Additional Options pursuant to Section 6.11(a), the Company shall take any action necessary to provide that Additional Options shall not vest, have their vesting accelerated or otherwise become exercisable as a result of the Closing or the transactions contemplated by this Agreement (including upon any termination of employment).

ARTICLE 7

COVENANTS OF PARENT

Parent agrees that:

Section 7.01. Obligations of Merger Sub. Parent will take all action necessary to cause Merger Sub to perform its obligations under this Agreement and to consummate the Merger on the terms and conditions set forth in this Agreement.

Section 7.02. Benefits. (a) From and after the Effective Time, the Company’s employees who continue employment with Parent or its subsidiaries shall be provided with employee benefits that, in the aggregate, are substantially comparable to those provided to employees of Parent who are similarly situated.

Section 7.03. Indemnification. From and after the Effective Time, Parent will cause the Surviving Corporation to fulfill and honor in all respects the obligations of the Company pursuant to (i) each indemnification agreement between the Company and its directors or officers in effect immediately prior to the date hereof (the “Indemnified Parties”) and (ii) any indemnification provision under the Company Charter and bylaws as in effect on the date hereof. The certificate of incorporation and bylaws of the Surviving Corporation will contain provisions with respect to exculpation and indemnification that are at least as favorable to the Indemnified Parties as those contained

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in the Company Charter and bylaws as in effect on the date hereof, which provisions will not be amended, repealed or otherwise modified other than as provided in the Company Charter or bylaws in effect on the date hereof in any manner that would adversely affect the rights thereunder of any Indemnified Party or of individuals who, immediately prior to the Effective Time, were employees or agents of Company, unless such modification is required by law. The provisions of this Section 7.03 shall survive consummation of the Merger and are (i) intended to be for the benefit of, and will be enforceable by, each of the Indemnified Parties and (ii) in addition to, and not in substitution for, any other rights to indemnification or contribution that any such Indemnified Party may have by contract or otherwise.

Section 7.04. Form S-8. Parent agrees to take all corporate action necessary to reserve for issuance a sufficient number of shares of Parent Common Stock for delivery upon exercise of Company Stock Options assumed pursuant to Section 2.05. As soon as practicable, but in any event not later than 60 days after the Effective Time, Parent shall file with the SEC a registration statement on Form S-8 (or any other successor or other appropriate form), with respect to the shares of Parent Common Stock subject to such options and shall use its reasonable best efforts to maintain the effectiveness of such registration statement for so long as such options remain outstanding. Parent agrees to cause shares of Parent Common Stock to be issued upon exercise of Company Stock Options of the Company assumed by Parent to be authorized for listing on the national securities exchange on which the Parent Common Stock is listed. The provisions of this Section 7.04 shall survive consummation of the Merger and are (i) intended to be for the benefit of, and will be enforceable by, each of the employees of the Company and (ii) in addition to, and not in substitution for, any other rights that any such employee may have by contract or otherwise.

Section 7.05. Certain Filings. Parent and Merger Sub shall (i) make all filings reasonably required of Parent and Merger Sub in order to obtain the required approval from the Antitrust Authority, (ii) use all commercially reasonable efforts and take all such actions necessary to provide any documents required in order to obtain the approval of the Chief Scientist, and (iii) assist in making all the filings related to any other Mandatory Approval.

Section 7.06. Severance Cost Notification. No later than four Business Days after the date hereof, Parent shall deliver to the Company a certificate of an officer of Parent setting forth the names of the officers and employees of the Company or the Company Subsidiary that Parent intends to terminate effective immediately after the Effective Time. For the avoidance of doubt, the Company shall include all severance and related payments due such officers and employees in the “Accrued Company Expenses”.

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ARTICLE 8

COVENANTS OF PARENT AND THE COMPANY

The parties hereto agree that:

Section 8.01. Reasonable Efforts. Subject to the terms and conditions of this Agreement, Company and Parent will use all commercially reasonable efforts to take, or cause to be taken, all actions and to do, or cause to be done, all things necessary, proper or advisable under applicable laws and regulations to consummate the transactions contemplated hereby, to obtain all necessary waivers, consents and approvals, to effect all necessary registrations and filings and to remove any injunctions or other impediments or delays, legal or otherwise, in order to consummate and make effective the transactions contemplated by this Agreement for the purpose of securing to the parties hereto the benefits contemplated by this Agreement; provided, however, that Parent shall not be legally required to agree to any divestiture by Parent or any of Parent’s Subsidiaries or Affiliates or by the Company or the Company Subsidiary or Affiliates of shares of capital stock or of any business, assets or property of Parent or its Subsidiaries or Affiliates or of the Company or the Company Subsidiary or Affiliates, or the imposition of any material limitation on the ability of any of them to conduct their businesses or to own or exercise control of such assets, properties and stock.

Section 8.02. Certain Filings. The Company and Parent shall cooperate with one another (i) in determining whether any action by or in respect of, or filing with, any governmental body, agency, official, or authority is required, or any actions, consents, approvals or waivers are required to be obtained from parties to any material contracts, in connection with the consummation of the transactions contemplated by this Agreement and (ii) in using all commercially reasonable efforts to take such actions or make any such filings, furnishing information required in connection therewith and seeking timely to obtain any such actions, consents, approvals or waivers, including without limitation the filings required by Section 6.07.

Section 8.03. Public Announcements. Parent and the Company will consult with each other before issuing any press release or making any public statement with respect to this Agreement or the transactions contemplated hereby and, except as may be required by applicable law or any listing agreement with any national securities exchange, will not issue any such press release or make any such public statement prior to such consultation.

Section 8.04. Further Assurances. At and after the Effective Time, the officers and directors of the Surviving Corporation will be authorized to execute and deliver, in the name and on behalf of the Company or Merger Sub, any deeds, bills of sale, assignments or assurances and to take and do, in the name and on behalf of the Company or Merger Sub, any other actions and things to vest, perfect or confirm of record or otherwise in the Surviving Corporation any and all right, title and interest in, to and under any of the rights, properties or assets of the Company acquired or to be acquired by the Surviving Corporation as a result of, or in connection with, the Merger.

Section 8.05. Notification of Certain Matters. Each party shall give prompt notice to the other parties hereto of (i) the occurrence or non-occurrence of any event, the occurrence or non-occurrence of which is likely to cause any representation or warranty of such party contained in this Agreement to be untrue or inaccurate in any material respect at or prior to the Effective Time, (ii) any failure in any material respect of such party to comply with or satisfy in any material respect any covenant, condition or

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agreement to be complied with or satisfied by it hereunder, (iii) any notice or other communication from any Person alleging that the consent of such Person is or may be required in connection with the transactions contemplated by this Agreement, (iv) any notice or other communication from any governmental or regulatory agency or authority in connection with the transactions contemplated by this Agreement, and (v) any actions, suits, claims, investigations or proceedings commenced or, to its Knowledge threatened against, relating to or involving or otherwise affecting the Company or the Company Subsidiary that, if pending on the date of this Agreement, would have been required to have been disclosed pursuant to Section 4.12 or that relate to the consummation of the transactions contemplated by this Agreement; provided, however, that the delivery of any notice pursuant to this Section 8.05 shall not limit or otherwise affect any remedies available to the party receiving such notice; and provided further, however, that no disclosure by the Company pursuant to this Section 8.05 shall be deemed to amend or supplement any Schedule hereto or prevent or cure any misrepresentation, breach of warranty or breach of covenant.

ARTICLE 9

CONDITIONS TO THE MERGER

Section 9.01. Conditions to Obligations of Each Party. The obligations of each party to this Agreement to consummate the Merger are subject to the satisfaction at or prior to the Effective Time of the following conditions:

(a) This Agreement and the Merger shall have been approved and adopted by the Stockholders in accordance with Delaware Law and the Company Charter.

(b) No provision of any applicable law or regulation and no judgment, injunction, order or decree issued by any court or governmental body having competent jurisdiction shall prohibit the consummation of the Merger.

(c) All actions by or in respect of, or filings with, any governmental body, agency, official or authority, domestic, foreign or supranational, required to permit the consummation of the Merger shall have been taken, made or obtained.

(d) No claim, action, suit, arbitration, inquiry, proceeding or investigation by or before any United States, federal, state or local or any foreign government, governmental, regulatory or administrative authority, agency or commission or any court, tribunal or judicial or arbitral body (each, a “Governmental Authority”) shall have been threatened by, or commenced before, any Governmental Authority against either the Company or Parent, seeking to restrain or materially and adversely alter the transactions contemplated hereby which is reasonably likely to render it impossible or unlawful to consummate the transactions contemplated by this Agreement or which could reasonably be expected to have a Material Adverse Effect on the Company or Parent.

(e) There shall not be instituted or pending any action or proceeding (or any investigation or other inquiry that would reasonably be expected to result in such action

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or proceeding) before any Governmental Authority, or by any other Person, domestic, foreign or supranational, before any court or governmental authority or agency of competent jurisdiction, domestic, foreign or supranational, seeking to restrain, prohibit or otherwise interfere with the ownership or operation by Parent or any of its Subsidiaries of all or any material portion of the business or assets of the Company or the Company Subsidiary or of Parent or any of its Subsidiaries, or to compel Parent or any of its Subsidiaries or Affiliates to dispose of or hold separate all or any material portion of the business or assets of the Company or the Company Subsidiary, or of Parent or any of its Subsidiaries.

(f) Parent and the Company shall have agreed in writing upon the Final Company Cash Amount in accordance with Section 6.08(b).

Section 9.02. Conditions to the Obligations of Parent and Merger Sub. The obligations of Parent and Merger Sub to consummate the Merger are subject to the satisfaction of the following further conditions, any of which may be waived, in writing, exclusively by Parent:

(a) The representations and warranties of the Company and the Company Subsidiary set forth in this Agreement, disregarding all qualifications and exceptions contained therein relating to materiality or Material Adverse Effect or any similar standard or qualification, shall be true and correct at and as of the Mandatory Approvals Receipt Date as if made at and as of such date (except for representations and warranties which address matters only as of a specified date, which representations and warranties shall be true and correct with respect to the specified date), except where the failure of such representations and warranties to be true and correct would not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect on the Company or the Company Subsidiary. Parent and Merger Sub shall have received a certificate dated as of the Mandatory Approvals Receipt Date signed by the Chief Executive Officer and Chief Financial Officer of the Company to the foregoing effect.

(b) The Company shall have performed or complied in all material respects with all agreements and covenants required by this Agreement to be performed or complied with by it at or prior to the Effective Time. Parent and Merger Sub shall have received a certificate signed by the Chief Executive Officer and Chief Financial Officer of the Company to the foregoing effect.

(c) Parent shall have received opinions of Testa, Hurwitz & Thibeault, LLP and Meitar Liquornik Geva & Leshem Brandwein, counsel to the Company, dated the Effective Date in substantially the forms attached hereto as Exhibits E-1 and E-2, respectively.

(d) The Company or the Company Subsidiary, as the case may be, shall have received all consents, authorizations or approvals from the governmental agencies referred to in Section 4.03 and Section 6.07, in each case in form and substance reasonably satisfactory to Parent, and no such consent, authorization or approval shall have been revoked.

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(e) The Stockholder Consents shall have been executed and delivered by the Stockholders listed on Annex A hereto and shall be in full force and effect.

(f) Each of the Non-Competition and Non-Solicitation Agreements executed and delivered to Parent by the individuals listed on Annexes B-1 and B-2 on the date of this Agreement hereto shall be in full force and effect, and without any amendment thereto, immediately prior to the Effective Time.

(g) (i) At least 17 of the total number of employees of the Company Subsidiary as of the date hereof shall continue to be employed by the Company Subsidiary in their respective positions as of the date hereof, including without limitation, (A) each of the individuals listed on Annex B-2 hereto that are employed by the Company Subsidiary and (B) Tal Beno, and (ii) the individuals listed on Annex B-1 hereto employed by the Company shall continue to be employed by the Company in their respective positions as of the date hereof, and Parent shall have received a certificate signed by an officer of the Company to the foregoing effect.

(h) Parent shall have received certified certificates of incorporation and bylaws, and good standing certificates in respect of the Company and the Company Subsidiary and certified board resolutions in respect of the transactions contemplated hereby, all in form and substance reasonably satisfactory to Parent.

(i) The amendments to the Company’s certificate of incorporation as set forth in Schedule 4.01(b) shall have been filed with the Secretary of State of the State of Delaware and shall be in full force and effect.

(j) The Company shall have delivered a certification pursuant to Treasury Regulations Sections 1.897-2(h) and 1.1445-2(c), signed by the Company and dated not more than 30 days prior to the Effective Time to the effect that the Company is not nor has it been within 5 years of the date of the certification a “United States real property holding corporation” as defined in Section 897 of the Code.

(k) No Material Adverse Effect on the Company or the Company Subsidiary shall have occurred prior to the Mandatory Approvals Receipt Date and be continuing.

(l) The Company shall have taken all actions required by Section 6.13(a) and Section 6.13(b).

(m) Parent shall have received a certificate signed by the Chief Financial Officer of the Company setting forth the Estimated Company Cash Amount pursuant to Section 6.08.

(n) The Company shall have paid all Transaction Expenses. Parent shall have received a certificate signed by the Chief Financial Officer of the Company setting forth the Transaction Expenses incurred with respect to this Agreement and the transactions contemplated hereby. The Company and Company’s legal counsel, auditors, investment bankers and financial advisors shall have agreed to the amounts set forth in such

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certificate. Any additional Transaction Expenses exceeding the amounts set forth in such certificate shall be considered a Loss pursuant to Section 10.02 and shall be paid out of the Escrow Fund in accordance with the provisions set forth in Section 10.02; provided that such Transaction Expenses shall be recoverable from the first dollar and shall not be subject to the Basket Amount.

(o) The Company shall have obtained the written consent of Morgan Stanley & Co. Incorporated to the Merger pursuant to Section 18.5 of the Software License and Development Agreement entered into as of June 30, 2003 by and between the Company and Morgan Stanley & Co. Incorporated.

Section 9.03. Conditions to Obligations of the Company. The obligation of the Company to consummate the Merger is subject to the satisfaction of the following further conditions, any of which may be waived, in writing, exclusively by the Company:

(a) The representations and warranties of Parent and Merger Sub set forth in this Agreement, disregarding all qualifications and exceptions contained therein relating to materiality or Material Adverse Effect or any similar standard or qualification, shall be true and correct at and as of the Mandatory Approvals Receipt Date as if made at and as of such date, except where the failure of such representations and warranties to be true and correct would not, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect on Parent. The Company shall have received a certificate dated as of the Mandatory Approvals Receipt Date signed by a duly authorized officer of Parent to the foregoing effect.

(b) Parent and Merger Sub shall have performed or complied in all material respects with all agreements and covenants required by this Agreement to be performed or complied with by it on or prior to the Effective Time, and the Company shall have received a certificate with respect to the foregoing signed on behalf of Parent, with respect to the covenants of Parent, by a duly authorized officer of Parent and a certificate with respect to the foregoing signed on behalf of Merger Sub, with respect to the covenants of Merger Sub, by a duly authorized officer of Merger Sub.

ARTICLE 10

SURVIVAL OF REPRESENTATION AND WARRANTIES; INDEMNIFICATION

Section 10.01. Survival of Representation and Warranties. The Company’s and Company Subsidiary’s representations and warranties contained in this Agreement shall survive the Effective Time until the first anniversary of the Effective Time. If written notice of a claim has been given in accordance with Section 10.02(b) prior to the expiration of the applicable survival period of the representations and warranties by the party seeking indemnification to the party from whom indemnification is sought (which notice shall indicate with reasonable specificity the amount and nature of the claim and the representation on which it is based), then the relevant representations and warranties shall survive as to such claim until such claim has been finally resolved. All of Parent’s and Merger Sub’s representations and warranties contained herein or in any instrument

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delivered pursuant to this Agreement shall terminate at the Effective Time. Parent’s and Merger Sub’s covenants and agreements contained herein which are required to be performed after the Closing shall survive until the first anniversary of the Effective Time.

Section 10.02. Indemnification. (a) Subject to Section 10.02(g), Parent and its Affiliates (including, after the Effective Time, the Surviving Corporation and its Subsidiaries), officers, directors, employees, agents, successors and assigns (collectively, the “Parent Indemnified Parties”) shall be indemnified and held harmless by the Stockholders of the Company, severally and not jointly, but solely out of the Escrow Fund for (i) any and all liabilities (including, without limitation, Taxes resulting from a breach of the provisions of Section 4.14), losses, damages, claims, costs and expenses, interest, awards, assessments, settlements, judgments and penalties (including, without limitation, reasonable attorneys’ and consultants’ fees and expenses and including any such expenses incurred in connection with investigating, defending against or settling any such claims) (“Damages”) suffered or incurred by them, including, without limitation, in connection with any action brought or otherwise initiated by any of them arising out of or resulting from the breach of any representation or warranty made by the Company or the Company Subsidiary in this Agreement or a breach of covenant or agreement made or to be performed by the Company or the Company Subsidiary pursuant to this Agreement; (ii) any Tax of the Company or the Company Subsidiary described in clause (i) of the definition of Tax related to a Pre-Closing Tax Period; (iii) any Tax described in clause (ii) or (iii) of the definition of Tax; (iv) any Transfer Tax; (v) any Damages arising out of or incident to the imposition, assessment or assertion of any Tax described in clause (ii), (iii), or (iv) of this sentence; (vi) Accrued Company Expenses incurred by a Parent Indemnified Party in excess of the Accrued Company Expenses included in the Final Company Cash Amount pursuant to Section 6.08(b); (vii) one-half of any Damages arising out of, in connection with or relating to the agreements set forth on Schedule 10.02(a)(vii); and (viii) any Damages arising out of, in connection with or relating to the Company’s agreement with Discovery Health (PTY) Ltd. to the extent relating to the $149,892 received by the Company on or about April 30, 2004 in connection with such agreement (the items in clauses (i)-(viii) of this sentence, collectively, “Losses”); provided, that a Loss shall not include amounts actually received by the Company in respect of insurance. The aggregate amount of Losses for which the Parent Indemnified Parties may receive indemnification pursuant to this Agreement shall not exceed the amount of the Escrow Fund. For purposes of this Section 10.02, in the case of any Taxes that are imposed on a periodic basis and are payable for a Tax period that includes (but does not end on) the Effective Date, the portion of such Tax related to the portion of such Tax period ending on and including the Effective Date shall (x) in the case of any Taxes other than gross receipts, sales or use Taxes and Taxes based upon or related to income, be deemed to be the amount of such Tax for the entire Tax period multiplied by a fraction the numerator of which is the number of days in the Tax period ending on and including the Effective Date and the denominator of which is the number of days in the entire Tax period, and (y) in the case of any Tax based upon or related to income and any gross receipts, sales or use Tax, be deemed equal to the amount which would be payable if the relevant Tax period ended on and included the Effective Date. All determinations necessary to give effect to the allocation set forth in the foregoing clause (y) shall be made in a manner consistent with prior practice of the Company and the Company Subsidiary.

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(b) Any Parent Indemnified Party seeking indemnification from another party hereto (the “Indemnifying Party”) under this Section shall give the Escrow Agent and the Stockholders’ Representative written notice of any matter which such Parent Indemnified Party has determined has given rise to a right of indemnification under this Agreement promptly (but in no event later than 21 days, but subject to the proviso to this sentence) after the Parent Indemnified Party becomes aware of such matter and, prior to the expiration of the applicable representations and warranties as set forth in this Section 10.02, stating the amount of the Loss incurred or that is reasonably anticipated to incur, and method of computation thereof, containing a reference to the specific provisions of this Agreement in respect of which such right of indemnification is claimed or arises and specifying in reasonable detail the individual items of such Loss and the nature of the claim to which such Loss relates; provided that the failure to give such notice shall not in any way affect the indemnification obligations set forth in this Article unless the Indemnifying Party is materially prejudiced by such failure.

(c) If (i) the Stockholders’ Representative shall not have objected to the amount claimed by the Parent Indemnified Party for indemnification from the Escrow Fund with respect to any Loss in accordance with the procedures set forth herein and in Section 6(d) of the Escrow Agreement or (ii) the Stockholders’ Representative and the Parent Indemnified Party shall have, subsequent to the giving of such notice and prior to the expiration of the period set forth in Section 6(d) of the Escrow Agreement, mutually agreed that the Parent Indemnified Party is entitled to indemnification from the Escrow Fund for a specified amount and shall have so jointly notified the Escrow Agent and the Escrow Agent shall have received joint written instructions from the Stockholders’ Representative and the Parent Indemnified Party, the Escrow Agent shall deliver to the Parent Indemnified Party funds from the Escrow Fund in respect of any amount determined to be owed to the Parent Indemnified Party under this Section in accordance with the Escrow Agreement.

(d) If the Stockholders’ Representative delivers notice of its disagreement as to the indemnification requested by the Parent Indemnified Party from the Escrow Fund (a “Contested Claim”), then such Contested Claim will be resolved by either (i) a written settlement agreement executed by Parent and the Stockholders’ Representative and provided to the Escrow Agent or (ii) in the absence of such a written settlement agreement within 30 days of such notice of disagreement, by binding arbitration between the Stockholders’ Representative and Parent in accordance with the terms and provisions of this Section 10.02(d).

(e) Parent and Company agree that any Contested Claim will be submitted to mandatory, final and binding arbitration before J.A.M.S./ENDISPUTE or its successor (“J.A.M.S.”), pursuant to the United States Arbitration Act, 9 U.S.C., Section 1 et seq. and that any such arbitration will be conducted in Santa Clara County, California. Either Parent or the Stockholders’ Representative may commence the arbitration process called for by this Agreement by filing a written demand for arbitration with J.A.M.S. and giving

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a copy of such demand to each of the other parties to this Agreement. The arbitration will be conducted in accordance with the provisions of J.A.M.S.’ Streamlined Arbitration Rules and Procedures in effect at the time of filing of the demand for arbitration, subject to the provisions of this Section 10.02(e). The parties will cooperate with J.A.M.S. and with each other in promptly selecting an arbitrator from J.A.M.S.’s panel of neutrals, and in scheduling the arbitration proceedings in order to fulfill the provisions, purposes and intent of this Agreement. The parties covenant that they will participate in the arbitration in good faith, and that they will share in its costs in accordance with subparagraph (i) below. The provisions of this Section 10.02(e) may be enforced by any court of competent jurisdiction, and the party seeking enforcement will be entitled to an award of all costs, fees and expenses, including attorneys’ fees, to be paid by the party against whom enforcement is ordered. Judgment upon the award rendered by the arbitrator may be entered in any court having competent jurisdiction.

(i) Parent on the one hand, and the Stockholders (through the Stockholders’ Representative), on the other hand, will bear the expense of deposits and advances required by the arbitrator in equal proportions, but either party may advance such amounts, subject to recovery as an addition or offset to any award. The arbitrator will determine the party who is the prevailing party and the party who is the non-prevailing party. The non-prevailing party will pay all reasonable costs, fees and expenses related to the arbitration, including reasonable fees and expenses of attorneys, accountants and other professionals incurred by the prevailing party, the fees of each arbitrator and the administrative fee of the arbitration proceedings. If such an award would result in manifest injustice, however, the arbitrator may apportion such costs, fees and expenses between the parties in such manner as the arbitrator deems just and equitable.

(ii) Except as may be otherwise expressly provided herein, for any Contested Claim submitted to arbitration, the burden of proof will be as it would be if the claim were litigated in a judicial proceeding governed by Delaware law exclusively.

(iii) Upon the conclusion of any arbitration proceedings hereunder, the arbitrator will render findings of fact and conclusions of law and a final written arbitration award (which with respect to monetary compensation for damages (other than with respect to costs as set forth in clause (i)) shall not exceed the amount of the claim) setting forth the basis and reasons for any decision reached (the “Final Award”) and will deliver such documents to the Stockholders’ Representative and Parent, together with a signed copy of the Final Award. The Final Award will constitute a conclusive determination of all issues in question, binding upon the Stockholders, the Stockholders’ Representative and Parent, and will include an affirmative statement to such effect.

(iv) The Stockholders’ Representative, Parent and the arbitrator will conclude each arbitration hereunder as promptly as possible for the Contested Claim being arbitrated.

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(v) The arbitrator chosen in accordance with these provisions will not have the power to alter, amend or otherwise affect the terms of these arbitration provisions or the provisions of this Agreement.

(f) In all matters relating to this Section, the Stockholders’ Representative shall be the only party entitled to assert the rights of the Stockholders, and the Stockholders’ Representative shall perform all of the obligations of the Stockholders hereunder. Parent shall be entitled to rely on all statements, representations and decisions of the Stockholders’ Representative.

(g) Notwithstanding anything else in this Agreement to the contrary, the Indemnified Parties shall not be entitled to recover under this Section with respect to any breach of representations and warranties, unless the aggregate amount of Losses arising out of all such breaches of representations and warranties exceeds $150,000 (the “Basket Amount”), at which time the Indemnified Parties shall be entitled to recover from the Escrow Account the full amount of all such Losses without regard to the limitations set forth in this Section 10.02(g); provided that any Losses arising out of the breach of any representation or warranty contained in Section 4.02, Section 4.05, Section 4.06, or Section 4.13 shall be recoverable from the first dollar and shall not be subject to the Basket Amount.

(h) The indemnification and dispute resolution procedures provided by this Article (including with respect to arbitration of Contested Claims) shall be the sole and exclusive remedy available to Parent and its Affiliates after the Effective Time for any claim related to this Agreement or the transactions contemplated hereby, except with respect to claims arising out of fraud, criminal activity or knowing misrepresentation by a party hereto.

Section 10.03. Defense of Claims. In connection with any claim giving rise to indemnity hereunder resulting from or arising out of any claim or legal proceeding by a third party, Parent shall give the Stockholders’ Representative prompt notice of such claim and the Stockholders’ Representative on behalf of the Indemnifying Party at its cost and expense (the sole source of satisfaction of such cost and expense shall be the Escrow Account pursuant to the terms of the Escrow Agreement) and with counsel reasonably satisfactory to the Parent Indemnified Party may, upon written notice to the Parent Indemnified Party, assume the defense of any such claim or legal proceeding if (i) the Escrow Account is comprised of sufficient financial resources to defend against such third-party claim and fulfill the Parent Indemnified Party’s highest reasonably likely Losses with respect to such claim or legal proceeding, (ii) the third-party claim does not seek an injunction or other equitable relief against or adversely affecting a Parent Indemnified Party, (iii) the Indemnifying Party acknowledges in writing its obligation to indemnify the Parent Indemnified Party against any Losses that may result from the third-party claim (subject to the sufficiency of the funds in the Escrow Account), and (iv) the Indemnifying Party agrees in writing not to settle such claim or proceeding without the prior written consent of the Parent Indemnified Party, which consent shall not be unreasonably withheld. If the Stockholders’ Representative so assumes, the Parent Indemnified Party shall be entitled to participate in (but not control) the defense of any

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such action, with its counsel at its own expense; provided, however, that if there are one or more legal defenses available to the Parent Indemnified Party that conflict with those available to the Indemnifying Party, or the Indemnifying Party fails to take reasonable steps necessary to defend diligently the claim after receiving written notice from the Parent Indemnified Party that it reasonably believes that the Indemnifying Party has failed to do so, the Parent Indemnified Party may assume the defense of such claim; and provided, further, that the Parent Indemnified Party may not settle such claim without the prior written consent of the Indemnifying Party, which consent may not be unreasonably withheld. If the Parent Indemnified Party assumes the defense of the claim, the Parent Indemnified Party shall be reimbursed out of the Escrow Account pursuant to the terms of the Escrow Agreement on a quarterly basis, provided a notice of such claim is first provided and resolved in accordance with Section 10.02, for reasonable fees and expenses of counsel retained by the Parent Indemnified Party and the Indemnifying Party shall be entitled to participate in (but not control) the defense of such claim, with its counsel at its own expense; provided, however, that the Parent Indemnified Party shall not be reimbursed for fees and expenses of more than one separate firm. If the Indemnifying Party thereafter seeks to question the manner in which the Parent Indemnified Party defended such third party claim or the amount or nature of any such settlement, the Indemnifying Party shall have the burden to prove, by a preponderance of the evidence, that the Parent Indemnified Party did not defend or settle such third-party claim in a reasonably prudent manner. The parties agree to render, without compensation, to each other such assistance as they may reasonably require of each other and to cooperate in good faith with each other, including providing such documents and records as may be pertinent and the time and attention of such personnel as may reasonably be necessary, in order to ensure the proper and adequate defense of any action, suit or proceeding, whether or not subject to indemnification hereunder.

Section 10.04. Stockholders’ Representative. By virtue of their approval of the Merger, the Stockholders shall have appointed the Stockholders’ Representative as representative of the Stockholders and as the attorney-in-fact and agent for and on behalf of each Stockholder with respect to claims for Losses under Article 10. The Stockholders’ Representative will take any and all actions and make any decisions required or permitted to be taken by the Stockholders’ Representative under this Agreement and the Stockholders’ Representative Agreement in compliance with the Stockholders’ Representative Agreement, including the exercise of the power to: (a) agree to, negotiate, enter into settlements and compromises of, demand arbitration of, and comply with orders of courts and awards of arbitrators with respect to, such claims for Losses; (b) arbitrate, resolve, settle or compromise any Contested Claim made pursuant to Article 10; and (c) take all actions necessary in the judgment of the Stockholders’ Representative for the accomplishment of the foregoing. The Stockholders’ Representative will have authority and power to act on behalf of each Stockholder with respect to the disposition, settlement or other handling of all claims for Losses under Article 10 and all rights or obligations arising under Article 10. In performing the functions specified in this Agreement, the Stockholders’ Representative will not be liable to any Stockholder in the absence of willful misconduct, to the extent permitted by applicable law, on the part of the Stockholders’ Representative. The Stockholders will

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severally, but not jointly, on a pro rata basis, indemnify the Stockholders’ Representative and hold him harmless against any loss, liability or expense incurred without willful misconduct, to the extent permitted by applicable law, on the part of the Stockholders’ Representative and arising out of or in connection with the acceptance or administration of his duties hereunder. If the Stockholders’ Representative shall die, become disabled or otherwise be unable to fulfill his responsibilities as representative of the Stockholders, then the Stockholders shall, within ten days after such death or disability, appoint a successor representative and, promptly thereafter, shall notify Parent and the Escrow Agent of such successor. The Stockholders’ Representative shall have the right to recover from the Escrow Fund, prior to any distribution to the Stockholders, an amount equal to any reasonable fees, costs and expenses in connection with the acceptance and administration of the Stockholders’ Representative duties hereunder.

ARTICLE 11

TERMINATION

Section 11.01. Termination. This Agreement may be terminated and the Merger may be abandoned at any time prior to the Effective Time (notwithstanding any approval of this Agreement by the Stockholders of the Company):

(a) by mutual written agreement of the Company and Parent;

(b) by either the Company or Parent, if:

(i) there shall be any law or regulation that makes acceptance for payment of, and payment for, the Shares pursuant to the Merger illegal or otherwise prohibited or any judgment, injunction, order or decree of any court or governmental body having competent jurisdiction enjoining Merger Sub, Company or Parent from consummating the Merger and such judgment, injunction, order or decree shall have become final and nonappealable; or

(ii) the Closing has not occurred by 5:00 P.M., California time, on the date that is 120 days from the date hereof (the “End Date”), or such later date as the Company and Parent may agree, provided, however, that the right to terminate this Agreement under Section 11.01(b)(ii) shall not be available to any party whose breach of any provision of this Agreement results in the failure of the Merger to be consummated by such time.

(c) by Parent, if (i) the Stockholder Consents are not properly executed and delivered by the parties listed on Annex A within 2 Business Days of the execution and delivery of this Agreement by the parties hereto or (ii) if any such Stockholder Consent is revoked prior to the Effective Time;

(d) by Parent, if (i) a breach of or failure to perform any representation, warranty, covenant or agreement on the part of the Company set forth in this Agreement shall have occurred that would cause the condition set forth in Section 9.02(a) or (c) not

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to be satisfied, and such condition is incapable of being satisfied by the End Date, or (ii) the Company shall have willfully and materially breached its obligations under Sections 6.02(b) or 6.03;

(e) by the Company, if a breach of or failure to perform any representation, warranty, covenant or agreement on the part of the Parent or Merger Sub set forth in this Agreement shall have occurred that would cause the conditions set forth in Sections 9.03(a) or 9.03(b) not to be satisfied, and such condition is incapable of being satisfied by the End Date;

The party desiring to terminate this Agreement pursuant to this Section 11.01 shall give notice of such termination to the other party.

Section 11.02. Effect of Termination. If this Agreement is terminated pursuant to Section 11.01, this Agreement shall become void and of no effect with no liability on the part of any party (or any stockholder, director, officer, employee, agent, consultant or representative of such party) to the other party hereto, provided that, if such termination shall result from the willful failure of either party to perform a covenant hereof, such party shall be fully liable for any and all liabilities and damages incurred or suffered by the other party as a result of such failure. The provisions of Section 8.03, Section 12.03, Section 12.05, Section 12.06 and Section 12.07 shall survive any termination hereof pursuant to Section 11.01.

ARTICLE 12

MISCELLANEOUS

Section 12.01. Notices. All notices, requests and other communications to any party hereunder shall be in writing (including facsimile transmission) and shall be given or made (and shall deemed to have been duly given or made upon receipt) by delivery in person, by cable, telecopy, facsimile, telegram, telex or courier or by registered or certified mail (postage prepaid, return receipt requested) to the respective parties at the following addresses (or at such other address for a party as shall be specified in a notice given in accordance with this Section 12.01):

if to Parent or Merger Sub, to:

Susan J. Skaer

Vice President, General Counsel & Secretary

Mercury Interactive Corporation

379 North Whisman Road

Mountain View, CA 94043

Fax: 650-584-3572

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with a copy to:

Francis S. Currie

Davis Polk & Wardwell

1600 El Camino Real

Menlo Park, California 94025

Fax: 650-752-2114

if to the Company or the Company Subsidiary, to:

Appilog, Inc.

90 William Street

Suite 703

New York, NY 10038

Phone: 212 - 269-2345

Fax: 212- 269-2656

Attn: Irwin Wallach

with a copy to:

Testa, Hurwitz & Thibeault, LLP

125 High Street

Boston, MA 02110

Telephone No.: (617) 248-7000

Facsimile No.: (617) 248-7100

Attention: Howard S. Rosenblum

or such other address or facsimile number as such party may hereafter specify for the purpose by notice to the other parties hereto. All such notices, requests and other communications shall be deemed received on the date of receipt by the recipient thereof if received prior to 5 p.m. in the place of receipt and such day is a Business Day in the place of receipt. Otherwise, any such notice, request or communication shall be deemed not to have been received until the next succeeding Business Day in the place of receipt.

Section 12.02. Amendments; No Waivers. (a) Any provision of this Agreement may be amended or waived prior to the Effective Time if, but only if, such amendment or waiver is in writing and is signed, in the case of an amendment, by each party to this Agreement or, in the case of a waiver, by each party against whom the waiver is to be effective, provided that, after the adoption of this Agreement by the Stockholders of the Company and without their further approval, no such amendment or waiver shall reduce the amount or change the kind of consideration to be received in exchange for the Shares.

(b) No failure or delay by any party in exercising any right, power or privilege hereunder shall operate as a waiver thereof nor shall any single or partial exercise thereof preclude any other or further exercise thereof or the exercise of any other right, power or privilege. The rights and remedies herein provided shall be cumulative and not exclusive of any rights or remedies provided by law.

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Section 12.03. Expenses. All costs and expenses incurred in connection with this Agreement shall be paid by the party incurring such cost or expense.

Section 12.04. Successors and Assigns. The provisions of this Agreement shall be binding upon and, except as provided in Section 7.03 and Section 7.04, inure to the benefit of the parties hereto and their respective successors and assigns, provided that no party may assign, delegate or otherwise transfer any of its rights or obligations under this Agreement without the consent of each other party hereto, except that Parent or Merger Sub may transfer or assign, in whole or from time to time in part, to one or more of their Affiliates, the right to enter into the transactions contemplated by this Agreement, but any such transfer or assignment will not relieve Parent or Merger Sub of its obligations hereunder.

Section 12.05. Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of Delaware, without regard to the conflicts of law rules of such state.

Section 12.06. Jurisdiction. Any suit, action or proceeding seeking to enforce any provision of, or based on any matter arising out of or in connection with, this Agreement or the transactions contemplated hereby may be brought in any federal court located in the Northern District of the State of California or any California state court located in Santa Clara County, and each of the parties hereby consents to the jurisdiction of such courts (and of the appropriate appellate courts therefrom) in any such suit, action or proceeding and irrevocably waives, to the fullest extent permitted by law, any objection that it may now or hereafter have to the laying of the venue of any such suit, action or proceeding in any such court or that any such suit, action or proceeding brought in any such court has been brought in an inconvenient form. Process in any such suit, action or proceeding may be served on any party anywhere in the world, whether within or without the jurisdiction of any such court. Without limiting the foregoing, each party agrees that service of process on such party as provided in Section 12.01 shall be deemed effective service of process on such party.

Section 12.07. WAIVER OF JURY TRIAL. EACH OF THE PARTIES HERETO HEREBY IRREVOCABLY WAIVES ANY AND ALL RIGHT TO TRIAL BY JURY IN ANY LEGAL PROCEEDING ARISING OUT OF OR RELATED TO THIS AGREEMENT OR THE TRANSACTIONS CONTEMPLATED HEREBY.

Section 12.08. Counterparts; Effectiveness; Benefit. This Agreement may be signed in any number of counterparts, each of which shall be an original, with the same effect as if the signatures thereto and hereto were upon the same instrument. This Agreement shall become effective when each party hereto shall have received counterparts hereof signed by all of the other parties hereto. No provision of this Agreement is intended to confer any rights, benefits, remedies, obligations, or liabilities hereunder upon any Person other than the parties hereto and their respective successors and assigns, except with respect to the Indemnified Parties under Section 7.03 and as provided under Section 7.04.

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Section 12.09. Entire Agreement. This Agreement, the NDA, each Non-Competition and Non-Solicitation Agreement and the Escrow Agreement constitute the entire agreement between the parties with respect to the subject matter of this Agreement and supersedes all prior agreements and understandings, both oral and written, between the parties with respect to the subject matter of this Agreement.

Section 12.10. Captions. The captions herein are included for convenience of reference only and shall be ignored in the construction or interpretation hereof.

Section 12.11. Severability. If any term, provision, covenant or restriction of this Agreement is held by a court of competent jurisdiction or other authority to be invalid, void, unenforceable, the remainder of the terms, provisions, covenants and restrictions of this Agreement shall remain in full force and effect and shall in no way be affected, impaired or invalidated so long as the economic or legal substance of the transactions contemplated hereby is not affected in any manner materially adverse to any party. Upon such a determination, the parties shall negotiate in good faith to modify this Agreement so as to effect the original intent of the parties as closely as possible in an acceptable manner in order that the transactions contemplated hereby be consummated as originally contemplated to the fullest extent possible.

Section 12.12. Specific Performance. The parties hereto agree that irreparable damage would occur if any provision of this Agreement were not performed in accordance with the terms hereof and that the parties shall be entitled to an injunction or injunctions to prevent breaches of this Agreement or to enforce specifically the performance of the terms and provisions hereof in any federal court located in the Northern District of the State of California or any California state court located in Santa Clara County, in addition to any other remedy to which they are entitled at law or in equity.

Section 12.13. No Implied Representation. Parent and the Company acknowledge that, except as expressly provided in Articles 4 and 5, none of the parties is making any representations or warranties of any kind, express or implied.

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IN WITNESS WHEREOF, the parties hereto have caused this Agreement and Plan of Merger to be duly executed by their respective authorized officers as of the day and year first above written.

APPILOG, INC.
By:	/s/ Irwin Wallach
Name:	Irwin Wallach
Title:	CEO

APPILOG LOGVIEW LTD.
By:	/s/ Irwin Wallach
Name:	Irwin Wallach
Title:	CEO

MERCURY INTERACTIVE CORPORATION
By:	/s/ Susan J. Skaer
Name:	Susan J. Skaer
Title:	Vice President, General Counsel & Secretary

ALASKA MERGER CORPORATION
By:	/s/ Susan J. Skaer
Name:	Susan J. Skaer
Title:	Vice President, General Counsel & Secretary

/s/ Amnon Shoham

Amnon Shoham, as STOCKHOLDERS’

REPRESENTATIVE

Annex A

List of Stockholders Executing Written Consents

1. Company Common Stock

Shmuel Assa

Delta Fund I, L.P.

Delta Fund I (Israel), L.P.

Gmulot Delta Fund, L.P.

Poalim Delta Fund, L.P.

Poalim Ventures Ltd.

Poalim Ventures I Ltd.

Poalim Ventures II Ltd.

2. Series A Preferred Stock

Delta Fund I, L.P.

Delta Fund I (Israel), L.P.

Gmulot Delta Fund, L.P.

Poalim Delta Fund, L.P.

Poalim Ventures Ltd.

Poalim Ventures I Ltd.

Poalim Ventures II Ltd.

3. Series B Preferred Stock

Delta Fund I, L.P.

Delta Fund I (Israel), L.P.

Gmulot Delta Fund, L.P.

Poalim Delta Fund, L.P.

Poalim Ventures Ltd.

Poalim Ventures I Ltd.

Poalim Ventures II Ltd.

Cedar Fund II L.P.

Cedar Fund II A L.P.

Cedar Fund II B L.P.

Genesis Partners II LDC

Genesis Partners II

(Israel) LP

Annex B-1

List of U.S. Persons executing Non-Competition and Non-Solicitation Agreement

Muli Assa

John Beischer

Ronen Rischler

Irwin Wallach

Annex B-2

List of Israeli Persons executing Non-Competition and Non-Solicitation Agreement

Israel David

EX-2.2

Exhibit 2.2

AMENDMENT NO. 1 TO THE AGREEMENT AND PLAN OF MERGER

This AMENDMENT NO. 1 dated as of June 24, 2004 (the “Amendment”) to the Agreement and Plan of Merger dated as of May 12, 2004 (the “Merger Agreement”) among Appilog, Inc. (the “Company”), Appilog Logview Ltd., registered with the Israeli Registrar of Companies as Number 51-304272-1 and a wholly-owned subsidiary of the Company (the “Company Subsidiary”), Mercury Interactive Corporation, a Delaware corporation (“Parent”), Alaska Merger Corporation, a Delaware corporation and wholly-owned subsidiary of Parent (“Merger Sub”) and Amnon Shoham as the stockholders’ representative (the “Stockholders’ Representative”).

WHEREAS, the Company, the Company Subsidiary, Parent, Merger Sub and the Stockholders’ Representative wish to amend certain sections of the Merger Agreement as provided below;

NOW, THEREFORE, in consideration of the premises and the agreements herein contained, and intending to be legally bound hereby, the parties hereby agree as follows:

1. Amendment of Merger Agreement.

1.01 The definition of “Accrued Company Expenses” in Section 1.01(a) of the Merger Agreement is hereby amended by deleting such definition in its entirety and replacing it with the following:

“Accrued Company Expenses” means, as of the date of Closing, the sum of (i) the amount of fees and expenses (including, without limitation, legal, accounting, investment banking, finders and advisory fees and expenses), employee bonuses and related expenses (including an aggregate of $500,000 to be granted, immediately prior to the Closing, to certain employees in the form of a cash bonus, whether or not such bonus is paid prior to the Closing), severance payments and any other expenses, in each case, incurred by the Company in connection with this Agreement and the transactions contemplated hereby but not paid as of such date; provided that, to the extent the aggregate fees and expenses owed to Broadview International LLC in connection with this Agreement and the transactions contemplated hereby are less than the amount of fees and expenses that would be owed pursuant to the terms of the Letter Agreement dated December 19, 2003 between Broadview International LLC and the Company, one-half of the amount of such difference shall not be included in “Accrued Company Expenses”, (ii) the amount of any payables owed by the Company or the Company Subsidiary as of June 1, 2004 which, if paid in the ordinary course of business consistent with the terms of the appropriate invoices, would have been paid as of June 1, 2004, (iii) one-half of all amounts collected by the Company on or after the date of this Agreement, and (iv) the aggregate of all amounts payable by the Company in connection with any extension of any directors and officers liability insurance policy or the purchase of any such new policy for any director or officer of the Company.”

1.02 The definition of “Parent Average Price Per Share” in Section 1.01(a) of the Merger Agreement is hereby amended by deleting such definition in its entirety and replacing it with the following:

“Parent Average Price Per Share” means the closing price of the Parent Common Stock on May 10, 2004 (i.e., $43.42)”.

1.03 Pursuant to Section 6.01 of the Merger Agreement, Parent hereby consents to (a) the issuance by Appilog to its employees of an additional 265,068 fully-vested Company Stock Options, with and exercise price no less than $0.04 per share, and (b) the grant by Appilog, immediately prior to the Effective Time, of an aggregate of $500,000 in cash bonuses to certain of its employees.

1.04 Section 10.02 of the Merger Agreement is hereby amended as follows:

(a) Subsection 10.02(a)(viii) is hereby amended by deleting such subsection in its entirety and replacing it with the following:

“(viii) up to $250,000 of any Damages arising out of, in connection with or relating to the Company’s agreement with Discovery Health (PTY) Ltd. to the extent relating to any refund paid to Discovery in connection with such agreement (the items in clauses (i)-(viii) of this sentence, collectively, “Losses”)”

(b) Subsection 10.02(c) is hereby amended by adding the following proviso to the end of such subsection:

“; provided, that the Stockholders’ Representative shall in no event object to the amount claimed by the Parent Indemnified Party for indemnification from the Escrow Fund with respect to any Loss pursuant to Section 10.02(a)(viii); provided further, that the Escrow Agent shall deliver to the Parent Indemnified Party funds from the Escrow Fund in respect of any Loss pursuant to Section 10.02(a)(viii) without any notification from the Stockholders’ Representative.”

(c) Subsection 10.02(d) is hereby amended by adding the following proviso to the end of such subsection:

“; provided, that the Stockholders’ Representative shall in no event disagree as to the indemnification requested by the Parent Indemnified Party from the Escrow Fund with respect to any Loss pursuant to Section 10.02(a)(viii).”

(d) Subsection 10.02(g) is hereby amended by adding the following proviso to the end of such subsection:

“; provided further, that any Losses arising out the matters set forth in Section 10.02(a)(viii) shall be recoverable from the first dollar and shall not be subject to the Basket Amount; provided further, that any such Losses that are recoverable from the first dollar and not subject to the Basket Amount, shall likewise not be counted towards the calculation of the Basket Amount.”

1.05 Schedule 4.05(b)(i) of the Company Disclosure Schedule is hereby amended by deleting such Schedule in its entirety and replacing it with the Schedule attached hereto as Exhibit A, such amendment being intended to give effect to the grant of options approved hereunder and the re-allocation of certain previously granted options.

1.06 It is no longer the parties intention (and pursuant to the Company’s authority under Section 11(a) of the Company Stock Plan to adjust options even if such adjustment would disqualify such options’ status as ISOs) that the Company Stock Options assumed by Parent pursuant to Section 2.05 of the Merger Agreement shall qualify as incentive stock options, as defined in Section 422 of the Code, to the extent such Company Stock Options qualified as incentive stock options immediately prior to the Effective Time. The last sentence of Section 2.05(a) is hereby deleted.

1.07 Schedule 4.16 of the Company Disclosure Schedule is hereby amended by deleting such Schedule in its entirety and replacing it with the Schedule attached hereto as Exhibit B, such amendment being intended to correct a scrivener’s error.

2. Miscellaneous.

2.01 Effect. Except amended hereby, the Merger Agreement shall remain in full force and effect.

2.03 No Waiver. This Amendment is effective only in the specific instance and for the specific purpose for which it is executed and, except as specifically set forth herein, shall not be considered a waiver or agreement to amend as to any provision of the Merger Agreement (as amended) in the future.

2.04 Defined Terms. All capitalized terms used but not specifically defined herein shall have the same meanings given such terms in the Merger Agreement unless the context clearly indicates or dictates a contrary meaning.

2.05 Notices. All notices, requests, demands and other communications provided for in this Amendment shall be delivered in compliance with Section 12.01 of the Merger Agreement.

2.06 Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of Delaware, without regard to the conflicts of law rules of such state.

2.07 Counterparts. This Amendment may be executed in one or more counterparts, all of which shall be considered one and the same agreement.

2.08 Effectiveness. This Amendment shall become effective when (a) each party hereto shall have received a counterpart, or facsimile of a counterpart, of this Amendment, each signed by the other party or parties hereto or thereto and (b) upon the approval of the Company’s Stockholders pursuant to Section 12.02(a) of the Merger Agreement.

[REMAINDER OF PAGE INTENTIONALLY LEFT BLANK.]

IN WITNESS WHEREOF, the parties hereto have executed this Amendment No. 1 or have caused it to be executed by their respective officers thereunto duly authorized, as of the date first above written.

APPILOG, INC.
By:	/s/ Irwin Wallach
Name:	Irwin Wallach
Title:	CEO

APPILOG LOGVIEW LTD.
By:	/s/ Irwin Wallach
Name:	Irwin Wallach
Title:	CEO

MERCURY INTERACTIVE CORPORATION
By:	/s/ Susan J. Skaer
Name:	Susan J. Skaer
Title:	Vice President, General Counsel & Secretary

ALASKA MERGER CORPORATION
By:	/s/ Susan J. Skaer
Name:	Susan J. Skaer
Title:	Vice President, General Counsel & Secretary

/s/ Amnon Shoham

Amnon Shoham, as STOCKHOLDERS’

REPRESENTATIVE

Exhibit A

SCHEDULE 4.05(b)(i)

Stock Options Outstanding

Name	Number of Shares	Vesting Commencement Date	Exercise Price ($)	Tax Status	Date of Grant	Expiration Date
Israeli Employees
Almog Shoshi	12,000 3,000 26,783 35,010 15,933	January 1, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.001 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Argov Ori	6,000 3,285 21,966 6,362	June 17, 2001 November 23, 2003 Vested Vested	0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Atzmon Ester	12,000 5,000 67,727 43,750 26,158	June 10, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.04 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Benenson Pola	6,000 3,285 21,234 6,362	January 1, 2001 November 23, 2003 Vested Vested	0.001 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 May 10, 2014 June __. 2014
Beno Tal	18,000 7,000 127,045 52,012 41,993	April 10, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.001 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Binder Dikla	12,000 5,000 67,727 28,872 23,129	July 10, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.04 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Blitzer Yael	6,000 3,000 32,783 46,323 18,089	January 1, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.001 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Broner Tal	9,000 5,000 70,727 55,897 28,631	June 19, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.04 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Cohen Judy	17,410 1,459	November 30, 2003 Vested	0.04 0.04	Approved 102 CGO Approved 102 CGO	December 30, 2003 June __, 2004	December 30, 2013 June __, 2014
Cohen Nahum	15,000 3,000 66,727 46,263 27,041	January 1, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.001 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014

Name	Number of Shares	Vesting Commencement Date	Exercise Price ($)	Tax Status	Date of Grant	Expiration Date
David Israel	180,000 50,000 2,091,300 241,839	January 21, 2001 June 1, 2002 November 23, 2003 Vested	0.001 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014
David Israel	180,000 50,000	January 21, 2001 June 1, 2002	0.001 0.04	Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003	December 30, 2013 December 30, 2013
Haltovsky Ronit	12,000 5,000 215,130 31,250 50,737	May 15, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.04 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30,2013 December 30, 2013 May 10, 2014 June __, 2014
Kreiman Edward	32,498 5,208	December 28, 2003 Vested	0.04 0.04	Approved 102 CGO Approved 102 CGO	May 3, 2004 June __, 2004	May 3, 2014 June __, 2014
Mardiks Nir	12,000 114,511 31,439 32,159	October 1, 2002 November 23, 2003 Vested Vested	0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Orbach Doron	9,000 5,000 112,511 47,064 35,339	July 15, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.04 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Pelner Naama	18,000 7,000 101,511 59,301 38,175	June 10, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.01 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Perets Gabriel	12,000 5,000 109,511 14,351 28,977	January 1, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.001 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Rassin Dimitry	15,000 5,000 80,977 53,444 31,812	January 1, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.001 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Shalev Rina	17,410 13,841 6,362	August 28, 2002 Vested Vested	0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 May 10, 2014 June __, 2014
Shvets Michael	41,783 5,223 9,570	October 12, 2003 Vested Vested	0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 May 10, 2014 June __, 2014
Sorkin Denys	15,000 5,000 80,977 53,444 31,812	January 1, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.001 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Tsuberi Ilan	12,000 5,000 109,511 45,364 34,993	June 10, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.04 0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
Yellin Hava	84,727 1,216 17,499	September 1, 2003 Vested Vested	0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 May 10, 2014 June __, 2014
Zagoiry Sima	17,410 3,545	February 17, 2002 Vested	0.04 0.04	Approved 102 CGO Approved 102 CGO	December 30, 2003 June __, 2004	December 30, 2013 June __, 2014
Zidon Bnaya	41,783 14,886	February 22, 2004 Vested	0.04 0.04	Approved 102 CGO Approved 102 CGO	May 3, 2004 June __, 2004	May 3, 2014 June __, 2014
Zilberstein Michael	6,000	October 16, 2001	0.04	Approved 102 CGO	December 30, 2003	December 30, 2013

Name	Number of Shares	Vesting Commencement Date	Exercise Price ($)	Tax Status	Date of Grant	Expiration Date
Zilberstein Michael	6,000 11,410 13,841 6,362	October 16, 2001 November 23, 2003 Vested Vested	0.04 0.04 0.04 0.04	Approved 102 CGO Approved 102 CGO Approved 102 CGO Approved 102 CGO	December 30, 2003 December 30, 2003 May 10, 2004 June __, 2004	December 30, 2013 December 30, 2013 May 10, 2014 June __, 2014
US Employees and Subcontractors
Assa (Muli) Samuel	300,000 5,163,900 1,160,650 663,620	January 1, 2001 September 1, 2003 September 1, 2003 Vested	0.001 0.04 0.04 0.04	NQ ISO ISO NQ	February 16, 2004 February 16, 2004 February 16, 2004 May 10, 2004	February 16, 2014 February 16, 2014 February 16, 2014 May 10, 2014
Beischer John	206,000 2,115,300 403,638	June 1, 2003 November 23, 2003 Vested	0.04 0.04 0.04	ISO ISO NQ	March 1, 2004 March 1, 2004 May 10, 2004	March 1, 2014 March 1, 2014 May 10, 2014
Bloch Guy	32,498 4,062 276	October 1, 2003 Vested Vested	0.04 0.04 0.04	ISO NQ NQ	February 16, 2004 May 10, 2004 June __, 2004	February 16, 2014 May 10, 2014 June __, 2014
Carroll Juliana	25,750 90,315 877	March 18, 2002 November 23, 2003 Vested	0.04 0.04 0.04	ISO ISO NQ	February 16, 2004 February 16, 2004 June __, 2004	February 16, 2014 February 16, 2014 June __, 2014
Cohn David	25,750 90,315 877	August 15, 2002 November 23, 2003 Vested	0.04 0.04 0.04	ISO ISO NQ	February 16, 2004 February 16, 2004 June __, 2004	February 16, 2014 February 16, 2014 June __, 2014
Fischler Ronen	103,000 1,057,650 122,676	November 24, 2002 November 23, 2003 Vested	0.04 0.04 0.04	ISO ISO NQ	February 16, 2004 February 16, 2004 May 10, 2004	February 16, 2014 February 16, 2014 May 10, 2014
Ifhar Iftah	1,538,211 286,367	December 15, 2003 Vested	0.04 0.04	ISO NQ	March 1, 2004 May 10, 2004	March 1, 2014 May 10, 2014
Johnson Lu	25,750 75,227 43,872 29,491	June 1, 2002 November 23, 2003 Vested Vested	0.04 0.04 0.04 0.04	ISO ISO NQ NQ	February 16, 2004 February 16, 2004 May 10, 2004 June __, 2004	February 16, 2014 February 16, 2014 May 10, 2014 June __, 2014
King Kimberly	435,244 3,289	September 15, 2003 Vested	0.04 0.04	ISO NQ	February 16, 2004 June __, 2004	February 16, 2014 June __, 2014
Klevansky Daniel	12,000 3,000 26,783 66,129 22,269	January 1, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.001 0.04 0.04 0.04 0.04	NQ ISO ISO NQ NQ	February 16, 2004 February 16, 2004 February 16, 2004 May 10, 2004 June __, 2004	February 16, 2014 February 16, 2014 February 16, 2014 May 10, 2014 June __, 2014
Levine Josh	350,000 2,645	February 2, 2004 Vested	0,04 0.04	ISO NQ	February 16, 2004 June __, 2004	February 16, 2014 June __, 2014
Primus Aryeh	32,498 6,616	October 27, 2003 Vested	0.04 0.04	ISO NQ	February 16, 2004 June __, 2004	February 16, 2014 June __, 2014
Prinsky Josh	24,374 3,047 207	September 2, 2003 Vested Vested	0.04 0.04 0.04	ISO NQ NQ	February 16, 2004 May 10, 2004 June __, 2004	February 16, 2014 May 10, 2014 June __, 2014
Wallach Irwin	515,000 4,707,925 580,325 1,013,599	January 15, 2002 June 15, 2003 June 15, 2003 Vested	0.04 0.04 0.04 0.04	ISO ISO ISO NQ	March 1, 2004 March 1, 2004 March 1, 2004 May 10, 2004	March 1, 2014 March 1, 2014 March 1, 2014 May 10, 2014
Wang Ling	6,000 28,820 263	May 13, 2002 November 23, 2003 Vested	0.04 0.04 0.04	ISO ISO NQ	February 16, 2004 February 16, 2004 June __, 2004	February 16, 2014 February 16, 2014 June __, 2014
Ziv Shai	90,000 10,000 63,652 37,613 43,212	January 1, 2001 June 1, 2002 November 23, 2003 Vested Vested	0.001 0.04 0.04 0.04 0.04	NQ ISO ISO NQ NQ	February 16, 2004 February 16, 2004 February 16, 2004 May 10, 2004 June __, 2004	February 16, 2014 February 16, 2014 February 16, 2014 May 10, 2014 June __, 2014

Name	Number of Shares	Vesting Commencement Date	Exercise Price ($)	Tax Status	Date of Grant	Expiration Date
US Consultant
Doron Yehuda	839,024 6,340	February 19, 2004 Vested	0.04 0.04	NQ NQ	February 16, 2004 June __, 2004	February 16, 2014 June __, 2014

(A) See Schedule 4.05(a)(1) and (3).

(B) The Agreement requires that the Company grant certain options and accelerate the vesting of certain other options.

(C) On May 10, 2004, the Board of Directors of the Company amended the Company Stock Plan to increase the number of shares of Common Stock issuable thereunder from 32,162,592 to 68,162,592. This increase is contingent upon the stockholder approval and shall be effective immediately prior to the Effective Time.\

(D) On May 10, 2004, the Compensation Committee of the Board of Directors of the Company authorized the grant of certain non-qualified stock options and Section 102 stock options to certain employees of the Company and the Company Subsidiary as set forth in the table above.

(E) On June     , 2004, the Compensation Committee of the Board of Directors of the Company authorized (1) the amendment of certain non-qualified stock options and Section 102 stock options granted on May 10, 2004 and (2) the grant of certain non-qualified stock options and Section 102 stock options to certain employees of the Company and the Company Subsidiary. The table above reflects these amendments and grants.

Exhibit B

SCHEDULE 4.16

Real Property

	Date	The Lessor	Property	Aggregate Annual Rental Fees		Termination date	Renewal Provision	Comments
1.	March 30, 2004	Yehudit Pomerantz and/or Ofer Pomerantz	Offices in Israel	$	21,840	March 31, 2005	+
2.	May 14, 2001	Y.D. vehicle and transportation Ltd. (Europcar)	Cars Leasing Agreement	$	79,949	36 Months		13 cars.
3.	November 23, 2003	IBM	pSeries 615	$	1,656	24 Months	-	Not signed.
4.	August 2002	Re Systems Group, Inc. (Sub-Lease)	Office in the U.S.A	$	81,900	December 29, 2004
5.	(not dated)	Canon Business Solutions –Northeast, Inc.	Copy Machine	$	6,540	36 Months	+
6.	Lien Agreement in favor of IBM Israel Ltd. concerning the pSeries 615 server, dated December 28, 2003.

EX-3.1

Exhibit 3.1

CERTIFICATE OF AMENDMENT

OF

RESTATED CERTIFICATE OF INCORPORATION

Mercury Interactive Corporation, a corporation organized and existing under and by virtue of the General Corporation Law of the State of Delaware,

DOES HEREBY CERTIFY:

FIRST: That at a meeting of the Board of Directors of Mercury Interactive Corporation, resolutions were duly adopted setting forth a proposed amendment of the Restated Certificate of Incorporation of said corporation, declaring said amendment to be advisable and calling a meeting of the stockholders of said corporation for consideration thereof. The resolution setting forth the proposed amendment is as follows:

RESOLVED: That the Restated Certificate of Incorporation of this corporation be amended by changing the first paragraph of the Article thereof numbered III, so that, as amended, said first paragraph of said Article shall be and read as follows:

“This corporation is authorized to issue two classes of stock to be designated, respectively, “Common Stock” and “Preferred Stock”. The total number of shares which the Corporation is authorized to issue is Five Hundred Sixty Five Million (560,000,000) shares. Five Hundred Fifty-Five Million (555,000,000) shares shall be Common Stock and Five Million (5,000,000) shares shall be Preferred Stock, each with a par value of $.002 per share.”

SECOND: That thereafter, pursuant to resolution of its Board of Directors, a meeting of the stockholders of said corporation was duly called and held, upon notice in accordance with Section 222 of the General Corporation Law of the State of Delaware at which meeting the necessary number of shares as required by statute were voted in favor of the amendment.

THIRD: That said amendment was duly adopted in accordance with the provisions of Section 242 of the General Corporation Law of the State of Delaware.

IN WITNESS WHEREOF, Mercury Interactive Corporation has caused this certificate to be signed by Amnon Landan, its Chief Executive Officer, and Susan J. Skaer, its Secretary, this 19^th day of May, 2004.

By:	/s/ Amnon Landan
	Chief Executive Officer

Attest:	/s/ Susan J. Skaer
	Secretary

EX-3.2

Exhibit 3.2

CORRECTED CERTIFICATE OF

CERTIFICATE OF AMENDMENT OF

RESTATED CERTIFICATE OF INCORPORATION

1. Pursuant to Section 103 of the Delaware General Corporation Law, a Certificate of Amendment of Restated Certificate of Incorporation (the “Certificate”), of Mercury Interactive Corporation was filed with the Delaware Secretary of State on May 19, 2004.

2. The document as filed with the Delaware Secretary of State on May 19, 2004, incorrectly reflects the number of shares of Common Stock authorized to be issued as 555,000,000. The correct number of shares of Common Stock authorized to be issued is 560,000,000.

3. The Certificate in its corrected form is attached hereto as Exhibit A.

IN WITNESS WHEREOF, this Corrected Certificate is executed on behalf of Mercury Interactive Corporation by Susan J. Skaer, its Secretary, this 4^th day of June, 2004.

By:	/s/ Susan J. Skaer
	Susan J. Skaer
	Secretary

EXHIBIT A

CERTIFICATE OF AMENDMENT

OF

RESTATED CERTIFICATE OF INCORPORATION

Mercury Interactive Corporation, a corporation organized and existing under and by virtue of the General Corporation Law of the State of Delaware,

DOES HEREBY CERTIFY:

FIRST: That at a meeting of the Board of Directors of Mercury Interactive Corporation, resolutions were duly adopted setting forth a proposed amendment of the Restated Certificate of Incorporation of said corporation, declaring said amendment to be advisable and calling a meeting of the stockholders of said corporation for consideration thereof. The resolution setting forth the proposed amendment is as follows:

RESOLVED: That the Restated Certificate of Incorporation of this corporation be amended by changing the first paragraph of the Article thereof numbered III, so that, as amended, said first paragraph of said Article shall be and read as follows:

“This corporation is authorized to issue two classes of stock to be designated, respectively, “Common Stock” and “Preferred Stock”. The total number of shares which the Corporation is authorized to issue is Five Hundred Sixty Five Million (565,000,000) shares. Five Hundred Sixty Million (560,000,000) shares shall be Common Stock and Five Million (5,000,000) shares shall be Preferred Stock, each with a par value of $.002 per share.”

SECOND: That thereafter, pursuant to resolution of its Board of Directors, a meeting of the stockholders of said corporation was duly called and held, upon notice in accordance with Section 222 of the General Corporation Law of the State of Delaware at which meeting the necessary number of shares as required by statute were voted in favor of the amendment.

THIRD: That said amendment was duly adopted in accordance with the provisions of Section 242 of the General Corporation Law of the State of Delaware.

IN WITNESS WHEREOF, Mercury Interactive Corporation has caused this certificate to be signed by Amnon Landan, its Chief Executive Officer, and Susan J. Skaer, its Secretary, this 19^th day of May, 2004.

By:	/s/ Amnon Landan
	Chief Executive Officer

Attest:	/s/ Susan J. Skaer
	Secretary

EX-31.1

Exhibit 31.1

CERTIFICATION OF CEO PURSUANT TO SECURITIES EXCHANGE ACT

RULES 13A – 14 AND 15D – 14 AS ADOPTED

PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Amnon Landan, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Mercury Interactive Corporation;

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 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) Paragraph omitted pursuant to SEC Release Nos. 33-8238 and 34-47986;

c) 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

d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s 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 performing the equivalent functions):

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: August 9, 2004

/s/ Amnon Landan

Amnon Landan

President, Chief Executive Officer and Chairman of the Board

EX-31.2

Exhibit 31.2

CERTIFICATION OF CFO PURSUANT TO SECURITIES EXCHANGE ACT

RULES 13A – 14 AND 15D – 14 AS ADOPTED

PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Douglas P. Smith, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Mercury Interactive Corporation;

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 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) Paragraph omitted pursuant to SEC Release Nos. 33-8238 and 34-47986;

c) 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

d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s 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 performing the equivalent functions):

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: August 9, 2004

/s/ Douglas P. Smith

Douglas P. Smith

Executive Vice President and Chief Financial Officer

EX-32.1

Exhibit 32.1

CERTIFICATION OF CEO PURSUANT TO 18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

The certification set forth below is being submitted in connection with this quarterly report on Form 10-Q (the Report) for the purpose of complying with Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 (the Exchange Act) and Section 1350 of Chapter 63 of Title 18 of the United States Code.

I, Amnon Landan, the Chief Executive Officer of Mercury Interactive Corporation, certify that, to the best of my knowledge:

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

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

Date: August 9, 2004

/s/ Amnon Landan

Amnon Landan

President, Chief Executive Officer and Chairman of the Board

EX-32.2

Exhibit 32.2

CERTIFICATION OF CFO PURSUANT TO 18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

The certification set forth below is being submitted in connection with this quarterly report on Form 10-Q (the Report) for the purpose of complying with Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 (the Exchange Act) and Section 1350 of Chapter 63 of Title 18 of the United States Code.

I, Douglas P. Smith, the Chief Financial Officer of Mercury Interactive Corporation, certify that, to the best of my knowledge:

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

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

Date: August 9, 2004

/s/ Douglas P. Smith

Douglas P. Smith

Executive Vice President and Chief Financial Officer